Thursday, October 1, 2015

Trans-Atlantic opportunities in Energy and Healthcare

Sometimes it can be useful to step back from focusing on the specifics of a single market to think about the relative performance of sectors globally and how macro conditions affect each region. In a lot of cases, the relative performance of American and European sectors to their markets track each other closely and their divergence can yield insights about either opportunity or macro differences between economic blocs.

For example, here is a chart of the relative performance of financial stocks on both sides of the Atlantic. They are highly correlated and there are no special insights to be gained here.

An opportunity in European Energy
By contrast, a relative performance gap has opened up between US and European Energy stocks. European energy stocks have far underperformed US energy on a relative basis and they are sitting near all-time relative performance lows stretching back 18 years.

On a cap weighted basis, the characteristics of the European and US sectors are fairly similar. The European Energy sector is dominated by mostly megacap integrated companies, e.g. Royal Dutch, Total, etc., while smaller names include the likes of ENI and Repsol - all of which are well diversified integrateds. By contrast, the US has far higher higher beta exploration and oil service companies in its energy universe.

As oil prices have cratered, it makes no sense that European large cap integrated oils should underperform more than American ones, especially when you consider that the price of Brent has performed better in euros than USD.

This pricing gap suggests a couple of opportunistic trades:

  1. Buy European large cap energy and short US large cap integrated energy
  2. Buy a long Europe Energy/European market pair, while short US Energy/US market pair
Unfortunately, there are no US listed ETFs that American investors can readily get easy exposure to European energy stocks. The alternatives are either a European listed ETF (example here), or create a custom basket of US-listed European energy stocks, all of which have US listings.

Is the Healthcare sell-off overdone?
By contrast, there seems to be a different kind of opportunity in Healthcare. The chart below shows that Healthcare stocks (read: Big Pharma) have tracked each other fairly well across the Atlantic for many years. Undoubtedly that can be attributed to the fact that the pharmaceutical business is a global business and these companies sell their products worldwide.

What the chart does show is that while US Healthcare stocks have weakened significantly relative to the SPX recently, their European counterparts have held up quite well. It could be argued that the sell-off could be attributed to a Hillary Clinton comment on drug pricing. If that were true, then shouldn't European drug companies that sell into the American market suffer equally?

This relative performance anomaly is therefore suggestive a relative bargain in US Healthcare stocks.

What I find equally intriguing is that a review of the latest BoAML Fund Manager Survey shows that institutional managers have roughly the same levels of relative exposure to both Energy and Healthcare. When I combine the FMS results with the relative pricing anomalies, it suggests that there are Trans-Atlantic opportunities for traders in these two sectors.

If you found this post to be valuable, please help me decide on the future of Humble Student of the Markets by completing a simple two question survey. More details here.

Tuesday, September 29, 2015

Humble Student turns 8 in Nov, time to retire?

Almost eight years ago, I wrote my first post on Humble Student of the Markets. While others have blogged in support of other business activities, such as financial advisory or asset management, this blog has been a labor of love. Other than the occasional seasonal charitable appeal, I have not asked my readers for anything other than their feedback and financial camaraderie.

While I continue to enjoy sharing my thoughts about the markets, what was once a simple sideline has turned into a significant drain on my time. In particular, the weekend market commentaries with its many charts and multi-dimensional analysis of macro, fundamental, technical and geopolitical analysis is exhausting for what amounts to be a "hobby".

I now face a critical decision, either significantly scale back or stop writing, or turn Humble Student of the Markets into a members only pay-site. Blog posts will be available and free to the public two weeks after they are published, while members get immediate and unlimited full access.

Please help me with my decision by completing the simple two question survey below (if the survey doesn't work, please use this link). If you have any comments or questions, feel free to email me at cam at hbhinvestments dot com.

Past posts of interest
Here are a few key highlights of Humble Student of the Markets:

Weekly market comment: The weekly market is what gets read the most. The latest one is here.

Timely market calls
Phoenix rising? Buy low-priced stocks a week before the March bottom in 2009, many of which doubled or tripled within a year

Why I am bearish (and what would change my mind) May 2015

Big picture macro analysis
Mario Draghi reveals the Grand Plan The eurozone Grand Plan for reforms - this has been the road map all along, ignore at your own peril
China turns Japanese? The long-term challenges to China's growth outlook
Inequality and the genetic lottery: Two views How the Left is both right and wrong on inequality
More evidence of a low return outlook Elevated valuations are pressuring long-term returns
A new golden age of demographic growth Expect a demographic tailwind for stocks and real estate by the end of this decade

Quantitative analysis
Examining your assumptions: The Fundamental Law of Active Management Using Grinold's Law of Active Management in real life
The limitations of Altman Z Why the Altman Z-Score doesn't work in all cases of solvency analysis

Investment policy and financial planning
The ABCs of financial planning Investment policy and asset-liability management concepts
Investment policy: Not just for pension funds Why you need an investment policy statement

Please complete the survey
Please complete the survey and help me make my decision (link here or survey below). Should I turn this into a real job instead of just a hobby?

