Another complementary factor model

In the past, I had written about how combining factors can lead to more performance stability (see Momentum + Bull market = Chocolate + Peanut butter?). My past research showed that while price momentum did exhibit positive alpha over the course of a market cycle, returns were highly volatile.

Instead, the Cass Business School paper entitled The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation indicated that momentum worked much better when conditioned on bull and bear market cycles. The paper showed that returns to price momentum was especially positive during bull phases at a stock level. My research showed that this effect was extended to the sector and industry level. I identified bull (uptrend), bear (downtrend) and neutral market phases using a 50-200 day crossing moving average trend following system.

Quality and Value
Now comes some interesting research results from Research Affiliates showing conditioning value investing with certain quality factors potentially adds alpha as well (emphasis added):

We used three measures to capture the pertinent information: return on equity (ROE) to reflect growth and profitability; the debt coverage ratio to represent the likelihood of default; and the accruals-to-average-total-assets measure defined by Sloan (1996) to quantify possible accounting red flags.12 To arrive at company-specific quality measures, we used the simple arithmetic average of each stock’s percentile rank for these three variables.

The first line of Table 2 shows the performance of a simple long–short strategy based on this quality measure. On average the strategy produces a small negative return. It has some alpha after we control for factor exposure and negative exposure to the value factor.

When we use quality in conjunction with value, the results are much better. The second line of Table 2 shows the results of a portfolio where we go long value stocks with high quality and short growth stocks with low quality. This long–short strategy has annual alpha of 11.2% per annum. A substantial portion of this statistically significant alpha comes from conditioning on quality information. The annualized alpha, controlling for the Fama–French–Asness–Carhart four factor model, is 9.3% per annum.

On a long-only basis, the value-high quality combination exhibited higher returns with lower volatility when compared to the value-low quality combination.

The authors concluded (emphasis added):

The high quality value portfolio has fewer distressed, slow growing, unprofitable companies with potentially questionable accounting practices. As a result, the high-quality value portfolio has a better risk-adjusted return. Quality is not, in itself, a factor that generates a premium; but value investing conditioned on a properly specified concept of quality is a powerful investment strategy.

This is another example of how combining factors can add value. In fact, the use of both of these disciplines, namely price momentum-trend following and quality-value, can be highly complementary strategies in a quantitative equity portfolio.

Returning to high school, investment style

Investment manager Jane Hwangbo wrote a terrific first post about what it's like to become an accomplished investment manager (emphasis added):

One of the strongest behavioral tendencies we possess as human beings, no matter what line of work we choose for ourselves, is that we never really want to leave high school. Let me explain: We would rather not go through the emotional pain again of being a freshman in a senior-dominated world. We like the feeling, once we have made it, of being one of the cool kids, and will actively promote it and behave in such a way that reassures that we never “start over”. In the world that I live in, managing people’s money and investing it in assets, there are many sets of cool kids – the bond managers, the equity managers, the currency kings, and so on. I have a strong professional history in equities (stocks), while others have a strong background in bonds (fixed income), currencies (e.g. US dollars vs. Japanese yen), or commodities (bets on future price swings of things like oil, natural gas, or corn).

As a general onlooker, you would think that as a particular fund manager grows more and more accomplished in a major field of the markets, say equities in my case, one would also become an expert on all things markets-related, like bonds and currencies and commodities as they are all connected to each other. However, the opposite really happens, because most of us never want to feel like a freshman again. It’s painful to start at ground zero, knowing nothing, how things move, and why they move the way they do. One must ask dumb-sounding questions to get going in accumulating a fresh knowledge base, and when you’re a highly respected specialist in the field you have mastered, this is a huge psychological barrier to becoming fluent in other asset classes. The equity managers I know have a very shallow understanding of how bonds trade, and most bond managers do not pay more attention to equities than noting the performance of the SP 500. These managers are very smart people, by any measure. This condition goes beyond asset managers – I have rarely met “in real life” an accomplished economist who can invest with great success. There are very few. The opposite applies to managers in markets – they are typically terrible economists.

Like Ms Hwangbo, my specialty is equities. However, as the saying goes, I know enough of other languages (bonds, derivatives) to get my face slapped.


A risk appetite warning gone wrong
So it has been with some disappointment that I have recently seen analysis by accomplished equity specialists making erroneous conclusions about risk appetite and making conclusions about the stock market. One of many examples is to compare the relative performance of the junk bond ETF (HYG) to the long Treasury ETF (TLT). As the chart below shows, the HYG-TLT ratio (in purple) started to roll over in January, while the stock market (in black) continued to advance. This analysis suggests a negative divergence that represents a warning of declining risk appetite.

Nothing could be further from the truth. The HYG-TLT ratio is a relative price performance chart. As good bond investors know, price performance of a bond portfolio comes from principally two factors:

1. Interest rate sensitivity (duration)
2. Changes in credit spreads

I will show that the HYG-TLT ratio rollover is more a function of the first factor than the second. As the bottom panel shows, the yield of the long Treasury bond has been declining since January and coincides with the underperformance of HYG against TLT. 

A bond math primer

First, here is a little bond math. The interest rate sensitivity of the price of a bond is a function of its duration. Here is the formula for Macaulay duration, but the math-phobic need not worry too much about what the Greek letters lounging on their sides mean.

