Thursday, August 21, 2014

Rethinking Buffett's "favorite" valuation metric

I have written about this topic before (see He who solves this puzzle shall be King), but in his weekly commentary, John Mauldin wrote about developing bubbles. Mauldin referenced the following chart (from Doug Short) of market cap to GDP as Warren Buffett's favorite valuation metric to show that stock market valuations are stretched.

I have called this same indicator as Buffett's favorite valuation metric before. However, I have not seen him publicly reference this ratio in interviews in the last 10 years. I am therefore re-considering the validity of this valuation measure.

The market cap to GDP ratio is really shorthand for an aggregate price to sales ratio. Recall that the price to earnings ratio is price to sales divided by net margin - and corporate net margins have risen considerably over the past few years and created distortions in both the P/E and P/S ratios. This chart from Goldman Sachs (via Business Insider) shows how corporate net margins have reached new highs.

The rapid expansion in net margins suggests that they are at risk of mean reverting and falling at some point in the future. However, analysts like Dan Suzuki of BoAML have shown before that net margins have mainly been rising for financial reasons, namely lower interest expense and lower tax rates, rather than an increase in operating margins (via Business Insider).

So, if P/E = P/S/(Net margins), then how valid is the price to sales metric if net margins are distorted by these factors?

This analysis doesn't mean that equity valuations aren't stretched. I wrote before that stock prices appear to be elevated based on a combination of PE, PB and dividend yield (see More evidence of a low-return equity outlook). However, price to sales may have outlived its usefulness as a valuation metric given the current net margin environment and, by extension, to call market cap to GDP Warren Buffett`s favorite valuation indicator may be a label that`s well past its "best use" date.

Tuesday, August 19, 2014

What the USD breakout means

In case you missed it, the USD Index staged an upside breakout today.

Should the USD breakout hold and greenback strength continue, here are some of the broader implications of this upside breakout:
  • Bearish for USD denominated yields (and bullish for bond prices)
  • Bearish for commodities

Bond price bullish
I have heard and read comments to the effect that you would have to be insane to lend the US Treasury money at 2.4% for 10 years. With inflation, depending on how you measure it, at or slightly below 2%, it implies a real yield of 0.4-0.7%.

While that view has validity, you also have to consider the alternatives in "safe" asset yields. Today, the 10-year Bund yields is 1.0% and US Treasuries represent a 1.4% spread over Bunds! Not only that, Spanish 10-year yields are at roughly the same 2.4% level and Italian yields are only slightly higher at 2.6%! UK 10-year yields are also at about 2.4%.

In that context, US Dollar assets are not expensive. The rally in the USD is no doubt partly a reflection of demand for USD assets, with Treasury paper a prime beneficiary of this trend, which is bullish for the prices of US Treasury paper.

Commodity bearish
Not perhaps coincidentally, J. C. Parets wrote a post called The problem I see with silver, in which he detailed the technical difficulties that he saw with the silver price.
Here is a weekly line chart showing these lows just below 19 tested successfully 3 times. Where I come from triple bottoms and triple tops are very very rare, if they even exist at all. In all likelihood, as I mentioned on Fox Business in late May, we’ll see a 4th or 5th test that eventually cracks the support. Well as we can see in this chart, we’re seeing just that: a 4th test of support in a commodity that is still in a 3+ year downtrend:

Any problems with silver are likely to extend to gold. The price of gold is also emblematic of the headwinds facing the commodity complex if the USD were to continue to rise, as commodities and the USD tend to be inversely correlated.

I would agree with Parets assessment of the silver outlook and add that the silver-gold relationship is flashing warning signs for gold itself. As the top panel of the gold price chart shows, gold is showing a triangle wedge formation indicating indecision. An upside or downside breakout would indicate the next direction for gold. However, the bottom silver-gold ratio, which measures the more volatile silver price as a barometer for the precious metal complex, is showing weakness. The ratio is nearing a test of relative support. Should that support line break, it would have bearish implications for precious metals. Given the renewed strength in the USD, further weakness in gold, silver and other commodities is the more likely outcome.

As technical analysts, we often overly focus on individual stocks or indices and forget the inter-connected nature of asset prices. This is just a little reminder of the importance of inter-market analysis.

Monday, August 18, 2014

A Jackson Hole sneak preview

As the markets anticipate Janet Yellen's keynote speech at Jackson Hole entitled "Re-Evaluating Labor Market Dynamics", I came upon this Chicago Fed publication that might offer a sneak preview of what Yellen might have to say.

The publication is entitled, "Understanding the relationship between real wage growth and labor market conditions". The abstract reads (emphasis added):
The authors find that the share of the labor force that is medium-term unemployed (five to 26 weeks unemployed) and the share working part time (less than 35 hours per week) involuntarily are strongly correlated with real wage growth. Moreover, they estimate that average real wage growth would have been between one-half of a percentage point and a full percentage point higher in June 2014 if 2005–07 labor market conditions had been restored, indicating that the slack in the jobs market still weighs heavily on the real wage prospects of U.S. workers.
Chicago Fed President Charles Evans is generally thought to be a dove and studies such as these provide more ammunition for Fed Chair Yellen to assert that you have to look beyond the headlines to assess labor market conditions. According to this Reuters report, "she'd rather fight inflation than another economic downturn" and this Chicago Fed publication is another step in that direction.

Sunday, August 17, 2014

Onwards and upwards

Weekly Trend Model signal
Trend Model signal: Risk-off
Direction of last change: Positive

The real-time (not back-tested) signals of the Trend Model is shown in the chart below:

Stay long the bounce
Last week, I showed this chart and pointed out that combination of the VIX term structure exiting inversion and TRIN falling from an 2.0 oversold condition was a powerful signal for an oversold rally (see A tradable bottom?). In the last two years, this combination has had a perfect record of calling bounces, which have lasted a minimum of two weeks.

My opinion hasn't changed. I continue believe that the odds favor a continued rally to test the old highs seen in the SPX. Initially, I was somewhat concerned that both the slope of the term structure of the VIX and the VIX Index itself was falling very quickly. This was leading very quickly to a short-term overbought condition. As the chart below shows, such behavior is typical of oversold rallies when the VIX term structure exits an inversion (dotted vertical lines) and bulls should not be concerned about the rapidity of the improvement in these indicators.

Rob Hanna at Quantifiable Edges confirmed the conclusion of my analysis when he conducted a study of what happens when the VIX Index moves from overbought to oversold very quickly. Though the sample size is relatively small at 18, it does show that the market still has a bullish tailwind at its back under such circumstances. Note that he posted this last Thursday, which meant that his analysis was based on Wednesday`s closing prices:

Panic is still in the air
Despite some technical concerns, such as the inability of the SP 500 to overcome its technical resistance at the 50 day moving average and the lagging performance of high-beta small cap stocks, the sentiment picture remains supportive of further advances.

I have written that I tend to be somewhat skeptical of the results of sentiment surveys as sentiment readings can bounce around because they reflect opinions, rather than what people are actually doing with their money. I therefore tend to watch sentiment data that indicate how market participants are actually betting. In this respect, the ISEE Index, which is a call-put ratio of opening customer option transactions, is a good reflection of short-term market sentiment. As the chart below shows, the equity-only ISEE Index remains low by historical standards, indicating few bullish call buyers, which is contrarian bullish.

As well, it seems that institutional investors have panicked as stock prices tanked the the past few weeks. I was initially skeptical of the NAAIM readings and questioned the sampling techniques and methodology of the survey. The chart below shows that the equity exposure of NAAIM institutional investors collapsed two weeks ago and they remained low in the latest weekly survey results.