Whatever my decision, I would like to thank all my readers for their feedback and support over the years.

Monday, September 28, 2015

Poised for a successful re-test of the August lows

I reported on the weekend that my inner trader got caught in a "low conviction long trade" (see A choppy bottom). The sell-off on Monday signaled that the market seems poised for a test of the August lows and possibly the October 2014 lows.

Despite the reversal, my inner trader decided to take his lumps and stay long. Based on my latest estimates of the analytics from IndexIndicators, the market is highly oversold on a 1-3 day time frame:

...and also on a 1-2 week time frame:

Moreover, my Trifecta Bottom Model flashed an "Exacta" buy signal and it is very close to flashing a full Trifecta signal. All that means, of course, is that the market is very oversold, - but then you knew that.

The caveat, of course, is that August experience showed us that oversold markets can get even more oversold.

A critical technical test
Most of the bearish chartists I read on social media are positively giddy right now, but Northman Trader offered a more balanced and nuanced take on the technical condition of the US equity market. He has been watching the 5 month EMA and 20 month MA and believes that the market is at a critical technical junction:
Let me highlight the key issue. Look at this monthly $SPX chart below. For many months we have been following two specific moving averages the 5EMA and 8MA. Every month, like clockwork, these 2 MA’s have acted as critical support. This support was decidedly broken with the August flash crash. In October 2014 the break was saved into month end. Unless something magical happens this coming week it appears these 2 MAs will not be recaptured by month end. However, that’s not quite the main critical issue.

More relevant is what happens whether the shorter term 5EMA and longer term 20 MA cross over each other:

He outlined the dire consequences of a cross-over:
The consequences of a crossover are pretty clear: As we’ve outlined previously the larger macro fibs indicate a market retrace to the 38.2% Fib which coincides with the 2007 highs. Pretty solid confluence.
Incidentally, we have seen the cross-over as of the close today, but the bears have to maintain that condition until month-end, which is two days away.

Standing in the way is positive seasonality for the markets:
In my mind the October 2014 lows need to be broken in the next 3 weeks or it’s game over for bears it seems. Lest not forget that in 2014 the correction ended in the middle of October as well and managed to produce a massive rally through year end...

As we outlined last week bulls need a 1998 like save or markets face a structural break targeting 2007 highs.

Curiously the recent action in price continues to show a similar structure to 1998 so a spike into month end before renewed selling into October would not surprise:

Incidentally, when did the 1998 correction bottom? October 8.

When did the 2011 correction bottom? October 4.

When did 2014 correction bottom? October 15.

He concluded (emphasis added):
So bears. To re-iterate: The monthly MAs need to be crossed and the neckline needs to be broken and STAY broken below October 2014 lows.

And bulls. You absolutely need an October magic show and get back above the daily 200MA (currently 2065) or the jig is up for a long time to come.

We will know who the winner is by the end of October at the latest.

Looking for the rally catalyst
I don't pretend to know what the market will do in the couple of days, other than to observe that it is highly oversold and poised to test the August lows. If we were to see a support violation in the next two days, we are likely to see a positive divergence, or non-confirmation of the lows, on the daily RSI14 indicator.

Sometimes being contrarian is highly painful and people like to tell you that you are wrong. I turned cautious on the market early this year and, after much criticism, wrote a post detailing my reasons on May 18, 2015 (see Why I am bearish (and what would change my mind)).

It seems that I am undergoing a mirror image of that experience now. Today, sentiment is showing a crowded short across many measures and it would only take a positive catalyst for the market to melt up. But what might that catalyst be?

The answer might lie in a cyclical upturn. A clue came from David Rosenberg who pointed out that the American consumer could ride to the rescue yet once again (via Business Insider):
Yes, we hear constantly about how China's share of global GDP has risen inexorably over the decades, but that obscures a huge point.

China's contribution to global producers has been in the basic material sphere as the country absorbed so much of the world's resources in its quest to build mega cities and build a world-class industrial infrastructure, but that is about it.

China, for years, racked up massive trade surpluses as these mega cities became home to low-cost export regions.

The reliable buyer of last resort, outside resources, was never China. It was and continues to be the United States.

The American consumer, if it were a country of its own, would be the largest economic base in the world. That's right — even bigger than China's entire economy.

A glance at the relative performance of Consumer Discretionary stocks show that they are on fire. Homebuilders are surging on a relative basis. Does this look like the signs of a slowing US economy?