Here are the important properties of duration that you need to know:

• The longer the duration, the more sensitive the price is to changes in interest rates
• For bonds with equal coupons, a longer maturity bond will have a longer duration
• For bonds with equal maturities, a lower coupon bond will have a longer duration

Putting this concept into practice, I went to iShares and looked up the duration of TLT, which came to 16.9 years.

iShares also showed the duration of HYG to be 4.0 years. These two ETFs have a serious duration mismatch. It was that duration mismatch that mainly accounted for the differential in performance when interest rates started to fall in January.

A better Treasury comparison for HYG would be IEI, the 3-7 year Treasury ETF, with a duration of 4.5 years:

Better measures of risk appetite in bonds
With that analysis in mind, here is the HYG-IEI ratio as a better measure of risk appetite as duration risk between the two ETFs have been minimized. The relative uptrend of HYG to IEI was broken and turned down only this month, not in January as the HYG-TLT ratio showed. This broken relative uptrend represents an early warning of declining risk appetite that needs to be watched and confirmed by other indicators. The downturn in the HYG-TLT ratio was a false alarm.

On the other hand, the relative performance chart of the Emerging Market bond ETF (EMB), with a duration of 7.1 years, against the 7-10 year Treasury ETF (IEF), with a duration of 7.6 years, shows that the EMB-IEF ratio staged a relative upside breakout and is now consolidating just about the breakout zone. While the EMB-IEF ratio readings have been far more volatile, its behavior has not confirmed the risk appetite rollover in the HYG-IEI ratio.

In conclusion, I staged this exercise as an illustration of what Jane Hwangbo wrote. Even if you are one of the "cool kids", you need to continually "ask dumb-sounding questions to...accumulate a fresh knowledge base". That's why I remain a "humble" student of the markets.

Dissecting the bull case for China

Regular readers will know that I have been relatively cautious on the outlook for China. But despite recent dire headlines such as China debt surges to 251% of GDP, China has not crashed. What`s more, I have seen a number of bullish calls on Chinese and Asian equities. Here is one example (via CNBC):

"We have been cautious on China for most of the past three years," Guy Stear, head of research for Asia at Societe Generale, told CNBC.

But this year, he's been "very impressed" by the government's reform measures.

"That's made us a little more comfortable that the valuations are worth it," he said, adding that Societe Generale has turned bullish. "The valuations are quite cheap," Stear said.

Comparing valuations between U.S. and China shares on a price-to-book and medium-term economic growth basis, "you're probably talking about a valuation difference of four to one," he said.

A Morningstar interview with Oppenheimer manager Justin Leverenz indicates that he is bullish on the China growth theme:

I think the most interesting theme at the moment is everything associated with the great concern about China. And those have many different facets.

What we've seen, of course, is that China has been this unbelievable growth story for the last decade, but equities have been probably the worst major bourse in the world. And selectively, we're now starting to see some opportunities emerge alongside this because the pessimism is far too great, and there are some really extraordinary companies, which is really what we're focused on.

The second issue in terms of China is opportunities for extraordinary global businesses that have a large part of their franchise in China. As you know, I typically have about 10% of my fund in developed-markets companies that domiciled in developed markets, but have their principal growth engines or principal assets and earnings and cash flow associated with the developing world, largely China in many cases.

Companies like Pernod or Prada have some really extraordinary prices associated with, again, concerns about the Chinese durability of the economy. Actually there are more recent concerns about anti-austerity measures which have taken away part of the gifting market in that segment. But these are incredibly durable businesses with relatively low penetration. And I think one of the great themes in the world is not the emerging-markets middle class, but the Chinese middle class, and part of that's associated with tourism and increased leisure and spending.

So, I think all things related to pessimism about China really is maybe the most interesting near-term theme we're looking at, or subtheme.

From a technical viewpoint, Peter Brandt wrote that Asia — The Tigers are Ready to Roar. Here is the key conclusion:

Asian equity markets are on the verge of explosive advances. Investors and traders need to find ways suitable to their investment strategy to have significant long exposure in Asian equities.

The Short Side of Long recently pointed to the rising bearishness over China but the resilience of the Shanghai Composite as an indication to turn cautiously bullish:

The truth is, Chinese mainland stock market is incredibly oversold. After peaking in 2007 at around 6000 points, the index finds itself 66% lower 7 long years later. Furthermore, since 2009, Shanghai Composite has failed to staged a multi-quarter rally. Constantly bombard by bad news and a sideways trending market, investors have surely forgotten that Chinese stocks can actually go up, too.

While I remain somewhat cautious on China, every good investor should always examine the other side of his views and this post is an attempt to review the bull case for the Middle Kingdom.


China's policy dilemma
I have outlined Beijing's policy dilemma before (see China, beyond the hard/soft landing debate). Here are the basics:

The roots of China's growth
The China miracle was fueled mainly by two factors:

1. Access to a cheap source of labor and the willingness to use it as a source of competitive advantage to grow the economy; and
2. The CNYUSD currency peg.

While the currency peg allowed Chinese labor to be highly competitive, it also created all sorts of nasty side effects. First and foremost, China was stuck with America's monetary policy, which was inappropriate for China. As the Chinese economy heated up and inflation rose, Chinese interest rates could not rise with inflation and inflationary expectations because of the currency peg. Thus, real interest rates went negative.

Negative real interest rates created winners and losers. The winners were the companies with easy access to capital, which were mostly the SOEs at the expense of private businesses, which are often referred to as Small and Medium Enterprises (SMEs). An academic paper called A Model of China’s State Capitalism (h/t Michael Pettis) that shows that the dominance of SOEs and their superior growth is largely attributable to their monopolistic or semi-monopolistic positions in the Chinese economy, e.g. telecom, oil refining. etc. John Hempton called this arrangement a kleptocracy because Party insiders have become enormously wealthy at the expense of the ordinary citizen.