These readings were confirmed by the results of the BoAML Fund Manager survey, which showed that cash holdings spiked from 4.6% to 5.1% last month and fund managers had rushed to buy tail-risk protection for their portfolios.

By contrast, the latest chart from Barron's indicate that insider activity is supportive of the bull case:
The weight of the evidence therefore suggests that market participants have already panicked. Bear markets and deep corrective market action generally do not start with sentiment readings at such bearish levels. Barring some catastrophic event, I expect the oversold rally to continue for at least another week, when we can look forward to possible hints of new directions in Federal Reserve policy at the annual Jackson Hole meeting.

IHS upside breakout
From a short-term technical perspective, the SPX appears to have staged an upside breakout from an inverse head and shoulders (IHS) formation. The Ukraine tension related pullback Friday saw the index retreat to successfully test the neckline of the breakout. The measured target of the IHS is 1985, which is roughly a test of the old highs in the index.

"Lack of a bear case for stocks"
Should I be correct and the SPX rallies to the 1985 target or test the all-time highs, what happens next?

To answer that question, I turn to an analysis of market fundamentals, which continue to tilt bullishly and remain supportive of further advances. Last week, Morgan Stanley published a report indicating that they saw little downside for equity prices for now as there was the "lack of a bear case for stocks" (via Marketwatch):
Here’s one reason why this stock market isn’t going to truly slump any time soon, according to Morgan Stanley analysts: “The lack of a credible bear case.”

The analysts, in a report published Monday, say the top of the market is defined by hubris and debt, and argue neither is present at the moment. Instead, it’s hard to argue that costs — whether as capital spending, inventory or hiring — are rising enough yet to be a threat to profit levels, they say.
They concluded (emphasis added):
They’re back to bullish view in the wake of the market’s recent pullback, after having gone to “balanced” on a 12-month forward view last month. The analysts say stock-market valuations could still expand strongly because the economy is improving, real yields are higher (and inflation is low), and Fed policy is still accommodative.
In an interview with Barron's, Stephen Auth of Federated Investors summed up the bulls' view this way:
As a way to describe the economy, Goldilocks was formulated back in the 1990s, when the Fed was relatively well behaved and the economy was expanding. Today, I call it "Goldilocks cubed" because we have what actually may be an accelerating economy, with the Fed and Treasury rates well-behaved and perceptions about risk declining. Market valuations depend on growth, bond rates, and perceptions of risk, and all three of those are going in the direction that actually expands the price/earnings multiple. At the same time, earnings are expanding, and that's a recipe for another leg up in the market. In terms of economic expansion, we have been stuck in this 2% growth range since 2008-09. But we think something has happened and that animal spirits have returned. We've had these sky-is-falling moments, and every time we get through one of them, more and more people come out of their caves and say, "Maybe the sky is not really going to fall."
In other words, the stock market is in a sweet spot right now. Economic and EPS growth look good, the interest rate environment is benign and risk appetite is healthy.

While my views are tilted bullishly, that does not mean that there is nothing but clear sailing ahead for stocks. The direction of change of the Trend Model is positive, which is bullish, but the absolute level of the reading remains in "risk off" territory, which brings up the possibility that the current rally is a counter-trend rally in a downtrend. I will detail some of my concerns for US equities in a later post this week and tweet any updates as I see them at @humblestudent. You can also subscribe to my blog posts by email here.

Disclosure: Long TNA, SOXL

Wednesday, August 13, 2014

Why active managers underperform

It is a tru-ism these days that active managers tend to underperform the index. Cullen Roche recently wrote a blog post about the challenges of active management compared to indexing. The main reason he cited is active managers hold too much cash:
If we look at the history of the stock market we know that stocks rise the vast majority of the time – generally somewhere between 70-80% of the time. So, any active investor who isn’t 100% fully invested is likely to underperform a highly correlated index after taxes and fees. The data on this is pretty conclusive and the basic logic behind it confirms it. The flip side, of course, is that most active managers are holding cash positions or hedging portfolios at times during the cycle so they’re never 100% invested to begin with. So, when we see studies that claim active mangers underperform the index we should not be ONE BIT surprised.
Roche is correct. Active managers, even if they have a mandate to be fully invested, often hold 2-5% cash in their portfolio for liquidity purposes as it is operationally difficult to hold 0% cash. So imagine that if you are holding 5% cash and the market went up 1% - you just underperformed by 5 basis points because of your cash holdings. Accumulate that effect over over the years and it adds up.

Size effect on active performance
I also want to point out another effect on active performance, the influence of stock weights in the index. The SP 500 is an index of 500 stocks with different weights. The larger companies, such as AAPL and XOM, have larger weights by virtual of their size and the smaller ones have much smaller weights.

Now imagine that you are an active stockpicker manager with an SP 500 mandate. You will hold a portfolio of 100 stocks. For the simplicity of this exercise, you will only pick stocks that are members of the index. With virtually all investment processes, statistically your portfolio will have a smaller capitalization profile than the index.

Read that last italicized sentence over and think about it. If you threw darts to pick your stocks and then formed an equal-weighted portfolio, i.e. 100 stocks with 1% weights, you will tend to underweight the large caps (e.g. AAPL and XOM) and overweight the small caps within your universe. In fact, it would be difficult to construct a weighting methodology where you pick 100 random stocks out of 500 that would have a larger cap profile than the index. That's because, statistically, the larger cap names have only a 1 in 5 chance of being picked to be in the portfolio. I recognize that stock picking managers do not pick stocks randomly, but few stock picking managers have a systematic bias towards large cap stocks.

Here is the punch line: When large caps outperform, active managers will face headwinds in their returns. The chart below shows the relative performance of the equal-weighted SP 500 compared to the SP 500. When the line is rising and steep, active managers will tend to perform better. When the line is falling, they do much worse than the index.

Savita Subramanian of BoAML (via Josh Brown) recently noted that only 27% of core managers beat their benchmark on a YTD basis. You will note that in the above chart, the equal weighted to cap weighted relative performance chart flattened out.

When viewed in that context, along with the cash drag headwinds cited by Cullen Roche, it puts the performance of active managers into context.

Tuesday, August 12, 2014

Three eclectic bullish trade ideas

As promised, further to my recent post where I indicated that I would write about some bullish ideas (see A tradable bottom?), here are three eclectic and out-of-the-box trade ideas for bulls. Each of them embody a different investment theme and each has different risk profiles and time horizons.

Russia as the deep value play
Carla Fried of Ycharts highlighted analysis by contrarian manager David Iben on Russia:
In a recent note to shareholders Iben drew a comparison between one of the finest contrarian investors of all time, the late John Templeton, dove into a battered Japanese stock market in the 1960s (when stocks were trading at low single digit PE ratios) and the opportunity Iben sees today in Russia.

The fact that Russia is a mess is a feature, not a bug for contrarians like Iben. In laying out his case for Russia, Iben invoked one of Templeton’s investing commandments: “People are always asking me where the outlook is good, but that’s the wrong question…. The right question is: Where is the outlook the most miserable?”