As for China, I have pointed out before that stress levels in the Chinese economy are falling. In particular, Chinese property prices in Tier 1 and 2 cities are turning up again. Don`t forget that most of the leverage in their financial system is in real estate  (via Callum Thomas):

Should China stabilize, we may see commodity prices bottom and start to turn around - and that would also alleviate much of the angst in the emerging market economies. Jim Paulsen of Wells Capital Management recently postulated such a turnaround and indicated that commodity prices have historically slowed in mid-cycle in the past:
As we examined in an earlier research note (see the Economic and Market Perspective from August 25, 2015), a significant collapse in commodity prices during the middle of an economic recovery is actually quite common. Chart 1 shows the S&P GSCI Spot Commodity Price Index since 1970. The collapse in commodity prices since last summer is similar to past recoveries and like then, it does not suggest economic growth is about to slow.

In three of the last four recoveries (i.e., the late-1970s, 1980s and 1990s recoveries), commodity prices suffered a severe decline “during” an ongoing economic recovery. In each of these cases, the economic recovery persisted well beyond the bottom in commodity prices. Indeed, in the past, once commodity prices bottomed, the pace of economic growth accelerated and the recovery did not end until commodity prices had substantially recovered. For example, in the late-1970s recovery, commodity prices bottomed in July 1977 and the recovery did not end until January 1980. Similarly, commodity prices bottomed in July 1986 but the economic recovery continued until July 1990. Finally, commodity prices bottomed in early 1999 but the recovery did not peak until March 2001. As shown, a significant decline in commodity prices usually points to stronger rather than weaker future economic growth. Moreover, once commodity prices do finally bottom, they have typically risen throughout the balance of the economic recovery.

Although most believe oil prices (and overall commodity prices) are continuing to collapse, chart 2 suggest they have been in a bottoming process since early this year. While the spot price of WTI crude oil did collapse last year, it is currently about $45, a level it first reached in mid-January. We suspect the commodity markets are about to embark on a multi-year advance which will likely alter leadership in the economy and in the stock market.
Right now, market psychology is overwhelmingly negative and I have no idea what would turn it around. However, with an oversold market with traders at a crowded short, should evidence emerge of a nascent cyclical rebound, stock prices would respond by melting up.

I remain wary of pressing any short positions right now. Instead, I would likely be watching for signs of a capitulation low to add to my long posiition.

Sunday, September 27, 2015

A choppy bottom

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

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

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

My inner investor: Still buying weakness
This will be a somewhat abbreviated post compared to past weeks.  Not that much has changed from my inner investor`s point of view since my last post (see Why this is not the start of a bear market). To briefly recap, I analyzed the market in four dimensions and here are my conclusions:
  • Technical:  Very bearish.
  • Sentiment: A crowded short, which is contrarian bullish. Who is left to sell?
  • Macro: Mixed, mildly bullish.
  • Fundamental momentum: Was mildly bullish, but has weakened to neutral.
My conclusion was that US stock prices have limited downside and this is not the start of a bear market. My inner investor therefore remains in a buy on weakness mode.

Here are the updates.

Sentiment remains a crowded short
Virtually every few days I see another item come across my desk showing an off the charts reading in bearish sentiment. The latest comes from Mark Hulbert, who reported that a purified version of his Hulbert NASDAQ Newsletter Sentiment Index, which is "purified", or adjusted for market action, is showing extreme levels of bearishness, which is contrarian bullish.

In the meantime, Barron`s reports that "smart money" corporate insiders continue to buy heavily.

Macro fears are falling
Here is the summary of New Deal democrat`s weekly review of high frequency economics, indicating that the "forces of darkness are gathering" in the form of non-US (read: EM inspired) weakness, but the US economy remains highly robust, as exemplified by the blow-out GDP report last week.
This week marked the most stark bifurcation among the data in a long time. Consumer-related indicators - mortgages, oil and gas, jobless claims, and consumer spending - all remain positive. But those portions of the US economy most exposed to global forces, including the US$, commodities, and industrial production and transportation, have all turned firmly negative. Two out of the three employment metrics have now also turned either firmly negative or neutral. I remain focused on housing and cars. Although the forces of darkness are gathering, so long as those two most leading sectors of the US economy remain positive, so do I.
The US economy shows no signs of rolling over into recession, which would be a bull market killer. That's one key reason why I remain constructive on equities longer term.

As well, an optimistic note can be found by waning market anxiety. The St. Louis Fed Financial Stress Index has fallen three weeks in a row and it remains below zero, which is considered to be a "normal" level of stress.

Most of the stress reduction comes from falling rates of financial volatility, both in the form of bond and stock market volatility.

The source of the most recent market angst is said to come from the risk of a emerging market meltdown because of a Chinese slowdown. However, a glance at the relative performance of EM bonds show that they are outperforming US high-yield.

Bottom line, the fear of financial contagion is falling.