Negative interest rates also meant very low or negative cost of capital. As Japanese companies found out in the late 1980's, it's easy to make money when your cost of capital is that low. You borrow as much as you can and invest in something, anything with a positive real return. If you are positioned properly, you can make obscene profits - and they did.


Currency peg = Financial repression
The biggest loser in China, on a relative basis, was the household sector. The ordinary Chinese who worked hard and managed to squirrel away savings had few places to put their money other than the banking system. The Chinese bond market is not sufficiently large. The stock market is very small and undeveloped compared to major industrialized countries and is regarded mostly as a casino. The household sector was forced to put money into the banking system at negative interest rates. Carmen Reinhart calls that financial repression. Here is the definition from Wikipedia:

Reinhart and Sbrancia characterise financial repression as consisting of the following key elements:

1.Explicit or indirect capping of, or control over, interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
2.Government ownership or control of domestic banks and financial institutions with simultaneous placing of barriers before other institutions seeking to enter the market.
3.Creation or maintenance of a captive domestic market for government debt, achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
4.Government restrictions on the transfer of assets abroad through the imposition of capital controls.

John Hempton at Bronte Capital outlined the dilemma of the Chinese household well:

The Chinese lower income and middle class people have extremely limited savings options. There are capital controls and they cannot take their money out of the country. So they can't invest in any foreign assets.

Their local share market is unbelievably corrupt. I have looked at many Chinese stocks listed in Shanghai and corruption levels are similar to Chinese stocks listed in New York. Expect fraud.

What Chinese are left with is bank deposits, life insurance accounts and (maybe) apartments.

For those ordinary Chinese citizens who could afford it, the only logical place for savings is in real estate. Real estate became a form of money and savings poured into it. In effect, the CNYUSD peg was indirectly responsible for China's property boom.


Where we are today
Fast forward to today. China's growth has hit a slow patch. One of the objectives in the Party's latest five-year plan calls for a re-balancing of growth away from heavy infrastructure spending, which has benefited SOEs, to the consumer (read: household sector). Andy Xie described the slowdown and how the authorities have managed to contain the worst effects of the downturn:

There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.

SOEs, the vehicle of wealthy Party insiders, have been hit hard:

State-owned enterprises (SOEs) reported 4.6% net profit margin on sales and 7.4% return on net asset in 2011. Both are very low by international standards. In the first five months of 2012, SOEs reported a 10.4% decline in profits but 11.3% increase in sales.
SOE performance indicators are low and declining. This is despite the fact that SOEs have such favorable access to financing and monopolistic market positions.

Xie also echoed Hempton's kleptocracy claims, though in a less dramatic fashion:

Closer observation gives clues as to why SOEs are so inefficient. Their fixed investment often costs 20% to 30% more than that for private companies and take about 50% longer to complete. The leakage through overpriced procurement and outsourcing and underpriced sales is enormous. SOE leakage can explain much of the anomalies in China.

In addition to the problems presented by slowing growth, the financial system is teetering because of an over-expansion of the shadow banking system (see my previous comment Ominous signs from China). Left unchecked, it could have the potential for a crash landing, i.e. negative GDP growth, which is not in anybody's spreadsheet model.

How do you end financial repression?
The key to re-balancing growth is to end, or at least, ease the effects of financial repression on the household sector. But ending financial repression would directly hit the wallets of Party cadres. Consider, as an example, this Bloomberg story of how people try to bribe their way into the People's Liberation Army, or PLA:

“It’s impossible to weed out corruption at the basic level, because it’s embedded in the culture,” said retired Major General Xu Guangyu, a senior researcher at Beijing-based research group the China Arms Control and Disarmament Association. “The central leadership knows corruption is the number one enemy the army faces, and if strong-handed measures aren’t taken, it would weaken the army’s capabilities to fight a modern war.”

That's because the incentives for corruption is ever present (emphasis added):

While entering the military provides a stable income, the incentive for corruption after joining remains. New recruits get a yearly package of around 25,000 yuan ($4,031) in Beijing and 15,600 yuan in rural areas such as Haiyan county in Zhejiang province, according to state media. Inspectors in April in two major military regions -- Beijing and Jinan -- said they found “irregularities” in the handling of promotions, construction and allocation of military buildings, and misuse of assets, especially land, the official Xinhua News Agency reported.

Notwithstanding what happens in the PLA, the temptation and opportunities for Party officials to line their own pockets is even bigger in SOEs. Sara Hsu, writing in The Diplomat, outlined the problem of Chinese SOEs:

The tight interconnection between state apparatus and economically critical firms has had other repercussions besides low efficiency. The National Audit Office recently uncovered fraud in 11 SOEs, finding that some managers spent company funds on luxury goods and entertainment. This is in addition to 35 cases of bribery and embezzlement uncovered earlier this year. Corruption associated with SOEs and, more broadly, state assets owned by the “princelings” and other cronies has recently been exposed in a comprehensive state crackdown on corruption.

"Reform" starts with an anti-corruption drive
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.