Iben clearly makes a case for Russia’s misery factor, and seems practically giddy about it: “Having lost the Cold War two decades ago, still hated passionately by many, infamous for organized crime and corruption, powerful oligarchs worth billions, and an emerging market, its stock market is now selling at a mere 5 times earnings and 0.6 times book value!!”
As confirmation of the contrarian value theme, Jim Grant said the following about Russia energy giant Gazprom back in May when the Russia-Ukraine crisis started hitting the headlines (via Business Insider):
Yeah. So this is – first of all, it’s a huge company. Revenues of $150 billion. The market cap is immense. They earn a lot of money even after, as my friend (inaudible) even after stealing they earn a lot of money. They pay a 5 percent dividend. As recently as 2006, the stock changed hands at 10 times the estimated earnings. So now it’s at 2.5. And why is that? Well, because people know that there will be even more extreme and costly sanctions imposed on Russia. They know that something terrible is going to happen with the Ukraine election in a couple of weeks. And well it might. There is certitude about outcomes that is notable given that so few people saw the current set of outcomes approaching some months ago. So in addition to the epigram that good things happen to cheap stocks, I will offer this epigram. This too will pass.
He did qualify his report by stating:
"Here’s a test of suitability for this investment," said Grant. "You can’t care about the time."
From a technical viewpoint, this chart below of the Russia ETF (RSX) appears to be trying to make a bottom. Even though the eruption of the latest round of geopolitical tensions, RSX failed to make a lower low. The relative performance chart of RSX to ACWI (MSCI All-Country World Index ETF) in the bottom panel shows that RSX remains in a relative downtrend, though it does seem to be finding relative support - which is positive.

An entry point for the Druckenmiller AMZN-IBM pair?
In November, 2013, Bloomberg featured an interview with Stan Druckenmiller about technology companies. Druckenmiller proceeded to pan IBM in the worst way possible:
Stan Druckenmiller, who has one of the best track records in the hedge-fund industry over the past three decades, said he’s betting against the shares of International Business Machines Corp. (IBM) because the company’s business will be replaced by technology such as cloud computing.

“It’s one of the more higher-probability shorts I have seen in years,” Druckenmiller, 60, said in an interview with Bloomberg TV’s Stephanie Ruhle at the Robin Hood Investors Conference in New York today. “IBM is old technology being replaced by cloud technology.”
By contrast, he praised for its its efforts in cloud computing:
Druckenmiller said he is betting on Inc. (AMZN), and praised CEO Jeff Bezos. Amazon’s Web Services division, whose server farms generate the processing power the retailer sells to heavy corporate data users on the cheap, “is killing it,” he said. IBM should be investing in its business and taking on the “challenge of the Amazons of the world” instead of doing share buybacks, according to Druckenmiller.

“I think he’s a serial monopolist,” Druckenmiller said of Amazon’s Bezos.
While Druckenmiller did not specifically describe a long AMZN-short IBM position as a pair trade, I chose to interpret it that way and the pair chart is shown below. At the time of the article, the pair trade was somewhat extended in favor of AMZN. Since then, the pair has come back down to earth a bit and current levels could serve as a good entry point.

Semiconductors, the momentum play
I have written before that my research has shown that in a bull phase, traders are best served by buying the hot industries and sectors showing the best price momentum (see Momentum + Bull market = Chocolate + Peanut butter).

On the weekend, I called for an oversold rally to start (see A tradable bottom?). In such an instance, the highest beta momentum group to play appears to be the semiconductor stocks. As the chart below of the relative performance of SOX to SPX shows, the semiconductor stocks have been displaying leadership qualities for all of 2014. The recent retreat, which was due to the minor pullback that we saw in the last couple of weeks, shows the group to have come down to a reasonable long entry point for traders to want to play the momentum game.

I want to repeat my previous caveat that these are all different kinds of trade ideas encompassing different investment themes, different time horizons and different levels of risk. Not all ideas are suitable for everyone. While I have no positions in any of these trades at the moment, I could initiate a position at any time. Further, I know nothing about your portfolio or your risk tolerance. Do your own due diligence before putting on any of these positions.

Monday, August 11, 2014

A new Golden Age of demographic growth

Back in 2011, I wrote about how US age demographics was likely to drive a new secular bull market at the end of this decade (see Wait 8 years for a new bull?). I cited research from a team of academics led by John Geanakoplos who wrote a paper entitled Demography and the Long-Run Predictability of the Stock Market. I wrote:
In this study, Geanakoplos et al related demography to long-term stock returns. They found that P/E ratios were correlated to the ratio of middle-aged people to young adults, otherwise known as the MY ratio. When MY rises, the market P/E will tend to rise and when it falls, P/Es tend to fall.

If the conclusions of the study are correct, then we should see a continued fall in P/E ratios with a long-term bottom in stock prices forming about 2018, or eight years from now.
In 2012, I followed up with a post about a San Francisco Fed study entitled Boomer Retirement: Headwinds for U.S. Equity Markets? The SF Fed researchers used a slightly different methodology than the paper by Geanakoplos et al, and they postulated a market bottom in 2021 (see A stock market bottom at the end of this decade).

Now I see that Bill McBride of Calculate Risk has approached this issue of demographics in a slightly different fashion but coming to a similar conclusion. He is calling for a boom in housing at the end of this decade (via Business Insider):
McBride argues that currently, with so many 20-24 year olds, the demographics are very favorable to apartment renting. And so of course these days, the multi-family housing sector has been leading the way. And you hear all these stories about how people aren't into homeownership anymore. But the demographics that are currently favorable to apartments will turn into demographics favorable to homeownership, as the cohort gets older, moves into higher paying jobs, and wants more space for those new babies.

Bottom line: As the Echo Boomers age, they get more affluent, start to have babies and they will drive a bull market in housing, as well as the stock market. It`s nice to get confirmation of my demographically driven analysis from an well-respected source.

Sunday, August 10, 2014

A tradable bottom?

Weekly Trend Model signal
Trend Model signal: Risk-off (downgrade)
Direction of last change: Positive (unconfirmed upgrade)

The real-time (not back-tested) signals of the Trend Model is shown in the chart below:

Trend Model Signal History

Volatility is coming: A high risk of whipsaw
The Trend Models are somewhat confusing this week, as the intermediate term Trend Model flipped from risk-on to risk-off, which is a downgrade, but the trading model, or direction of last change, moved to an unconfirmed positive. The obvious question is, "If the intermediate term model goes from 'risk-on' to 'risk-off', shouldn't the direction of last change be 'negative' instead of positive?"

That's because the signals have been moving around so quickly last week as the signal flipped from negative early in the week to an unconfirmed positive on Friday. These volatile conditions heighten the risk of performance whipsaw. Let me explain how the modeling process works.

Further to the post showing the promising returns of the Trend Model (see Trend Model report card: July 2014), I was asked, "How systematic or discretionary are the trading decisions?"

Trend Model signals are primarily based on the application of a highly systematic trend-following model, which uses crossing moving averages, on commodity prices and global equity prices. The details are of which moving averages, which commodities and indices and their weights are proprietary, but the conclusions are more of less the same no matter how you look at the global picture. However, trend-following models have two weaknesses (not bugs, but "features"). They tend to be late in calling tops and bottoms and, if there is no trend, their signals are subject to whipsaw which detract from performance.

To address some of these weaknesses, I have relied on a series of sentiment based indicators to better time entry and exit points. These sentiment models primarily focus on measures of sentiment from option data, largely because the option market is reflective of what people are doing with their money rather than sentiment surveys where people express opinions which may or may not be acted upon. I also cross-check the conclusions from the option data models with overbought-oversold indicators. These short-term sentiment based indicators tend to used more for risk control purposes.

