Monday, February 20, 2017

Negative real yields = Equity sell signal?

An reader asked me my opinion about this tweet by Nautilus Research. According to this study, equities have performed poorly once the inflation-adjusted 10-year Treasury yield turns negative. With real yields barely positive today, Nautilus went on to ask rhetorically if the Fed is behind the inflation fighting curve.



Since the publication of that study, The January YoY CPI came in at 2.5%, which was surprisingly high. The higher than expected inflation rate pushed the 10-year real yield into negative territory. So is this a sell signal for equities?


Well, it depends. The interpretation of investment models often depends a great deal on their inputs. In this case, the questions is how does we adjust for inflation? Do we use the headline Consumer Price Index (CPI), core CPI, which is CPI excluding volatile food and energy prices, or some other measure?

As I go on to show, how we adjust for inflation dramatically alters the investment conclusion for a variety of asset classes, like equities, gold, and the USD.

As is the case in the application any quantitative model, the devil is in the details.

The full post can be found at our new site here.


Sunday, February 19, 2017

Watch what they do, not just what they say

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

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

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



The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bearish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

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



Great expectations
Bloomberg recently highlighted the huge gap between expectations and reality. As the chart below shows, soft (expectations) data has been surging, but hard (actual) data has risen, but it has not caught up with expectations.


The markets are pricing for perfection, which sets up a situation where minor disappointments could spark a market sell-off. BCA Research found that such divergences between "soft" expectations data and "hard" economic data has seen equity corrections in the past.


This week, I examine the details of how expectations have diverged from actual data on a number of dimensions.
  • Small business confidence
  • Corporate confidence
  • Consumer confidence
  • Federal reserve expectations
  • Wall Street's tax reform expectations
The full post can be found at our new site here.

Wednesday, February 15, 2017

Why the S&P 500 won't get to 2400 (in this rally)

Mid-week market update: As the major market averages make new all-time highs, I conducted an informal and unscientific Twitter poll. I was surprised to see how bullish respondents were.




Let's just cut to the chase - forget it. Neither the fundamental nor the technical backdrop is ready for an advance of that magnitude. Even though the earnings and sales beat rates for Q4 earnings season is roughly in line with historical averages, Factset reports that the 12-month forward EPS growth is stalling. Past episodes has seen stock price struggle to make significant advances under such conditions.


In addition, the technical condition of the market shows that it is vulnerable to a pullback.

The full post can be found at our new site here.

Tuesday, February 14, 2017

Cry Havoc, and slip loose the dogs of (trade) war!

The WSJ reported that the Trump administration is considering a new tactic in managing its trade relationship with China. Here is the Bloomberg recap for those without a WSJ subscription:
Under the plan, the commerce secretary would designate the practice of currency manipulation as an unfair subsidy when employed by any country, instead of singling out China, the newspaper reported. American companies could then bring anti-subsidy actions to the U.S. Commerce Department against China or other countries, it said.

The discussions are part of a strategy being pursued by the White House’s new National Trade Council to balance the goals of challenging China on certain policies while keeping broader relations on an even keel, the paper said. The Trump administration would avoid, at least for now, making claims about whether China is manipulating its currency, it said.
While such an approach may seem clever, it has the risk of sideswiping American relations with a whole host of other countries other than China. As well, the imposition of countervailing duties is subject to a challenge under WTO rules.

The full post can be found at our new site here.

Monday, February 13, 2017

Why this uncanny recession indicator may not work this time

The chart below depicts the yield curve, as measured by spread between the 10-year and 2-year Treasury yields, (blue line) and equity returns (grey line). The yield curve has been an uncanny recession forecaster. It has inverted ahead of every single recession, and ahead of major equity bear markets.


Unfortunately, this indicator may not work this time.

The full post can be found at our new site here.

Sunday, February 12, 2017

A blow-off top, or a wimpy top?

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

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

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



The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

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


So many questions, so few answers
Regular readers know that I have been calling for a cyclical market top in 2017 (see The roadmap to a 2017 market top). Outside of the risk of permanent loss from war or insurrection, severe bear markets have been mainly associated with economic recessions. My analysis has been based on the likely path of the US economy, and the timing of the next recession.