In a recent WSJ article, Anne Stevenson-Yang and Ken DeWoskin explained these concepts:

China analysts have missed the story by peering at the landscape of reform and trying to find step-by-step progress toward economic liberalization. The disjunction between foreign and domestic understanding of what constitutes "reform," in fact, illuminates a fundamental misunderstanding of foreign commercial involvement. In today's post Third Plenum China, "reform" means to sideline and squash institutionalized bureaucracy and inject personal power into a sclerotic system. It means cutting through the layers of paperwork that invite bribery.
But what China has never had and never meant by its use of the word "reform" is the codification in law and practice of rules to govern transparently and at scale a growing economy. Rules are seen as stultifying, an impediment to the ability of the core ruling class to impose its will. The color of China's huge library of new laws, rules, and regulations is gray, leaving broad license for administrators to enforce them. The consequence is a large measure of chaos in the actual regulation of industry and commerce.

The true "reform" came from the concentration of power in the hands of Xi Jinping:

Yet the true and dramatic reforms are already laid out in plain sight; observers were simply looking for the wrong thing. The most sweeping of changes was a major restructuring of power, the formation of two new super-ministerial committees, one for foreign and domestic security and one for economic reforms, which, in actuality, were designed to override the machinery of government. After a period of lively speculation about who would head these committees, it was announced that Xi Jinping would head them both.

The hopeful bull case for China
That`s where the hopeful bull case for China begins. In the past, the leadership has launched "show" anti-corruption campaigns. This time, it seems to be real and the aim is to consolidate power at the top so that Xi can launch the real "reform" campaign of economic liberalization to re-balance economic growth.

Consider these stories that have come across my desk in the past few weeks. From Foreign Policy:

In late June, the Chinese Communist Party expelled Xu Caihou, who before his retirement in 2012 was one of the highest ranking members of China's military the People’s Liberation Army (PLA). Xu had been accused of taking bribes, and "gravely violating party discipline." A former vice-chairman of the Central Military Commission, the body that oversees the PLA, Xu is the highest ranking military official to be publically accused of corruption in at least 35 years. Simply put, this is a big deal.

Xu’s ouster comes on the heels of a host of dismissals and investigations of other occupants of top political offices since Xi Jinping became China’s leader a year and a half ago. A top Chinese investigative magazine Caixin recently published a graphic list of these key targets in Xi’s anti-corruption campaign; Chinafile has adapted it, adding its own research, to create this interactive timeline.

From Bloomberg:

China filed graft charges against the former deputy director of the economic planning ministry, saying he illegally received money and goods in bribes.

Liu Tienan, 59, former deputy head of the National Development and Reform Commission, was accused of seeking gain for others, a statement on the Supreme People’s Procuratorate said yesterday. The case was filed with the People’s Intermediate Court in Langfang city in central China’s Hebei province, it said. The procuratorate described the bribes as “extremely large.”

From the South China Morning Post:

An ancient Chinese aphorism says a wily hare has three burrows. Gong Aiai , a former bank executive in Shaanxi's Shenmu county, went one better, using four identities to build up a Beijing property portfolio worth more than one billion yuan (HK$1.24 billion).

At first, internet users revealed that the 49-year-old former deputy chief of Shenmu Rural Commercial Bank had used two names, two identity cards and two hukou (registered household addresses) to buy 20 properties in the capital.

Gong, once reputed to be the coal mining county's richest woman, said she thought it was auspicious to have two names and she had just been silly and ignorant. She said the properties were bought with her family, using money from coal mining.

Shenmu police said it was a registration error and the extra hukou was revoked.

People found this hard to swallow and they were proved right when further tip-offs led the media to report that Gong actually had four ID cards and four hukou, three in Shenmu county and one in Beijing.

Another tale of corruption of Party officials from the South China Morning Post:

China's ruling Communist Party said today it had expelled two more former senior officials for corruption, laying the way for their prosecution, as the government continues a high-profile campaign against deep-rooted graft.

The party's anti-corruption watchdog said in brief statements that Mao Xiaobing, former party boss of the western city of Xining, and Zhang Tianxin, former party chief of the southwestern city of Kunming, had “serious discipline problems”.

“The investigation found that Mao Xiaobing took advantage of his post to seek profits for others, demanded and took a huge amount of bribes and committed adultery,” the watchdog said in a statement.

Party members, especially senior officials, are supposed to be morally upstanding and adulterous affairs are considered a serious breach of party discipline.

Mao, whose investigation was announced in April, will be handed over to judicial authorities for prosecution, the watchdog said. He has also been sacked.

The former Kunming official, Zhang, also abused his official position, with his dereliction of duty causing “a loss of state assets”, the party said.

It did not say if he had been handed over to the prosecutors, but that is the most likely next step.

The anti-corruption campaign appears to be in full swing. The Washington Post reported Xi has relied on a special anti-corruption group to pursue wrongdoers:

The institution has an obscure name — the Central Commission for Discipline Inspection. But in the year and a half since Xi Jinping became China’s leader, it has become his main weapon in an anti-corruption campaign that has gone further than any other in the country’s modern history.

The campaign is meant to clean up the party’s image — so soiled by graft that some leaders fear public contempt could threaten their grip on power. It also appears aimed at consolidating Xi’s power. He has used the commission to weaken rival factions and, more broadly, to warn off anyone who might challenge his agenda.

The commission has extraordinary powers, much in the way the Holy Inquisition *ahem* Congregation of the Doctrine of the Faith had powers:

The Chinese commission has far more latitude than those U.S. agencies and is much more politicized. It operates entirely outside the legal system, as a Communist Party justice mechanism. Its investigators need no warrants to seize evidence. And it has the power to imprison and interrogate any party official.

Although the worst official punishment the commission can mete out is booting cadres from the party, its investigations are often transferred after the fact to the judicial branch, where the expelled officials usually receive heavy sentences.