Here is an example of how the two components interact with each other. If the trend-following model is flashing a buy signal and the markets are in an uptrend, but the sentiment models are showing a crowded long and an extremely overbought condition, I would be inclined to either lower my long position, move to cash, or perhaps take a very small short position in anticipation of a pullback.

So in answer to the question of how systematic or discretionary are the trading decisions, the signals of both of trend-following components and the short-term sentiment indicators are systematic, but their interpretation is somewhat discretionary.

Trend following models: Risk-off
Let's consider what each of the components are saying now. From an intermediate term perspective, the trend following components of the models are screaming "risk-off".

Consider, for example, this chart of the SP 500. While the SPX remains above its 200 day moving average (dma), it decisively broke down below its 50 dma. At best, the SPX can be ranked as "neutral".

The technical conditions of the European markets look far worse. This chart of the STOXX 600 shows that it has not only violated the 50 dma, but the 200 dma as well. It seems to be selling off with no sign of stabilization in sight.

The Trend Model was built to analyze markets from a global perspective. The three trading blocs and engines of growth in the world today are the US, Europe and China. While US and European equity market indices tell a great deal about these economies, the Chinese equity market is far less developed and less liquid than any of the major developed market indices. To get a read on China, I rely more on commodity prices.

This chart of the CRB Index shows that commodity prices to be in a downtrend. The equal-weighted CRB Index, or CCI, looks even worse than the CRB. That's largely because of the downdraft we are seeing in the agricultural complex.

When you put it all together, the intermediate term picture looks dire. It was the weakness in foreign equity and commodity markets that led me to issue a warning about US equities (see Global growth scare = Trend Model downgrade).

Sentiment models: A possible tradable bottom
The short-term sentiment-based models, however, tell a different story. In the last week, sentiment model readings have been volatile. In the previous week, I had postulated that US equities would see an oversold rally based on what I saw in the VIX term structure (see Still bearish, but watch for the dead-cat bounce).

We saw a minor bounce on Monday, but there was little or no follow through. I re-thought my analysis and consider the possibility that we could be seeing the start of a deeper pullback (see Bounce is over, time to get bearish). The scenario would be that we were on the verge of a deeper sell-off into a capitulation low.

I was right, sort of. The sell-off began overnight Thursday when President Obama announced that US humanitarian relief in Iraq and airstrikes against ISIS. I tweeted:

The sell-off occurred overnight, but when the market opened on Friday morning, an oversold rally had begun. The "capitulation sell-off" was over if you blinked (or slept through it).

Today, technical conditions are pointing to a tradable bottom in US equities. My research has found that whenever the VIX term structure exited inversion, it has shown to be fairly reliable buy signals, and whenever the TRIN Index rose above 2.0 (oversold) and then fell below that level, it has also indicated profitable long entry points. Both systems have flashed false positives.

What is remarkable is the combination of these two indicators (marked by dotted vertical lines on the chart below) has had an infallible record of calling tradable bottoms in the last two years.During that period, ensuing rallies have lasted a minimum of two weeks.

The track record of this system in the 2010-2011 period, which had more up-and-down markets, has also been very consistent. I have marked the instances where this combination of two indicators successfully marked a tradable bottom in blue and unsuccessfully in red. During this more volatile period, however, "buy" signals generated by this system generally saw rallies that lasted a minimum of one week, instead of the two weeks that we have seen in the last couple of years.

As well, whenever my favorite overbought-oversold indicator, which is based on the ratio of stocks above their 50 dma to stocks above their 150 dma, exits from the 0.50 oversold reading, which it did this week, stock prices have tended to rebound.

Overbought-Oversold Indicator (in green)

At the end of the week, the volatile market action left me in somewhat of a quandary. The trend-following models are calling for risk-off, while the short-term sentiment model readings are bouncing all over the place. This left me calling for an unconfirmed risk-on trading signal.

At the time of this writing on Sunday night, ES futures are modestly in the green, which raises the odds of bullish confirmation. Nevertheless, I would like to see some bullish follow-through next week before committing to a full risk-on reading on my trading account.

If readers would like to see the real-time developments of how the signal develops, please follow me on Twitter at @humblestudent. I will be tweeting during the week and try to post updates on this blog, which you can subscribe to with email updates (with a delivery delay) here.

Fundamentals still positive for equities
While my inner trader has been frantic last week, my inner investor has been wondering what the fuss is all about. Consider that:
  • The interest rate environment continues to be benign. Interest rates matter because they affect the discount rate on earnings, or the inverse of the PE ratio. With 10-year Treasury yields at 2.4%, what is there to complain about?
  • We have seen solid reports from the current Earnings Season. The earnings beat rate has been between 67% and 73%, depending which sample you are looking at, and the revenue beat rate has also been above the historical average. Analysis from Factset indicating that the market was not rewarding earnings beats but punishing misses is more of a comment on market psychology than market fundamentals. However, Brian Gilmartin reports that "The year-over-year (y/y) growth rate of the forward estimate fell to 9.53%, from last week’s 9.58%", which is a possible concern that growth expectations are coming down and this development needs to be watched.
  • The near term economic growth outlook remains positive. Consider, for example, the steady fall in weekly unemployment claims. New Deal Democrat agrees, though he believe that longer term storm clouds may be on the horizon:
  • Growth for the rest of 2014, and early 2015, looks intact. But weakness in the housing market evident in the first part of this year may be spreading into the rest of the economy, suggesting that growth will slow down.
Last week, I had been searching high and low for a fundamental catalyst for the stock market sell-off (see When fundamentals and technicals clash). The most plausible explanation I found came from Josh Brown, who explained it in terms of rising interest rate expectations that manifested itself in the form of angst in the junk bond sell-off (emphasis added):
Plain and simple, they are shifting their allocations toward a world of faster economic growth and higher volatility. Not all at once, and not severely, but definitely. It’s happening.

This explains the bludgeoning of the consumer staples sector last week – its worst sell-off since the late-May Taper Tantrum of 2013. Consumer staples are the perfect stocks for slow growth and low yields – as they offer consistency of earnings regardless of cyclicality and higher than average dividends. In a higher-rate, more pro-cyclical environment, they are not so perfect – especially given their current high valuation. And so they are under distribution so long as economic news – like last week’s record post-crisis ISM report – continue to roll out.

Which brings me to the junk bond sell-off, another symptom of our awaking to the possibility of faster growth. It’s been a pretty orderly sell-off for the $1.6 trillion high yield market, but quite steady and relentless all the same. Why? In a higher rates environment – if ever such a thing should come about – investors are going to demand more return for the risks they’re taking in the asset class. Defaults have been almost non-existent, so the popularity of high yield bonds in investor asset allocations is perfectly understandable. But higher rates have a tendency of disturbing this placidity like a skipped stone across the surface of a pond. And so $5 billion has come out of high yield funds in July, including the highest one-week redemptions in more than a year. Once again, this is the Big Money preparing for something new.

Now, you may be asking, why, if large groups of investors are preparing for higher rates, are rates actually declining – as evidenced by the near record-low yields we saw in the 10-year Treasury last week?

This is a great question, I’m glad you asked.

My theory is that the activity and jostling for position inherent in a market regime shift like the one we’re now seeing is guaranteed to cause volatility. Elephants cannot play musical chairs, even slowly, without some degree of breakage and collateral damage. Nor can large pools of invested capital switch themselves around in complete silence.
 Indeed, the junk bond and, its half-sister, EM bond markets have begun to roll over relative to Treasuries (see my post here about the proper performance benchmarks for bond ETFs).