An uncertain Earnings Season
There is, however, a blemish starting to appear in the bull case. The latest update from Factset shows that forward EPS ticked down by -0.15% in the week after climbing steadily for the last few weeks (annotations in red and estimates are mine).

Factset also shows that the negative pre-announcements are slightly below historical norms, which could indicate that the weakness in forward EPS is part of the the warnings season game. We all know how that game is played by now. Companies guide downwards in order to lower the bar when they actually report earnings so that they can beat expectations.
At this point in time, 108 companies in the index have issued EPS guidance for Q3 2015. Of these 108 companies, 76 have issued negative EPS guidance and 32 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the third quarter is 70% (76 out of 108). This percentage is below the 5-year average of 72%.
Is falling forward EPS just statistical noise, pre-Earnings Seasons guidance or the start of a negative trend? A one week pause is no reason to panic, but it is something to keep an eye on as Earnings Season progresses.

My inner trader: A seriously choppy market
As my inner investor looks ahead bullishly to year-end and 2016, my inner trader is conflicted about short-term market direction. He believes that the market is in the process of making a bottom, much like it did in 1998 and 2011. Here are the SPX charts of that period (via Chris Ciovacco):

The patterns are similar - the stock market made an initial bottom and then chopped around for a few weeks before falling back to test the old lows. Once the second test was complete, stocks resumed their uptrend.

Given the kind of recent volatility that we have seen in the stock market, the chart of weekly prices that I usually show of my Trend Model trading signals does not come anywhere near to capturing the daily ups and downs of the market and the signal. The Trend Model was designed for trending markets, but any recent market trends has instead been replaced by a choppy market in the past few weeks in the manner of the market bottom of 2011.

The current environment has been more favorable to an approach of fading strength and weakness. I have come to rely more on the excellent charts at IndexIndicators. Short-term indicators (1-3 day horizon) such as % of stocks above their 10 dma have recently shown an oversold reading. Regardless of any signs of short-term momentum, I would be wary about pressing short positions.

Longer term (1-2 week time horizon) indicators such as net 20-day highs-lows also flashed an intra-day short-term oversold reading on Thursday.

A better representation of the choppiness of the current environment is to zoom in from a weekly price chart above with an hourly chart that pinpoints the recent trading signals of the last few days.
  • September 17: I tweeted that I was flipping from long to short on the reaction to the FOMC decision (red down arrow). 
  • September 22: I tweeted that I was scaling back my short positions as the market was getting oversold on short-term indicators (first blue up arrow).
  • September 23: I tweeted that I was taking a modest long position, as the market had become oversold on a 1-2 week view (second blue up arrow).

At the end of the week, price momentum is tilted to the downside as rally attempts failed but the market is oversold. My inner trader is in a low conviction long trade and he is watching a couple of unfilled gaps that have the potential to fill very quickly next week. If both get filled, then we could easily see a test of the SPX 2000 level. Otherwise, there is decent support at the 1900-1915 zone.

The market remains range-bound short-term and mildly oversold right now, but declines have been on high volume and advances have been on weak volume. This conditions are highly indicative that a test of the August lows is still ahead in the days to come.

The current market pattern is consistent with past market "crashes" and bottoms. If history is any guide, then we still have a few weeks of choppiness ahead before the stock market can stage an enduring rally into year-end.

Next week will feature a number of potentially high volatility events with binary outcomes. First, the Catalan elections this Sunday have been positioned by the governing party as a referendum on independence and early results indicate that the secessionists are close to a majority. In addition, John Boehner's surprise resignation as the Speaker of the US House of Representatives is a wildcard in the uncertainty leading to a possible government shutdown. Current consensus thinking suggests that Boehner will cobble together a coalition of House Republicans and Democrats to continue to funding the government, but the debt ceiling fight will be a much tougher fight later. Finally, the market will be on edge Friday as the Employment Report gets released - a much watched indicator in light of the Fed`s close decision not to hike interest rates in September.

Volatility is here to stay, at least for the next few weeks.

Disclosure: Long SPXL

Thursday, September 24, 2015

Why this is not the start of a bear market

I have received a fair amount of feedback, mostly from technicians and chartists, on my view that the idea that downside risk on stock prices is limited and this is not the beginning of a major bear market. I want to clarify my views on that topic.