The commission now appears poised to take down its biggest target yet: Zhou Yongkang, once a member of the top standing committee headed by Xi.

The takedown of Zhou Yongkang is unprecedented in modern Chinese history. One analyst likened it to the Obama Administration taking down the circle of Dick Cheney with criminal, tax and other investigations, starting with his friends, his associates, his family (e.g., Liz Cheney) and finally the former vice-president himself.


The next step is easing financial repression
The anti-corruption drive is a necessary first step to end, or at least ease, the effects of financial repression for the household sector in China. Since the state-owned sector has reaped the lion's share of the benefits from past growth, it appears that Xi needs to curtail their power before the real task of financial liberalization can begin.

This Bloomberg story entitled China’s Repression of Savers Eases shows that the process is already underway:

The extra interest Yin Xuelan earned last year by socking her savings into wealth management products instead of bank deposits paid for a tour of Taiwan and a microwave oven.

“I didn’t need to go to Taiwan and I didn’t need to buy a microwave oven, but with this extra money, why not?” said retired schoolteacher Yin, 60, as she put receipts into her pink purse at an Industrial + Commercial Bank of China Ltd. branch in central Beijing. “It’s like free money.”

Yin is a beneficiary of an easing in China’s financial repression, a term that describes the way savers have suffered artificially low returns on deposits in order to provide cheap loans for investment. Measures used for the size of the toll -- such as inflation-adjusted deposit rates, the gap between rates on loans and the pace of economic growth -- have shifted in favor of savers in the past four years.

The burden has dropped to the equivalent of about 1 percent of gross domestic product annually from 5 percent to 8 percent as recently as three to four years ago, estimates Michael Pettis, a finance professor at Peking University. (618) That’s a shift of as much as 2.6 trillion yuan ($420 billion) to households from borrowers from 2010 to 2013.

The effects of financial repression are easing and SOEs are bearing a greater burden:

Financial repression, a concept detailed in 1973 by Stanford University economists Ronald McKinnon and Edward Shaw, refers to policies that force savers to accept returns below the rate of inflation and that enable banks to provide cheap loans to companies and governments, reducing the burden of their debt repayments.

A sustained easing would channel more of China’s wealth to the average person while squeezing bank margins and the debt-fueled investment that’s evoked comparisons with the excesses that generated Japan’s lost decades and the Asian financial crisis. On the flip side, slimmer bank profits may add to risks for an industry grappling with the fallout from record lending in the aftermath of the global financial crisis.

“Many local governments and state enterprises have made low-return investments based on the low-cost funding,” said David Dollar, a former U.S. Treasury Department official in China who is now a senior fellow at the Brookings Institution in Washington. “As the cost of capital rises, some of them no doubt will have difficulty servicing their debts and may even be pushed into bankruptcy.”

One of the goals is to move the economy towards a more market based economy:

Chinese authorities are transitioning from a system of state-directed credit to one where markets play what Communist Party leaders term a “decisive” role in pricing capital. A floor was removed from lending rates in July 2013 and People’s Bank of China Governor Zhou Xiaochuan said in March that deposit rates will be liberalized in one to two years.

China's short-term challenges
In short, what I have outlined are the hopeful bullish signs for China's growth outlook. The anti-corruption drive throws the bureaucracy off-balance and enables the Beijing leadership to effect market-based reforms and to re-balance the source of growth from the same-old-same-old credit driven infrastructure driven growth to consumer-driven growth. To do that, Xi needs a re-distribution of wealth from the state-owned sector and Party insiders to the household sector. It will be a challenging task.

As if that is not enough, China has to deal with a credit-driven overhang of excessive investment in property and infrastructure. Bloomberg reported that a record number of cities (55 of 70) saw property prices fall.

This chart from George Magnus illustrates the magnitude of the supply and demand problem in real estate:

These problems are not totally intractable, but there are no easy answers. The trillions in foreign exchange reserves held by the PBoC cannot solve the problem without unwanted consequences (see my previous post China's new paper tiger?). Just because the central government has a deep pocket, it cannot assume the loss for those non-productive assets built during the boom without some form of blow-back. Michael Pettis explained in a recent post:

To the extent that China has significant hidden losses embedded in the balance sheets of the banks and the shadow banks, over the next several years Beijing must decide how to assign the losses. If it assigns them to the household sector, it will put significant downward pressure both on household income growth (which will be less than GDP growth) and, consequently, on consumption growth. Rebalancing means effectively that consumption growth (and household income growth) must exceed GDP growth, which means that even if GDP growth slows to 3-4%, as I expect, household income can continue growing at 5-6%. This explains why, contrary to the consensus, a more slowly growing, rebalancing China will not lead to social unrest.

Who eats the loss? If it's the household sector, then it means a return to financial repression and the end of re-balancing:

If the losses are assigned to the household sector, China cannot rebalance and it will be more than ever dependent on investment to drive growth. This is why I reject absolutely the argument that because China resolved the last banking crisis “painlessly”, it can do so again.

If the SME, or private, sector takes the loss, then the government is seriously penalizing a key engine of economic growth:

Beijing can also assign the losses to SMEs. In effect this is what it started to do in 2010-11 when wages rose sharply (SMEs tend to be labor intensive). It is widely recognized that SMEs are the most efficient part of the Chinese economy, however, and that assigning the losses to them will undermine the engine of China’s future productivity growth.