As David Merkel explains, we should not be overly worried about the contagion effects from a junk bond sell-off:
Is this move in the junk bond market a hiccup, or the start of something big? I’m open to other opinions, but for it to be something big, you have to have a lot of things that look misfinanced. Where are there economic entities with short-term debt financing long term assets that look overvalued? Where have debts grown the most? I can’t identify a class like that unless we try student loans, or government debts. Corporate debt has grown, but doesn’t seem unreasonable now.

So, with high yield, I lean toward the hiccup. But even at current yields, it is not cheap. Speculators may play; I will stay away.
To sum up, my inner investor is not overly worried. Equity market fundamentals look ok and the recent bout of risk aversion is only a hiccup. He is therefore looking around for interesting bargains. In a future post, I will write about a few out-of-the box opportunities that I see in this market.

Disclosure: Long TNA

Saturday, August 9, 2014

What Chinese financial repression looks like

I have written much about financial repression in China, how the artificially depressed cost of capital have benefited SOEs and Party insiders, etc. (see this link for past posts). The current round of purges is one way of addressing that issue so that financial reforms can be effected (see IMF's China: Blind men and the elephant).

This chart from Lukas Daalder tells the story:

Sometimes a picture is worth more than a thousand words. Note the rightmost bars, where the top 10% gets over 100% of the gains while the bottom 90% loses ground.

In China, it is truly glorious to be rich.

Thursday, August 7, 2014

IMF's China: Blind men and the elephant?

I have been meaning to write about this but other tasks got in the way. Last week, the IMF released its Article IV report on China. There were lots of concerns and suggestions, but to me, it seemed like the story of the blind men and the elephant.

There were many summaries of the report. This WSJ article hit most of the main points, namely prescriptions to slow down the growth rate and to focus on economic reforms:
The International Monetary Fund warned that China's growth rate could plummet in the coming years unless Beijing speeds up the pace of its economic reforms.

In its annual review of China's economic prospects released Wednesday, the IMF forecast that China's economy will slow to 7.1% growth in 2015, from a projected 7.4% this year and continue to slow further later in the decade. It said the forecast is based on the assumption that China continues at its current pace to overhaul its economy so that it relies more on consumer demand and less on exports and capital-intensive industries.

If it falters and doesn't carry them out, the IMF said, China's GDP could fall to 3.5% by about 2020, and close to 2.5% after that. China last year reported growth of 7.7%.

The IMF urged Beijing to"promptly" carry out financial reform and exchange-rate liberalization and to make a number of fiscal changes within two years, including taxing real estate. The IMF now expects China to phase in such changes over five years, though there is a possibility that the changes would be delayed further or not enacted.

"If they aren't able to move reasonably fast [on reform], we see the risks of a disorderly adjustment rising," said IMF China chief Markus Rodlauer in an interview.
More telling was the fact that Chinese controlled media Xinhua de-emphasized the IMF projections of slower growth into the future:
The Chinese economy is expected to grow about 7.5 percent this year and implementation of reforms would help the country achieve a more balanced and inclusive growth, the International Monetary Fund (IMF) said on Wednesday.

Key risks
The IMF outlined the now familiar key risks to the Chinese economy in its report. One is the torrid pace of credit growth. In all past instances of such episodes, the countries involved experienced banking crises (emphasis added):
Previous studies suggest that a credit boom that starts from a higher level of credit-to-GDP ratio and lasts for longer period is more likely to precede a systemic banking crisis. In the past five years, China’s TSF stock increased by 73 percent of GDP,2 while adjusted TSF and bank credit to nonfinancial sector increased by around 30 percent of GDP. Looking at a sample covering 43 countries over 50 years, staff identified only four episodes that experienced a similar scale of credit growth as China’s recent TSF growth. Within three years following the boom period, all four countries had a banking crisis. With a lower threshold of a 30-percent-of-GDP increase in credit over five years, there are 48 episodes of credit boom, half of which were followed by banking crises.
The second concern raised by the IMF was the pace of re-balancing the economy from one driven by infrastructure growth to consumer-led growth. As the chart below shows, China has been dominated by investment at the expense of private consumption compared to other economies:

As well, the contribution of investments to GDP (green line) far outpaces private consumption (blue line). While the two have started to converge in the last few years, the degree of convergence has been extremely slow:

Indeed, the most recent divergence between the positive trajectory of the manufacturing PMI compared to the slippage of the services PMI indicates that Beijing still has much work to do in order to re-balance growth.

Financial repression reforms
The IMF prescribed reforms measures to liberalize the financial markets and to end "financial repression" (my words, not theirs). The Chinese authorities recognized that financial reforms were the right course of action and reiterated the Third Plenum goals of allowing market forces to dictate policy (emphasis added):
The authorities agreed that financial sector reforms were critical, and highlighted the progress already made in this area. They planned to introduce deposit insurance in the near future and advance deposit rate liberalization as circumstances allowed. They also agreed that removing implicit guarantees, pervasive throughout the financial and corporate landscape, was key. This saw moral hazard as distorting the allocation of credit and investment, posing a risk to the success of financial liberalization which rested critically on hard budget constraints. Linked to this, the authorities explained that their strategy for SOE reforms included leveling the playing field and opening up to more competition, with the exception of some strategic sectors. Regarding the monetary policy framework, they agreed on the importance of relying more on interest rates over time.

Sequencing, sequencing!
Just as I believe that many outsiders didn't understand how economics and politics were intertwined in the eurozone (see Lest we forget, or why you don`t understand Europe and Mario Draghi reveals the Grand Plan), many western analysts don't understand how political decisions affect the economics of China and vice versa. They just focus on one piece of the puzzle and wind up like one of blind men in the story of the blind men and the elephant. They only understand the elephant as a leg, a trunk or a leafy ear but don`t understand the big picture.

So I will use a term most often used by the European Central Bank in addressing the problems of the eurozone: "sequencing". Just as the remedies of the eurozone problems need to be correctly "sequenced", the remedies addressing the problems of the Chinese economy need to be "sequenced" as well.

The first step in the sequence is Xi Jingping's Grand Plan for China is his anti-corruption drive in order to consolidate power in order to effect financial reforms (see my previous post Dissecting the bull case for China):
Many western analysts misunderstand the term "reform" when it comes to China. They think in terms of westernized institutions, such as transparency, property rights, democracy, etc. For Beijing and President Xi Jinping in particular, reforms starts with a consolidation of power through an anti-corruption drive. Otherwise, no financial reforms are possible because Beijing would issue edicts and the bureaucracy would resist.
As the highlighted text from the IMF report indicates, one of the Third Plenum  objectives is SOE reform to level the playing field. But "leveling the playing field" would hurt SOEs and Party insiders, many of whom have grown obscenely rich because of their positions. The objective of the anti-corruption drive is, as the Chinese put it, "killing the chicken to scare the monkeys". As Caixin reports, the Central Discipline Inspection Commission has a website which reports the results of the anti-corruption drive on a daily basis:
Curiosity is one reason the website of the Central Discipline Inspection Commission (CDIC) attracts up to 2 million page views every day.

Another reason is fear. Some website visitors, for example, want to know whether they or anyone they know has been targeted by a government campaign to root out corruption led by the CDIC Inspection Team.