I base my market analysis on different dimensions of analysis, which are summarized as follows:
  • Technical analysis: The stock market has suffered much technical damage, which can be resolved with another leg down, or a sideways consolidation. Trend following models, as well as other projections, suggest considerable downside risk. Call the technical outlook neutral to bearish, with a tilt towards the bearish view.
  • Sentiment analysis: Many sentiment models are showing off-the-charts levels of fear. It isn't any single measure of sentiment, but most sentiment measures an across the board basis. If there is so much fear, who is left to sell? Sentiment models are therefore very bullish.
  • Macro analysis: Here, the outlook is mixed. The US economy is growing so well that the Fed is contemplating raising interest rates. There is no sign of a recession on the horizon, which is a bull market killer. However, there are concerns that the slowdown in China is leaking into other EM economies, which would pull down global growth. As we are mainly focused on the effects on US equities and the US economy remains robust, I would call this neutral to a mild positive.
  • Fundamental momentum: One of the key driver of US equity valuation is earnings growth. Despite much angst over Q3 earnings, forward EPS are still rising, which is still supportive of stock prices. Looking into 2016, however, I do have some concerns about the pace of EPS growth, which could put a ceiling on stock prices. Call this a short-term positive, but medium term neutral to negative.
In short, the most bearish dimension is the technical picture. The other dimensions are either wildly bullish or mildly bullish. But let me go through each component of my analysis, one by one.

The charts look terrible
The long-term technical picture can be summarized by this chart. The SPX saw a violation of the uptrend that began in 2009. Moreover, it has fallen through its 50 and 200 day moving averages. Stock prices generally don`t see V-shaped recoveries when the major averages has suffered this much technical damage.

There are two scenarios to consider. The more optimistic one involves the market finds support somewhere and start to base through a period of sideways consolidation. The more bearish and seemingly consensus scenario among most chartists, is we are likely to see another downleg. The logical downside target would be a key support zone and Fibonacci retracement target at about 1570.

I see a lot of analysis indicating further downside risk. Here are just a few examples. Andrew Thrasher recently highlighted breadth deterioration indicating a bearish outlook.

Kirk Spano (via Marketwatch) pointed to heightened market risk (middle panel) and extreme downside risk (bottom panel):

Even Josh Brown is giving a nod to technical analysis during the current period of market turmoil:
So what can you go by to figure out the mood and psychology around a stock or a market? There’s only one thing: Price itself. And the numerous derivations of price – momentum, relative strength, volume, advancing vs declining issues, moving averages, historical levels of significance.

What you are seeing in price is market psychology writ large. The emotions and attitudes surrounding a given investment are being splattered before you on a canvas. All of the fundamental data that you and others could possibly be aware of is being reflected in the lines on the chart, all day every day.

When you look at these items, they don’t scream out a binary yes-or-no, buy-or-sell answer at you. But they tell you everything you need to know about how people feel. They give you clues to arrive at where the P in PE is headed. Some clues are more valid than others at different times and all clues can fool you. Something that was significant on Tuesday can be an utter red herring on Thursday.
These are just a few of the examples that came across my desk. I could go on, but you get the idea. Technically, the risk-reward of owning stocks right now is very unfavorable.

Sentiment is contrarian bullish
I have demonstrated before (see A test for the bears) that sentiment models are showing a crowded short among several different groups of investors, namely retail (Rydex), US RIAs (NAAIM) and global institutions (BoAML Fund Manager Survey). With respect to sentiment models, I prefer metrics that reflect what people are actually doing with their money, instead of opinion surveys. That's why I give extra weight to measures like Rydex cash flows.

This chart (via Bloomberg) shows that option skew, or the cost of put option downside insurance compared to call option pricing, is elevated (top panel). In addition, short interest has been rising steadily (bottom panel). These are all signs of a contrarian bullish environment.

On the other hand, Barron's shows that "smart money" corporate insiders have been buying heavily since mid-August:
To be sure, sentiment models don't work all the time and they are weak at pinpointing the exact date of a market bottom. I received a thoughtful email from an experienced trader, who highlighted this chart from Ed Yardeni. The green bars show periods when the II bull/bear ratio was under 1.0 (crowded short). To paraphrase Keynes, sentiment can get excessively fearful than the pain threshold of your portfolio.

No indicator works all the time. That's why I rely different dimensions of market analysis.

A benign macro outlook
There are three ways that a bear market can begin:
  • Recession: There is no sign of a US recession on the horizon.
  • Overly aggressive Fed tightening: You've got to be kidding me! Contrast the current Fed with 1987, when the Fed tightened twice in September to defend the Dollar.
  • War or revolution leading to a permanent loss of capital: How are those Confederate bonds doing, or those Tsarist Russia railway bonds?
The last two causes are not an issue right now. So let me focus on the risks of a recession. Scott Grannis sees no signs of a recession from the credit markets. Here is his take:
Today, money is abundant and resources are abundant. Even energy is abundant, because its price has fallen by over 50% in the past year or so. Corporate profits are near record highs, the supply of labor is virtually unconstrained, energy is suddenly cheap, and productive capacity is relatively abundant. This adds up to a lot of room for maneuver and very little reason for the economic engine of growth to shut down.
New Deal democrat came to a similar, but more nuanced conclusion. He maintains a weekly watch on the high frequency economic indicators and he divides them into long leading, short leading and coincidental indicators. Here are his latest comments from last week:
This week like last week highlighted the difference between those portions of the US economy most exposed to global forces, which have all turned negative, and those most insulated from global problems, which are all positive, and even strengthening. I suspect that the globe, as a whole, is in recession. With good numbers in housing and vehicle sales, and especially with gas prices declining again, the US is still positive, and although I believe we are past the midpoint of this expansion, I still remain positive through the first half of next year.
The American economy and consumer remains strong. Here is the relative returns of the Consumer Discretionary sector and some of its components relative to the SPX. With the exception of Media, which is underperforming, does this look like the market is worried about the consumer?