They can get the SOEs to pay, but that is politically difficult:

Finally Beijing can assign the losses to the state sector, by reforming the houkou system, land reform, interest rate and currency reform, financial sector governance reform, privatization, etc. Most of the Third Plenum reforms are simply ways of assigning the cost of rebalancing, which includes the recognition of earlier losses, to the state sector. This is likely however to be politically difficult. China’s elite generally benefits tremendously from control of state sector assets, and they are likely to resist strongly any attempt to assign to them the losses.

It appears that Xi Jinping is trying to effect the last alternative and starting the process with an anti-corruption drive. If it works, it will be positive for China in the long-term, but the near-term outlook remains uncertain.


The Pettis "best case" scenario
Michael Pettis laid out the policy dilemma facing Beijing and outlined a best case scenario for China this way:

I have always thought that the soft landing/hard landing debate wholly misses the point when it comes to China’s economic prospects. It confuses the kinds of market-based adjustments we are likely to see in the US or Europe with the much more controlled process we see in China. Instead of a hard landing or a soft landing, the Chinese economy faces two very different options, and these will be largely determined by the policies Beijing chooses over the next two years.

Beijing can manage a rapidly declining pace of credit creation, which must inevitably result in much slower although healthier GDP growth. Or Beijing can allow enough credit growth to prevent a further slowdown but, once the perpetual rolling-over of bad loans absorbs most of the country’s loan creation capacity, it will lose control of growth altogether and growth will collapse.

The choice, in other words, is not between hard landing and soft landing. China will either choose a “long landing”, in which growth rates drop sharply but in a controlled way such that unemployment remains reasonable even as GDP growth drops to 3% or less, or it will choose what analysts will at first hail as a soft landing – a few years of continued growth of 6-7% – followed by a collapse in growth and soaring unemployment.

In other words, the best case is a “long landing” where growth slows gradually to 3-4% and re-balances wealth distribution in favor of the household sector:

The amount of the direct or indirect wealth transfer from the state sector to ordinary households is, I think, the most important variable in understanding China’s adjustment. The pace of growth will be driven largely by the pace of household income growth, which will itself be driven largely by the pace of direct or indirect wealth transfers to ordinary Chinese households. If we could guess this right, much else would almost automatically follow.

Unfortunately, the latest GDP figures suggest that the "long landing" may not be the base case outcome for China. In the short term, Ed Yardeni commented that China is still relying too much on credit driven growth, which is more likely to the Pettis "loss of control" and "collapse" scenario in the not too distant future:

The Chinese government is no longer providing massive economic stimulus to prop up China’s growth rate. Instead, the government is targeting spending in a more rifle-shot approach. That’s the official mini-stimulus story. It just doesn’t jibe with the latest “social financing” data, which show that China’s economy continues to be flooded with credit. It worked in the past, and it should work now. But one day, it won’t work, and the economy could sink rather than float on the sea of credit. Let’s review the latest data:

(1) Social financing rose $320 billion during June. That’s not an annualized number. It is the amount of borrowing by all sectors just during that one month. On a ytd basis, it totals a staggering $1.7 trillion compared to $1.6 trillion over the same period last year.

(2) The totals above include bank loans, which increased $175 billion during June and $934 billion ytd. Chinese bank loans totaled a record $12.6 trillion during June, 64% more than the loans held by US commercial banks.

The market's verdict
Despite some of these somewhat hopeful signs of an anti-corruption campaign, my long-term technical call for China remains an "underperform" ranking. The chart below of an equal-weighted portfolio Greater China ETFs (FXI for China, EWH for Hong Kong, EWT for Taiwan and EWY for South Korea) shows that Greater China (in red) remains in a long-term relative downtrend compared to MSCI All-Country World Index (ACWI). In addition, the Chinese sensitive resource markets (EWA for Australia, EWC for Canada and EZA for South Africa) are also in a relative downtrend.

However, if Xi Jiping were to succeed in his initiatives and achieve the Pettis "long landing", the primary beneficiary would be the Chinese household sector, as represented by consumer-sensitive PGJ ETF, and not the old state sector, as represented by FXI. The chart of PGJ compared to FXI shows that Chinese consumer stocks remains in a volatile uptrend compared to the financial sector heavy FXI (also see my previous post A New China vs. Old China pair trade):

If any China bulls were to make a bet on China, then PGJ is probably the better vehicle as it is more exposed to the consumer sector (though I would add the caveat that it is very technology and internet heavy and therefore exposes the investor to a high degree of sector concentration risk).

The leadership surprise in this bull cycle

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Positive (for an explanation, see An intriguing Trend Model interim report card).


Looking for leadership in the current bull cycle
It is a truism among technical analysts that each bull market is characterized but different kinds of market leaders. After the bull peaks, the old market leaders fade and new leaders take the baton.

As examples, the bull phase of the late 1970`s was marked by hard-asset, inflation-hedge leadership such as Energy and Materials. As a reminder of how difficult it is for former leaders to recover, the poster child of inflation-hedge vehicles, gold, peaked out at $850 in early 1980 and went into a long bear phase that did not bottom out until 2001.

The next bull cycle was characterized by consumer stocks, first the Consumer Staples and the enthusiasm spread into Consumer Discretionary companies. The shares of these companies was driven by the LBO-boom, fueled by junk bond offerings. (Recall Robert Campeau and his junk-bond fueled takeovers of Federated and Allied Department Stores and how it all came crashing down on him.)

The bull market of the 1990`s was the TMT era - Tech, Media and Telecom. The Four Horsemen (Intel, Cisco, Sun Microsystems and Oracle) boomed and it all ended with the NASDAQ peak in March 2000.