Since the campaign began in December 2012, 33 high-level government and state company officials — all in positions at the deputy provincial level or higher — have come under investigation for violating laws or Communist Party rules. Each has been removed from office and detained. Some have been kicked out of the party.
This chart from CNBC shows that China's anti-corruption drive has definitely heated up:

The Economist reports that, though the data is spotty, past anti-corruption campaigns seem to have boosted growth, not detracted from it (emphasis added):
China’s past anti-graft campaigns, though admittedly less extensive than the current one, hurt the economy little and may even have boosted it. Investigations directed at the local government of Beijing in 1995 and of the port-city of Xiamen in 1999 coincided with growth slowdowns of roughly three percentage points. Both cities quickly recovered. When Shanghai’s party chief was toppled in 2006, growth accelerated the following year. Across China, counties that are strongly against corruption tend to have higher incomes than those that go easy on sleaze, according to research by Yiping Wu of the Shanghai University of Finance and Economics and Jiangnan Zhu of the University of Hong Kong.
Just remember the term: "sequencing".

Financial repression and the currency puzzle
The one curious observation which I did not understand from the IMF report was the conclusion that the RMB was slightly undervalued:
The external position is moderately stronger compared with the level consistent with medium-term fundamentals and desirable policy settings (Box 9). On that basis, the renminbi is assessed as being moderately undervalued. In terms of the External Balance Assessment (EBA) model, China’s policy gaps (policies different from desired ones, contributing to a moderately stronger external position) stem mainly from intervention, capital controls, and health spending. The pace of reserve accumulation slowed significantly in 2012, but picked up again in 2013 against the backdrop of large capital inflows induced by interest rate differentials, the relatively high real return of capital, and expectations of continued RMB appreciation. Reserves are above the range suggested by the Fund’s metric, rendering further accumulation unnecessary from a reserve adequacy perspective.

A flexible, market-determined exchange rate is an important part of the reform agenda. A market-determined exchange rate—in which there is no sustained, large, and asymmetric intervention—is key for sustained rebalancing and as a shock absorber as the capital account is progressively liberalized. Moreover, given the rapid growth in offshore renminbi markets and growing opportunities for financial arbitrage, it is also becoming increasingly important for maintaining an independent monetary policy. The recent doubling of the daily trading band is a welcome step forward. Looking ahead, the goal should be to allow greater flexibility and reduce intervention, which could be achieved by further widening the band and ensuring the central parity better reflects market conditions.
The Chinese disagreed with the conclusion and believed the RMB exchange rate to be roughly at equilibrium and placed part of the blame on the QE policies of developed world central bankers:
Authorities’ views. The authorities disagreed with the assessment that the real exchange rate was moderately undervalued and considered that it was close to equilibrium. They reiterated their previous concerns and strong reservations on EBA, and emphasized the importance of evenhandedness. In particular, they considered that the assessment failed to account for the impact of advanced economy monetary policies on global financial flows and emerging market economies, the continued narrowing of China’s current account surplus, two-way fluctuations of the exchange rate, substantial appreciation of REER, and the movements of other currencies (such as the U.S. dollar).
Here is what I have trouble understanding. We know that for years, China pegged the RMB to the USD so it had to adopt the US interest rate policy. At the same time, inflation in China was rising, but because of exchange rate and interest rate controls, household savings in the banking system had to make do with a negative real interest rate, which subsidized the cost of capital for (mostly) SOEs, whose Party insiders made out like bandits.

Thus, the natural rate of interest in China is considerably higher than it is in the US, which invited all sorts of leveraged carry-trade schemes like borrowing against copper and iron ore inventories, etc. Now imagine what would happen if exchange rate controls disappeared overnight and the market set rates.

In the short term, the interest rate differential between the USD and CNY would invite the carry trade and put upward pressure on the CNY. On the other hand, the inflation rate differential between the two economies would put downward pressure on the CNY. In effect, market forces suggest that the long term equilibrium exchange rate for CNY is lower than current levels, not higher as indicated in the IMF report.

Perhaps the IMF conclusion that CNY is slightly undervalued is a nod to the political sensibilities of the Washington-based IMF. A falling CNYUSD exchange rates would create political fallout in the United States and make many American unhappy (maybe unhappy enough to follow Sarah Palin's suggestion to stop eating Chinese food).

In this respect, the IMF is also like one of the blind men trying to describe the elephant.

Wednesday, August 6, 2014

Bounce is over, time to get bearish again

I just wanted to write a quick trading note. I had been postulating a short-term oversold stock market rally based on what I observed in the term structure of VIX (see Still bearish, but watch for the dead-cat bounce).

Since then, we saw a minor bounce on Monday and the market failed to follow through Tuesday. I have been thinking about a second scenario where stock prices, instead of rallying when the VIX/VXV ratio exits an inverted condition (dotted vertical lines), consolidate and fall as they did in late January.

We can find more evidence of this kind of pattern in the corrective episode in 2011. When VIX/VXV ratio inverted in August and mean reverted, we saw a brief period of minor consolidation only to be followed by a waterfall decline into the final corrective low.

By contrast, the dotted vertical lines depict periods when the market did rally after exiting VIX/VXV inversion. The difference seems to be the market`s behavior in the critical two or three days after exiting inversion. Did it see a sustainable rally, or consolidate sideways. If it`s the latter, the risk of further declines are very real.

In the current case, I believe that we have to seriously look at the latter scenario as the base case. Since the Trend Model has already flashed a trading sell signal (see Global growth scare = Trend Model downgrade), it`s time for my inner trader to get bearish again.

Disclosure: Long SPXU

Tuesday, August 5, 2014

Lest we forget, or why you don't understand Europe

About 100 years ago, the First World War Great War began in Europe. I have written on this topic before (see The European experiment in context and Remembrance Day in the eurozone). European countries suffered devastating losses of young men in this "war to end all wars". In all, Wikipedia reports that military and civilian casualties totaled over 37 million dead and wounded.

The United States was not involved in the First World War in the same manner as the European powers. So let me give my American friends some context. In a single battle for the Verdun fortress, which spanned several years, the casualties of both sides approached a million men. Compare and contrast those figures to American casualties in Vietnam and Korea.

Here in Canada, the loss of life was equally appalling (via Globe and Mail):
Canada’s commitment to the First World War was staggering when viewed from the 21st century: from a nation of eight million, more than 600,000 Canadians were mobilized in the war effort.

By the end of the war, more than a third were killed or wounded. Upwards of 66,000 died and more than 172,000 were injured.
Today, if you were to visit the Vietnam Memorial in Washington, DC, you will see the names of the 56K US service members who lost their lives in that conflict. If the same proportion of war dead to population for Canada in the First World War were to be applied to the US losses in the Vietnam War, the equivalent figure would be roughly 2.5 million dead, or 45 times the actual count.

So is it any wonder that after the carnage of the First World War and the Second World War, the countries of Europe came together and said, "Enough!"

Thus, the EEC and later the EU was born. Today, that project has largely succeeded. We have seen no major European conflict since 1945, the end of the Second World War. The formation of the European Union has kept the peace. The political elite of Europe, despite all the bickering, are still committed to that bigger than life myth of the formation of the EU.

For overseas analysts who look at Europe and only focus on the cost of bailing out Greece, Portugal, etc. Don`t ever forget the political glue that holds Europe together.

Lest we forget.

Monday, August 4, 2014

Trend Model report card: July 2014

Further to my last report card on the account run based on the signals of the Trend Model (see An intriguing Trend Model interim report card), here is the report card for that account for the month of July 2014.

I reiterate my disclaimer that I have nothing to sell anyone. Moreover, I am not in a position to manage anyone`s money based on the investment strategy that I am about to describe. (If nominated, I will not run. If elected, I will not serve.)