The main source of market angst is the slowdown coming from China and its effects on global growth. There are signs that those concerns may be overstated (via Bloomberg):
China’s economy isn’t as weak as it may look, according to a private survey from a New York-based research group that says it’s a myth the nation’s slowdown is intensifying.

“No collapse is nigh” in the aftermath of the stock market plunge and currency devaluation, according to the third-quarter China Beige Book, published by CBB International and modeled on the survey compiled by the Federal Reserve on the U.S. economy. Capital expenditure rebounded slightly in the period and the services sector showed strength, the report said.

“Perceptions of China may be more thoroughly divorced from facts on the ground than at any time in our nearly five years of surveying the economy,” CBB President Leland Miller wrote in the report. “Global sentiment on China has veered sharply bearish--too bearish. While we have long cautioned clients against relying on rosy official views of the Chinese economy, we believe sentiment has swung substantially too far in the opposite direction.”

The report describes a mixed, rather than disastrous, picture of the world’s second-largest economy. Weakening exports, deepening factory-gate deflation and a manufacturing slowdown have highlighted the risk of this year’s expansion undershooting Premier Li Keqiang’s target for growth of about 7 percent.
There are signs that all of the stimulus is paying off as the Chinese economy is starting to see a cyclical upturn. The South China Morning Post reported that the property market and land sales in first and second tier Chinese cities are perking up.
Developers have begun to beef up their land banks as China's residential property market shows signs of steady recovery.

Most of these land purchases are occurring in first- and second-tier cites but the resultant rise in land prices could squeeze some smaller players out of the market, say analysts.

"Land transactions, especially in the first-tier cities, have become very active," said David Ji, head of research and consultancy, Greater China, at international property consultant Knight Frank. "As property prices and transaction volumes rebound, developers have started bidding aggressively to replenish their land banks," he said.
If the US economy remains robust and China is turning up again, what are you so worried about?

EPS expectations holding up (for now)
The fourth major component that I use to analyze the stock market outlook is how EPS expectations are behaving (see my previous post The right and wrong way to analyze earnings for my analytical framework). Right now, forward 12 month EPS are still growing (via Factset, annotations in red are mine).

Ed Yardeni found that forward EPS is highly correlated with coincidental economic indicator and went on to guesstimate that the next recession would start in 2019
SP 500 forward earnings is highly correlated with the US index of coincident economic indicators (CEI). The latter rose to another new record high during August. Previously, I have observed that based on the past five cycles in the CEI, the next recession should start during March 2019. That’s not based on science, but rather on a simple average of the length of the previous expansions once the CEI had rebounded back to its previous cyclical peak. So it’s a benchmark of what could happen based on what happened in the past on average.

In any event, I’ve circled March 2019 as the possible date for the next recession. Given the Fed’s latest decision to do nothing, it’s safe to bet that the next recession won’t be caused by the tightening of monetary policy anytime soon. It could be caused by a severe downturn abroad, I suppose. More likely is that the US will continue to grow fast enough to keep the global economy growing as well, albeit at a pace that is best described as “secular stagnation.”

2015 = 1998 and 2011 (with a difference)
When I put it all together, my conclusion is that the template for the current corrective episode are 1998 and 2011. In both those cases, the US markets were spooked by the fear of contagion from abroad (Russia and Asia in 1998 and Europe in 2011), but the US was largely insulated from negative economic effects and life went on.

Using those episodes as rough roadmaps, the US equity market is likely to stay choppy for the next few weeks until the source of the market angst resolve themselves. It does mean that SPX downside projections of 1570 or lower are overblown. It does not mean, however, that the market will not decline and test the August lows or even the October 2014 lows at about 1820. In all likelihood, I believe we will see another minor leg down to test support in the 1820-1870 zone.

There is a key difference between 2015 and 1988 and 2011. Both of those previous corrective episodes saw the resumption of a bull trend in stock prices. This time, I have my concerns.

Given the excess fear in the markets, stocks are likely to see a reflex rally and a 2100 year-end SPX target is not unreasonable, but I have my doubts as to how much further it can go for fundamental reasons.

There is no question that the Federal Reserve is poised to raise interest rates, the only question is when, not if. When rates rise, it will start to compress the P/E ratio (because the inverse E/P is dependent on interest rates). That will put tremendous pressure on the E in that ratio to expand, which may be doubtful.