The lesson for investors is, "Once a bull market ends, don't cling to the leadership over the previous bull cycle. Look for new leadership." As an illustration of this principle, consider this 15-year chart of the relative performance of Technology stocks relative to the SPX. The sector peaked out with the NASDAQ in early 2000, tanked and has been in a sideways relative consolidation phase for over a decade. While the relative uptrend (shown by the blue arrowed trend line) shows some promise, this sector is unlikely to be the next market leaders for some time. Telecom stocks (not shown) also display a similar pattern of rise, fall and sideways relative consolidation.

Previous leaders falter
So what are the leaders in this bull cycle? I would not look for them among the last bull cycle's leaders. Here is the relative performance chart (all 15-year time frames) of Financials against the market. The relative performance pattern of this sector looks like the Tech sector, but pulled forward by a few years. Financials appear to be undergoing a sideways relative consolidation pattern.

The bull market of the early 2000s was marked by the revival of hard-asset plays. Here is the relative performance chart of the Energy sector. While Energy did not crash as the Financials did in the aftermath of the Lehman Crisis, this sector is either making a broad relative top by rolling over or, more charitably characterized as undergoing a sideways relative consolidation. No leadership here.

The relative performance of the other hard-asset sector, Materials, show a similar pattern of either relative rollver or sideways consolidation.

What about gold and gold stocks, the bellwether inflation hedge vehicles? When I look at the relative performance chart of HUI against SPX, the most likely conclusion is that the best days for this group are in the past and not in the immediate future.

These last three charts suggest that the bull phase of the Commodity Supercycle is largely over.


Looking for the new leaders
Once we have ruled out past leaders, we then look for the new leadership among other candidates. The cyclically sensitive Industrial stocks don`t appear to be the new leaders, as they remain in a broad sideways relative range against the SPX.

A case could be made for the Consumer Discretionary sector, but the knock against these stocks are 1) relative outperformance in the past couple of episodes appear to be cyclical and not secular in nature; and 2) these stocks are starting to falter as they recently breached a relative uptrend. If we accept the premise that Consumer Discretionary stocks constituted this cycle`s secular leadership, then the conclusion is this bull market is over. Kaput!

The healthcare surprise
There are only 10 GICS sectors and the sectors that are left are thought to be defensive in nature: Utilities, Consumer Staples and Healthcare. Relative performance charts of the first two, Utilities and Consumer Staples, do not reveal them to be the market leaders. This bull market`s leadership appears to be (surprise) healthcare.

While healthcare stocks are generally thought to be relatively stable and defensive, there is one growth industry within the sector: Biotechnology (sorry, Janet Yellen). In the past decade, we have seen an amazing number of life extension technologies being announced and worked on in the Biotech industry. As a consequence, the Biotech and Healthcare space are good candidates to be the market leaders for this bull cycle.

From a technical point of view, the Biotech stocks appear to be just getting started. The relative performance chart of IBB against SPY shows that IBB only staged a relative breakout out of a long base lasting over a decade. That`s a formula for much more relative gains.

Despite Janet Yellen's recent comments about stretched valuations in Biotech stocks, CNBC reported that Mark Schoenbaum, who was the top ranked biotech analyst for the past nine years according to Institutional Investor, pushed back on Yellen's comments in a recent published report:

"Dr. Yellen — Thank you for sharing your thoughts recently on the biotech sector. … You stated that biotechnology valuations are 'stretched, with ratios of prices to forward earnings remaining high relative to historical norms.'"

As evidence, Schoenbaum included Russell 1000 data from biotech stocks dating back to 1978, "and my data show that the current ratio is roughly in line with the historical median and is approximately 40% below the peak.

"Please tell me what I'm missing, Dr. Yellen," he wrote.

Schoenbaum added that he had a "great deal of respect" for Yellen.

"However, we have a different view, perhaps, of the data on price-to-earnings ratios," he said.

Schoenbaum called biotech is "a large, large sector" with hundreds of companies, "most of which have no profits and no earnings. They're basically options vehicles based on a drug that will report data out in a few months. And certainly, in 2012 and 2013, it was an unprecedented bull run in biotech. For some of those stocks, there's probably too much optimism baked in.

"But of course, in the giant universe of biotech stocks, you're going to find stocks that are overvalued and you're going to find some that are undervalued."

More room for this bull to run
Since market leadership generally changes when a bull market ends, then the longevity of the run in Healthcare and Biotech is a function of the health of the current bull run. Despite my concerns about valuation (see More evidence of a low return equity environment), I believe that this bull market is long from over. Even Jeremy Grantham, who has been known as a value investor, is postulating a M+A driven market bubble for the stock market:

These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word “uniquely” in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making.

Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. Worse than being in full swing, they were usually way over capacity. Thus, 2000 was helped along by the bubble in growth stocks to over 60 times earnings, allowing companies like Cisco, possibly correctly, to believe they were dealing with a near-zero cost of capital in making deal after deal for their massively overpriced stock.

Bull markets end in one of two ways, recession or a correction from excess valuation (1987, 2000 for NASDAQ). There are few signs of a US recession in the near future. Grantham wrote that the US economy "looks in many ways like quite a young economy" with more expansion potential in the future. As well, the latest review of high-frequency economic indicator from New Deal Democrat is also pointing to continued strength.

While valuations appear somewhat stretched, any market downturn needs a trigger. I have expressed some concerns about the possibility of an EPS growth scare. However, the early indications from Bespoke show that EPS and revenue beat rates this earnings seasons are at or above historical norms.