For readers who are unfamiliar with my Trend Model, it is a market timing, or asset allocation, model which uses trend following techniques as applied to commodity and global stock market prices to generates a composite Risk-On/Risk-Off signal (risk-on, risk-off or neutral). I have begun updating readers on the Trend Model signals on a weekly basis (for the last comment, see When fundamentals and technicals clash).

Trend Model description
The chart below shows the real-time (not back-tested) changes in the direction of the signal, which are indicated by the arrows, overlaid on top of a chart of the SP 500. You can think of the green up arrows, which occurred when the trend signal changed from negative to positive, as buy signals and the red down arrows, which occurred when the trend signal changed from positive to negative, as sell signals. Note that this is a real-time (not back-tested) record.

Trend Model Signal History

A proof of concept
While the results from the above chart, which represents paper trading, is always interesting, there is no substitute for actual performance. As a proof of concept, I started to manage a small (about 100K) account that traded long, inverse and leveraged ETFs on the major US market averages. Trading decisions were based on Trend Model signals combined with some short-term sentiment indicators. The inception date of the account was September 30, 2013 and the chart below represents a preliminary report card of the account.

When evaluating the performance of this trading account, keep in mind that this is intended to be an absolute return vehicle. While I do show the SPY total return, which includes re-invested dividends, for illustrative purposes, the SP 500 is not an appropriate benchmark for measuring the performance of this modeling technique.

July 11.3%, June restated to 1.2% from 1.5%
The results in July was highly satisfying as the account showed a total return of 11.3% while SPY was -1.3%. June was re-stated to 1.2% from 1.5% because I had was showing a preliminary estimated result rather than the value on the account statement. The July figure reflects the account statement value and is not an estimate. I would caution, however, that the July return is overstated by an estimated 2.6% because the account statement values are based on settlement date accounting and trade date accounting, which includes the effect of trades executed but not settled as of month-end, lowered returns by 2.6% and the adjustment will show up in the returns for August.

These positive returns was achieved by:
The Trend Model was fortunate in spotting the inflection point in the stock market in July. Deteriorating technical indicators from commodity and overseas equity markets warned of impending US equity market weakness, but I would not expect the model to be so prescient at every turn. The main engine is a trend following model and such models are, by definition, late in picking up trend changes and subject to whipsawing signals, as the disappointing returns in 1Q2014 can attest.

Results continue to be promising
As with last month, these live results continue to be promising:
  • Returns are strong and the Trend Model is performing as expected.
  • Returns are uncorrelated with equities (correlation of -0.15 with SPY), bonds (-0.25 with AGG).
While these results are promising, I consider the Trend Model to be untested by stressful markets. The test period that began in September 2013 only includes a stock market that has only gone up. The acid tests for this model is how it behave when the market corrects and when it turns around and starts to rally again.

Should the weakness from last week turn out to mark the start of a corrective period, then the test will have begun. Until then, I would view results with a skeptical eye.

How you can follow Trend Model signals
In the meantime, I would readers who want to monitor the signals of the Trend Model to subscribe to my posts, which include Trend Model updates, by clicking on one of these links on the sidebar or follow me via Twitter @humblestudent:

Sunday, August 3, 2014

When fundamentals and technicals clash

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Negative

The real-time (not back-tested) signals of the Trend Model is shown in the chart below:

Trend Model Signal History
(Please scroll to the bottom of this post to see how you can get a free subscription to Trend Model updates.)

A puzzling retreat
If I told you I had a crystal ball and told you the following facts last weekend:
  • Earnings season will continue to be strong, with solid beat rates for both the top and bottom lines (Factset reports the SP 500 EPS beat rate was 74% and the revenue beat rate was 65%, well above the historical average);
  • The growth outlook will continue to be positive, as the 1Q GDP report will beat expectations by a full 1%;
  • The FOMC statement will come in roughly as expected and the yield curve will steepen somewhat, but interest rates remain stable; 
  • Non-Farm Payroll will miss expectations, but the closely watched participation rate ticks up and wage pressures remain benign;
  • Chinese PMI will come in ahead of expectations; and
  • There will be no new geopolitical shocks.
What would your expectations be for US equities? Would you have predicted that the SPX would crater by 2% on Thursday and continue to decline Friday?

What is puzzling for fundamental investors is that the stock market retreat last week has been singularly lacking in fundamental underpinnings. Most importantly, the two principal drivers of stock prices are E and PE. With respect to the former, the earnings outlook remains positive as Ed Yardeni reported that Street expectations continue to get revised upwards:

More timely data came from Brian Gilmartin as he reported that the forward EPS growth rate had ticked up to 9.58% from 9.41% the previous week, indicating that forward 12 month earnings continue to get revised upwards.

As for the results of the Fed meeting, Marc Chandler summarized the tone the FOMC statement this way:
The FOMC statement made it clear that while the downside risk to inflation had lessened, the slack in the labor market favored continued accommodation, and the low Fed funds rate was anticipated to continue for a considerable period. There was one dissent over that forward guidance, but no one, even those that have publicly argued the Fed was slipping behind the curve, called for a rate hike. The course that Bernanke put the Fed on remains intact.
With regards to the capitalization rate for earnings, the 10-year Treasury yield ticked up 6 bp on the week, but the 5-year yield declined. Steepening yield curves are a typical characteristic of a robust and growing economy. That`s good news, right?

So why did the stock market freak out on Thursday and Friday?

A technically driven decline
The only reasons that I can cite for the decline in the major US equity averages are based on technical analysis. As I pointed out last weekend (see Global growth scare = Trend Model downgrade), I suggested that Mr. Market is anticipating a global growth scare. As a result, I downgraded the technical signal for my Trend Model for the following technical reasons based on inter-market analysis:
  • Falling commodity prices
  • Weak equity prices in Europe
For the month of July, the SPY showed a total return of 1.3% , which was highly disappointing in the face of the good news of a positive earnings season and benign interest rate environment. From a technical perspective, a market that fails to respond to good news is characterized as being an exhausted bull.

In addition, I observed that risk aversion is rising, as junk bonds are starting to underperform equivalent Treasuries. As the week progressed, the underperformance continued as credit spreads continued to widen:

(There were many charts in the analysis from last week, but I won`t repeat them here but you can review them at this link.)

While I am gratified that the Trend Model was correct in turning bearish for technical reasons, the decline that began last week is unlikely to have legs unless it is supported by a solid fundamental backdrop. For now, market fundamentals remain bullish.

When fundamental and technical analysis disagree 
Before technicians celebrate and trumpet the triumph of technical analysis over fundamental analysis, let me remind everyone that the last time the fundamentals and technicals disagreed, fundamentals won out in in the end.

Regular readers will recall that I turned cautious on the stock market in the Spring based on Trend Model readings as negative technical divergences were developing. In early May, I penned a well-reasoned market commentary based on market cycle analysis as to why traders and investors should sell in May (see The bearish verdict from market cycle analysis). To summarize, late cycle sectors were assuming the market leadership as early and mid-cycle sectors faltered in relative strength.

Much like the episode in April and May, while the technical picture was deteriorating, the fundamentals remained positive. Growth was reviving after a horrible 1Q and earnings were rising and the interest rate environment was benign. As the stock market continued to grind higher, the Trend Model and I threw in the towel and turned bullish on the market in early June (see Correction, interrupted).

In short, the last time the fundamentals and technicals disagreed, the fundamentals won. What happens this time?