The economic cycle is maturing and the signs of a tightening labor market are everywhere. The key question as we look forward into 2016. How much can earnings grow in the face of margin pressure from rising labor costs? Jim Paulsen of Wells Capital Management recently voiced these worries, though he phrased his concerns in the context of an aging profit cycle (emphasis added):
Earnings performance is well past its best for this recovery and investors need to consider whether earnings growth will prove sufficient to support current stock market valuations. The rapidly aging earnings cycle is perhaps best illustrated by an economy nearing full employment with corporate profit margins near record highs. Should global growth remain tepid and overall sales results modest, since profit margins are unlikely to rise much, earnings trends will also likely prove disappointing. Conversely, should global growth and corporate sales results accelerate, because the U.S. is nearing full employment, companies may soon face cost-push pressures and margin erosion which will likely off set improved sales results.

Essentially, it is difficult to see how earnings growth will be adequate during the rest of this mature recovery to support current price/earnings multiples. Is a relatively modest earnings growth against a backdrop of rising inflation and higher interest rates sufficient to support the current 18 to 19 times price/earnings multiple?
Indeed, the latest speech from Janet Yellen today indicated that the economy is nearing full employment (emphasis added):
Although other indicators suggest that the unemployment rate currently understates how much slack remains in the labor market, on balance the economy is no longer far away from full employment.
In that case, wage pressures will surely start to pressure operating margins.

Margins could unexpectedly improve should the USD weaken. Factset did show that there is a distinct difference in Q3 earnings and revenue growth for companies exposed to the domestic economy compared to foreign sourced sales (annotations in red are mine).

In conclusion, my base case scenario calls for the market to bounce around for the next few weeks, with a rally into year-end and January. Looking out into 2016, labor costs and the USD will be key drivers of SPX profit expectations - and stock prices. In the absence of a retreat in the USD, the SPX will likely become range-bound in 2016 with 2100-2200 as a ceiling and 1900-2000 as a floor, which would fit well with a resolution of the technical damage done through a period of basing and sideways consolidation.

One last word addressed to my bearish doubters. Before you start flaming me, just a reminder that this post is in effect a mirror image of what I wrote in May: Why I am bearish (and what would change my mind).

Sunday, September 20, 2015

A test for the bears

Trend Model signal summary
Trend Model signal: Risk-off
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. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

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

More choppiness ahead
Last week, I featured a chart showing the progress of the SPX compared to past market "crashes". I indicated that my best "wild-eyed guess" would be a rally last week, followed by a decline the week after (see A V or W shaped bottom?). The market has followed that script well so far. Next week will see a test of how strong the bearish forces are.

I continue to believe that the US stock market is making a choppy bottom as patterned by the chart above. Fundamentals are supportive of higher stock prices (see The right and wrong way to analyze earnings) and the latest macro outlook from New Deal democrat shows no recession ahead, which is a leading cause of bear markets. Short leading indicators are a little soft, but long leading indicators continue to point to robust economic growth:
Among long leading indicators, interest rates for corporate bonds and treasuries remained neutral. Mortgage rates are positive, while purchase and refinance mortgage applications are slight positives. Real estate loans are positive. Money supply is positive.

Among short leading indicators, the interest rate spread between corporates and treasuries is its worst in 3 years. The US$ also turned even more negative. Temporary staffing was negative for the 18th week in a row. Positives included jobless claims, oil and gas prices, and gas usage. Commodities remain a big global negative.
Sentiment models are still off the charts bearish, which is contrarian bullish for equities. While the combination of bullish macro, fundamental and sentiment indicators all point to higher stock prices, these models are imprecise at pinpointing the exact day or week of the market bottom. In the short-term, the stock market faces a number of challenges that could see some downside volatility in the days ahead.

Let me explain.

Excessive fear puts a floor on prices
This is starting to sound like a broken record, but sentiment models are still showing a crowded short, which is contrarian bullish and should put a floor on stock prices. This chart of Rydex cash flows shows that the level of bearishness is at a 16-year high, indicating extreme fear from individual investors.

The NAAIM survey, which measures RIA sentiment, shows that bearishness has slightly receded but fear levels remain high.

The latest BoAML Fund Manager Survey, which mainly measures the sentiment of global institutional portfolio managers, shows that this group at high levels of defensiveness. Their global growth expectations are turning down.

As a consequence, equity allocations have fallen.

The selling has been mainly in UK and Japanese stocks and they bought into the US market, indicating a reduce market beta and therefore a flight to safety.

Their fear of an emerging market meltdown has spiked:

In the face high levels of fear and caution from individual investors (Rydex), US investment advisors (NAAIM) and global institutional managers (BoAML FMS), "smart money" insiders are contrarian bullish and they have been buying heavily since mid-August (via Barron`s):
There have been a number of technical analysts who are forecasting considerably lower prices for stocks. Examples include Chris Ciovacco who postulated SPX downside potential at 1680 and Michael Kahn with a downside target of 1577, indicating downside risk of 20% or more in stock prices.