My base case, call it the "blow-off top" scenario, goes something like this:
  • The economy, which is in the late stages of an expansion, starts to overheat.
  • Investors and traders get enthusiastic about growth and bid stock prices up to unrealistic levels (hence the "blow-off")
  • The Fed responds by raising rates to cool off the economy, but find it's behind the curve...
  • Which results in a recession and bear market.
The blow-off top scenario would see the SPX reach the 2500-2600 level this year as it tops out.


I have been considering an alternative, call it the "wimpy top" scenario, where the market may have topped out already.
  • The economy, which is in the late stages of an expansion, starts to overheat.
  • Investors and traders get enthusiastic about the prospects for cuts cuts and deregulation under the Trump tax reform plan, which is what has happened so far.
  • Tax reform gets tied up in Congress and gets delayed until 2018.
  • Trump appoints hawks to the Federal Reserve board (now there are three vacancies with the resignation of Daniel Tarullo).
  • The new Trump appointed Fed governors, composed of hard-money advocates, becomes more aggressive, tightens monetary policy, and pushes the economy into recession.
  • An equity bear market is the result.
The wimpy top scenario is based on a double whammy of fiscal policy disappointment and a pivot to a more hawkish Fed policy. In that case, Current stock index price levels are roughly as good as they get.

The key differences between the two scenarios are the likely path of fiscal and monetary policy. Those are the big questions to which we have no answers. This week, I explain the risks and offer some suggestions of how to watch which scenario is the more likely one to unfold.

The full post can be found at our new site here.

Wednesday, February 8, 2017

What's wrong with the VIX?

Mid-week market update: Increasingly, I have seen cases being made for an equity market correction. This Bloomberg article, "Five charts that say not all is well in the markets" summarizes the bear case well.
  • Uncertainty is at a record high: The number of news stories using the word "uncertainty" is surging.
  • Wall Street vs. Washington: While the Global Economic Uncertainty Index is elevated, the VIX Index remains low by historical standards.
  • The price of hedging tail-risk is rising: Even as the VIX remains low, the CBOE SKEW Index, which measures the price of hedging extreme events, is high. Which is right?

  • Gold is rising: Gold is often thought of as a safe haven in times of stress and the gold price has recently been inversely correlated with equity prices.

  • Watch for gold and bond yields to rising together: "Gold may prove the “tell,” according to Chris Flanagan, also at Bank of America. He advises investors to watch “for the combo of rising yields and rising gold prices to signal impending market volatility.” Three consecutive quarters of rising benchmark bond yields and gold prices preceded previous market falls including the 1973-1974 bond market crash and Black Monday in 1987, he says. The yield on the benchmark 10-year U.S. Treasury has risen to 2.44 percent from 1.77 percent since Trump’s election win. Gold has moved sideways."


Much of the anxiety can be summarized as, "What's wrong with the low level of the VIX Index? Isn't the VIX supposed to be a fear gauge?"

Why are't stock prices falling if actual fear is so high?

The full post can be found at our new site here.

Monday, February 6, 2017

Peak populism?

Technical analysts often use the magazine cover indicator as a contrarian indicator. When an idea has become so commonplace that it becomes the cover of a major magazine, the public is all-in and it's time to sell.

The Economist reported on an ad hoc study by Greg Marks and Brent Donnelly at Citigroup using covers from The Economist and did find contrarianism works, even though The Economist is not really a popular mainstream magazine:
Interestingly, their analysis finds that after 180 days only about 53.3% of Economist covers are contrarian; little better than tossing a coin. After 360 days, the signal is a lot more reliable—68.2% are contrarian. Buying the asset if the cover is very bearish results in an 18% return over the following year; shorting the asset when the cover is bullish generates a return of 7.5%.
Now consider the following Time magazine cover and accompanying story on Steve Bannon, who is said to be the man behind the Donald Trump presidential throne.



There is also this cover from The Economist within the same week.



Still not convinced? How about this cover from Der Spiegel. You don't even have to read German to understand the idea.


It isn't just me, Helene Meisler raised the same question about magazine covers, which was answered by Liz Ann Sonders at Schwab.


Here at Humble Student of the Markets, our mission to focus on investing and try to remain apolitical. Like most on Wall Street, we don't protest political developments, we trade them.