The small cap fundamental vs. technical puzzle
Consider, for example, the underperformance of small cap stocks. It`s not just the Russsell 2000. Dan McCrum of FT Alphaville highlighted BCA Research`s observation that small caps are lagging their large cap counterparts on a global basis:

BCA postulated that it was because smaller companies are more sensitive to rising labor costs, which would be negative for wage inflation, a measure closely watched by the Fed:
In the interim, the message is that small cap labor expenses are likely to be far more punitive than wage costs for large businesses. This is confirmed by the sharp rise in the household employment survey relative to the establish- ment survey this year. The former includes smaller companies and the self-employed, and when it rises faster than the payroll survey it is a signal that wage pressures are building among smaller firms. Thus, small cap profit margin pressure will become more acute earlier than it will for large caps.
Several days later, McCrum`s FT Alphaville colleague Cardiff Garcia tweeted that wage growth was weak across advanced economies:

What`s the real story? How can wage growth be weak and small caps be pressured by wage growth? Is this a case of the technicals (small cap underperformance) telling one story and the fundamentals (wage growth) telling another?

There is always a divergence somewhere
Today, US equities continue to experience negative divergences. As an example, Mark Cook uses a proprietary breadth measurement to gauge the health of the stock market and he is seeing conditions similar to the tops in 2000 and 2007 (emphasis added):
Mark Cook, a veteran investor included in Jack Schwager’s best-selling book, “Stock Market Wizards,” and the winner of the 1992 U.S. Investing Championship with a 563% return, believes the U.S. market is in trouble.

The primary indicator that Cook uses is the “Cook Cumulative Tick,” a proprietary measure he created in 1986 that uses the NYSE Tick in conjunction with stock prices. His indicator alerted him to the 1987, 2000, and 2007 crashes. The indicator also helped to identify the beginning of a bull market in the first quarter of April 2009, when the CCT unexpectedly went up, turning Cook into a bull.

What does Cook see now?

There have been only two instances when the NYSE Tick and stock prices diverged radically, and that was in the first quarter of 2000 and the third quarter of 2007. The third time was April of 2014,” Cook says.

In simple terms, as stock prices have gone higher, the NYSE Tick has moved lower. This divergence is an extremely negative signal, which is why Cook believes the market is losing energy.

In fact, the Tick is showing a bear market, which seems impossible considering how high the market is rising.

“The Tick readings I am seeing (-1100 and -1200) is like an accelerator on the floor that is pressed for an indefinite amount of time,” Cook says. “Eventually the motor will run out of gas. Now, anything that comes out of left field will create a strain on the market.” Since the CCT is a leading indicator, prices have to catch up with the negative Tick readings.

“Think of a dam that has small cracks that are imperceptible to the eye,” he says. “Finally, the dam gives way. Eventually, prices will go south, and the Tick numbers will be horrific.”

Cook is also concerned that the market is acting abnormally. “It’s like being in the Twilight Zone," he says. “Imagine going outside when it’s raining and getting sunburned. That’s the environment we’re in right now.”
Josh Brown aptly wrote last week that there is always a divergence somewhere and sometimes they matter and sometimes they don`t:
The thing is, there is always a divergence. Sometimes they matter, sometimes they don’t. Sometimes one key divergence that was extremely important ends up meaning exactly zero the next time around. A single divergence, in and of itself, has all of the reliable predictive power of a bowl of chicken bones spilled out across the table.

And since no one has ever been able to prove otherwise – isolating a single divergence and showing a consistent win rate based on following it – you’re going to have to take my word for it.
My view is that unless this decline has a fundamental underpinning, any pullback is likely to be ephemeral. Without fundamental support, the downside for any market weakness is going to be highly limited. The last time the market declined in any major fashion was 2011. Recall that episode was driven by the combination of a eurozone debt crisis and fiscal uncertainty due to a political impasse in Washington.

What's the fundamental bearish trigger?
So what`s the fundamental trigger this time? The most likely one is a fear of rising interest rates. Perennial bear Ambrose Evans-Pritchard pointed out that it isn`t just the Fed, but China is also tapering and withdrawing global liquidity:
The spigot of global reserve stimulus is slowing to a trickle. The world's central banks have cut their purchases of foreign bonds by two-thirds since late last year. China has cut by three-quarters.

These purchases have been a powerful form of global quantitative easing over the past 15 years, driven by the commodity bloc and the rising powers of Asia.

They have fed demand for US Treasuries, Bunds and Gilts, as well as French, Dutch, Japanese, Canadian and Australian bonds and parastatal debt, displacing the better part of $12 trillion into everything else in a universal search for yield. Any reversal would threaten to squeeze money back out again.
In separate article, Evans-Prichard asserted that the "World is at inflexion point as Fed tightening looms":
The Third Taper Tantrum has been postponed, perhaps. It has not been averted.

The US Federal Reserve is preparing to tighten. Dallas Fed chief Richard Fisher said today that rates may rise early next year: “we are closer to lift-off than the market assumed we were, sometime late in 2015. I believe we moved that forward significantly,” he told CNBC.
He concluded:
Suddenly the world we have all know for the last five years is swivelling into reverse. The US will soon stop leaking emergency liquidity into the world economy, stoking asset bubbles everywhere.

The exact opposite may now happen. The Fed will tighten because the US is strong enough to withstand the pain – or thinks it is – causing a flood of capital back into dollar assets. The global liquidity will be vacuumed up again.

As the saying goes, never fight the Fed.
The interest fear thesis could be the trigger for stock market weakness. While such a change in psychology could trigger a correction, it is unlikely to signal the start of a full-blown bear market because the initial hike in rates is linked to rising growth, which is bullish for equity fundamentals. David Rosenberg explained it this way (via Business Insider):
Rosenberg points out that the last rate hike occurred in 2006. And that in fact now it will be nine years before a hike. He writes that a rate hike is "long overdue," and that he is worried the Fed might outstay its welcome.

"The history books show that at no time did a bull market end after the first rate hike. Typically — in terms of trough to peak moves in the SP 500 — we are only one-third of the way into the bull run on the eve of the first Fed tightening in rates. That is an average, but the median is almost identical and there has never been a time when the cycle was more than halfway through at that point of the first rate increase."

He points out that the stock market only begins to "peak out and roll over —in terms of magnitude, not just duration," when Fed rate hikes are already under way.
My inner investor is watching carefully whether stock prices remain correlated with bond prices, as they did late last week, or if they remain negatively correlated as they have recently. If stock and bond prices move together, then equities are likely to correct further because of interest rate fears. In the meantime, the US economy continue to motor along and EPS growth continue to be positive.

On the other hand, my inner trader is more focused on the technical picture and he remains bearish intermediate term. However, he is acutely aware that the market is short-term very oversold and could see a counter-trend rally at any time (see Still bearish, but watch for the dead cat bounce). He has therefore covered his shorts and taken a small speculative long position.

As the chart below shows, my favorite overbought-oversold indicator is flashing an oversold signal. In the past (dotted vertical lines), oversold readings have generally led to rebounds in stock prices - except when it has signaled the start of a more prolonged decline.

My best guess is that current conditions resemble the corrective periods in 2011 and 2012, when we saw a series of recurring oversold signals which culminated in the final pullback that marked those episodes. We just have to figure out what the fundamental trigger for market weakness.

How to subscribe to Trend Model updates
To subscribe to my posts, which include Trend Model updates, click on one of these links on the sidebar or follow me via Twitter @humblestudent:

Disclosure: Long TNA