While I do understand the benefits of technical analysis and use it extensively in my own work, bear markets simply do not start with sentiment at such off the charts fear levels. That's why my inner investor remains in a "buy weakness" mode, with the belief that equity prices will be considerably higher by year end.

Near term challenges
Near term, however, the US equity market faces a number of challenges, any of which could be the source of downside volatility in the days ahead:
  • US monetary policy: I had expected either a "dovish hike" or "hawkish pass" in the FOMC decision last week, but the statement was far more dovish than either the market or I had anticipated (see Does the FOMC decision matter much to the markets). Janet Yellen is scheduled to speak this coming Thursday, at which time she will likely explain the thinking behind the interest rate decision. If the FOMC statement is already dovish, any change in her posture is a more hawkish tilt - which would likely be a bearish development.
  • US fiscal policy: In case anyone has forgotten, the US government faces the possibility of a government shutdown and a split in the Republican ranks. That scenario has not been discussed much by analysts and could quickly become a negative for the markets.
  • Greece: Greece (yes, remember that Greece?) is holding parliamentary elections this Sunday whose results are not final at the time of this writing. While Alexis Tspiras's SYRIZA appears to have won his party does not have a majority and there may be a lot of bargaining in the days ahead. At best, we will see a continuation of the status quo. At worse, we could see political deadlock and more uncertainty in the eurozone. This Bloomberg article summarizes the upside and downside risks, which appear to be asymmetrically tilted to the downside.
  • Spain: Catalan is holding elections on September 27 and the stakes are high. Bloomberg reported that "regional President Artur Mas has framed it as a de facto referendum on independence". The politics of Europe, which had been dormant since the summer, are heating up again and risk premiums in Europe have nowhere to go but up.
  • China: President Xi is scheduled to visit the US next week. Expect greater scrutiny of Chinese economic weakness, as exemplified by the angst expressed by Martin Wolf over Willem Buiter's "made in China" global recession scenario and speculation about further RMB devaluation. As well, watch for an intense focus on security issues such as cyber spying and the tensions in the South China Sea (see this Sydney Morning Herald primer on the situation in the SCS).
In short, there are lots of catalysts for volatility, but the risks are mostly tilted to the downside. The market is already technically vulnerable, we just need something to lit the fuse.

How far down?
Chad Gassaway showed analysis a week ago indicating that September option expiry week (OpEx), which was last week, tended to have an overwhelming bullish seasonal bias (which was true, up until the FOMC meeting) and while the following week, next week, has a bearish bias. 

Ryan Detrick also pointed out that average returns during the week after OpEx in September is the worst of the year of any post-OpEx week in the year.

In fact, the next three weeks have shown very poor returns on a seasonal basis.

So far, the part about strong OpEx week returns in September was correct this year. We saw the ramp into the FOMC decision last week. I warned on Wednesday morning that the stock market was getting overbought.

...and I shorted into the strength of the FOMC inspired rally on Thursday.

Now that we have seen the rally, it`s time for prices to mean revert and next week will present a test of the strength of the bears. How far can stocks fall?

A glance at the SPX chart tells us that multiple uptrends have been broken, both at price and momentum levels, which confirm the near-term bearish outlook. Initial support levels to watch for is 1940-1945 and secondary support exists at 1910-1915. If those don`t hold, expect a test of the August low support at 1860-1870. Should that fail, there will be further technical support at the November 2014 lows at about 1820.

Could the SPX actually get down as far as 1860-70, or 1820? In the past few weeks, we have seen a choppy market pattern where a trading strategy of buying weakness and fading strength has been highly profitable since the August bottom. Already, we are seeing short-term (1-3 day) overbought conditions being worked off, as per this chart from IndexIndicators. It will only take one more big down day like Friday for this metric of stocks above the 10 dma metric to reach oversold levels. A retreat to 1870 would take this breadth measure to an extreme oversold reading, which has been inconsistent with the market conditions seen so far in September.

On the other hand, longer term (1-2 week) indicators remain in neutral territory and further weakness like the ones we saw on Friday will not move this indicator into the oversold target zone. So it would not be unreasonable to see the market weaken to levels where longer term (1-2 week) indicators flash oversold readings.

The week ahead will therefore be a big test for the bears. Will bearish momentum be strong enough to overcome short-term (1-3 day) oversold readings and push prices lower to test the August and possibly November lows?

Stay tuned.

My inner trader turned flipped from long to short on Thursday with the FOMC rally. His plan is to start to scale out of short positions should the market flash short-term oversold conditions and then watch how the market responds before making further decisions.

Disclosure: Long SPXU