Rather than interpreting these magazine covers as just peak Trump, as he will be POTUS for the next four years, the contrarian message may be "peak populism". Nate Silver recently wrote an article called "14 versions of Trump's presidency, from #MAGA to impeachment", where he laid out a variety of scenarios of how Trump's presidency might proceed.

I would like to offer some details of how the reversal of peak populism might work. As well, there is a possible trade for contrarian investors who are willing to bet on the "peak populism" theme.

The full post can be found at our new site here.

Sunday, February 5, 2017

Still bullish after my chartist's round-the-world trip

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

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

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



The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bullish (upgrade)*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

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


Confusing macro cross-currents
Last week, I wrote that investors should tune out the political noise and focus on the fundamentals of growth (see A focus on growth). Still, the markets appear to be confused.

On one hand, Friday's positive surprise from the January Jobs Report told the story of an American economy that is on a solid non-inflationary growth path. Indeed, the latest update from ECRI shows their Weekly Leading Indicator has surged to an all-time-high.



Urban Carmel pointed out that the macro outlook is strong in virtually all respects, and I agree. Moreover, the upturn is global in scope, which suggests that this recovery has staying power because of the breadth and scope of the advance.


On the other hand, the new Trump administration is starting to give Wall Street the jitters. Josh Brown summarized the anxiety well this way:
All the investment guys want the tax cuts and repatriation to happen. They want the 4% GDP growth. They want the infrastructure push to actually work. But, they’re definitely afraid. They don’t like the tweets, the executive orders, the daily mass protests or the shady people who seem to be accumulating power and influence.
I know of no conventional way to resolve the interplay between the bullish macro backdrop and bearishness from policy uncertainty. One approach to cut through the noise is to just ignore it. Instead, use technical analysis to understand what the markets are discounting.

This week, I will dispense with my usual macro and fundamental analysis and take a chartist's tour around the world. Let's see what the markets are telling us.

The full post can be found at our new site here.

Thursday, February 2, 2017

An "island reversal" sell signal?

In response to my last post (see Watching the USD for clues to equity market direction), an alert reader pointed that the SPX had formed a bearish island reversal.


Wikipedia explained the island reversal formation this way:
In stock trading and technical analysis, an island reversal is a candlestick pattern with compact trading activity within a range of prices, separated from the move preceding it. This separation is said to be caused by an exhaustion gap and the subsequent move in the opposite direction occurs as a result of a breakaway gap.
I had grown up with trading aphorisms and folklore like this, so I decided to test out whether the island reversal formation had any trading information. The results were surprising, and it was another lesson in how asymmetric signals were at tops and bottoms (see The ways your trading model could be leading you astray).

The full post can be found at our new site here.

Wednesday, February 1, 2017

Watching the USD for clues to equity market direction

Mid-week market update: With stock prices pulling back to test its technical breakout to record highs, it is perhaps appropriate to watch other asset classes for clues to equity market direction, especially on a day when the FOMC made its monetary policy announcement.

From a cross-asset perspective, there is much riding on the direction of the USD. As the chart below shows, the USD Index has weakened after making a high in December. It is now testing a key support zone, as well as a Fibonacci retracement level. Despite the pullback, the uptrend remains intact.


The other panels of the chart shows the UST 2-year yield and its rolling 52-week correlation with the USD. As well, I show the price of gold and its rolling correlation to the USD. The correlation charts show that the relationship between the USD and these two assets have been remarkably stable. The USD has been positively correlated to interest rates, as measured by the 2-year UST yield, and inversely correlated to gold prices.

As well, please be reminded that gold and equity prices have recently shown a negative correlation. In the past few months, stock prices have risen when gold fell, and vice versa.

With these cross-asset, or inter-market, relationships in mind, what happened to the USD in the wake of the Fed announcement?

Nothing. Sure, the greenback weakened a bit in response to the FOMC decision, but soon bounced back. The same could be said of interest rates, and stock prices.

That leaves investors and traders waiting for a decisive break for clues to stock market direction. Equities are mildly oversold, but my metrics of risk appetite remains in an uptrend. I am inclined to give the bull case the benefit of the doubt, but with reservations.

The full post can be found at our new site here.