If Healthcare and Biotech are indeed the new leaders of this market cycle, then we need more excesses to build before this bull run is over. One sign is the sector weighting of Healthcare. Bespoke reports that Healthcare only represents the third highest weight in the SP 500. Before the bubble pops, we need to see this sector to get to at least the second largest weighting, or perhaps the top weighted sector in the SP 500.

Given the technical picture of the relative upside breakout of Biotech stocks and the sector weighting position of Healthcare, these stocks may have a lot further to run.

In praise of human, over machine intelligence

The late Milton Friedman was famous for his quip that monetary policy should be run by a computer. It was likely with Friedman's views in mind that Republican legislators challenged Janet Yellen to conduct monetary policy using a preset formula, which she resisted (according to this WSJ report):

Ms. Yellen, responding to some of the toughest questioning she has faced on Capitol Hill since becoming the Fed's leader in February, said provisions in a recently introduced House bill would lead to greater political meddling in the Fed's affairs, curtailing its independence and constraining the ability of policy makers to manage crises.

"It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule," Ms. Yellen told the House Financial Services Committee on Wednesday, amplifying her message in testimony to the Senate Banking Committee a day earlier.

The House bill would require the Fed to adopt a mathematical formula for determining the appropriate level for its benchmark short-term interest rate, which influences other borrowing costs across the economy. The bill's proponents cite as an example the so-called Taylor rule, devised by Stanford University economics professor John Taylor, which calculates the ideal level of the rate based on changes in several economic variables.

What's better? A rules based approach or a discretionary one? The debate rages on:

Economists have been debating for years the relative merits of basing interest rate policy on rules versus discretion—that is, whether they should adhere to a mathematical formula or maintain some flexibility to respond based on circumstances and judgment. Mr. Taylor and some Fed officials are in the first camp, saying rules-based policy-making creates more predictability and transparency, leading to better economic outcomes. Ms. Yellen and other Fed officials are in the latter camp. She said Wednesday that the recent recession would have been deeper if the Fed had stuck closely to the Taylor rule.

The trouble with robots
I have long been an advocate of an intelligent application of rules. That's why I describe myself as a "left and right brained modeler of quantitative systems" in my LinkedIn profile. I don't agree with Yellen on a number of issues (more in a future post), but human intelligence is far more flexible than rules-based machine intelligence and you need human oversight over machine intelligence.

While rules-based quantitative systems can be great, they have their limitations. They do exactly what you tell them to do, but at the same time they can be very stupid.

Consider this Kenny Polcari CNBC commentary of what happened on Thursday when news of the downing of MH17, followed by the Israeli invasion of Gaza. The first selling wave came in the wake of the MH17 tragedy and the selling appeared to have caused by trading algos:

The first "sell" reaction was actually created by algorithms. The speed at which the market took the hit indicates that the order flow was generated and then delivered — or really sprayed out — across the 70+ venues that exist in current market structure by high-speed algorithms designed to react to words in a headline.

Recall the "hacked Associated Press" Tweet last summer —"Breaking: Two Explosions in the White House and Barack Obama is injured" — this caused a swift 200-point selloff that quickly reversed itself when the AP announced that they were hacked and it was a false headline. The speed at which the market sold off and then re-balanced is only possible with the help of high-speed automated order generation and delivery.

So yesterday's headlines to the effect of "Malaysian Airliner Shot Out of the Sky" or "Russian Forces Down Malaysian Air Passenger Flight 17" clearly weren't positive and triggered the high-speed algorithms to have a field day.

News of the Israeli incursion caused the next wave of selling:

Then came the news that Israel had begun the invasion of Gaza as a result of Hamas not respecting the temporary ceasefire. Once again, the computers kicked in, causing the market to immediately plunge 50 more points in their "take no prisoner" style, taking the Dow down 125 points as traders and investors assessed the new news.

We built the technology to quickly profit on news and it`s causing unexpected adverse effects:
Technology today allows for a computer with artificial intelligence to make a determination as to the meaning of the headline and then shoot first, ask second. This is the state of affairs for the U.S. capital markets thanks to the Internet, the social media, and the need to know.

As a result, we see the markets get whipped around on just the headline alone, and then once the human being gets to read and digest the news, the move is either confirmed or not. So, did traders believe in the end that this was an act of terrorism or an act of stupidity? The jury says: stupidity.

The next day, the market recovered all of the losses from the previous day. As for the previous day's volatility? Oh, well. Life goes on.


How bad paperwork becomes a sex crime
Rules-based systems, however intelligently designed, can go horribly wrong. Consider this account of how someone became a sex offender at the age of 12 because he played ”doctor” with his 8 year old sister:

Josh became a sex offender at age 12. That's when he touched his sister's vagina, twice. His sister told their mom, Josh said it was true (he was too embarrassed at the time to mention that he himself had been raped as a young boy by three local high school kids), and their mom called a counseling service for advice. The counsellor said Josh's mother was required to report his crime to the authorities and the next day, he was arrested.

He spent the next four years in juvenile prison: the Texas Youth Commission, as it is officially called.

The charge was “aggravated sexual assault,” because any sex offense against a person under age 14 is automatically “aggravated.” He got out at age 16 and was put on the sex offender registry, which, in Dallas, requires him to report in person to the authorities once a year, as well as anytime anything in his life changes.

Here is the story of he became a re-offender at the age of 27:

Today he is 27, married with children, and smiley. We met up, had a jolly breakfast (except for the fact he said he felt too pudgy to start a speaking tour), and then we went off to the registry, because his family had just moved to a new house and he had to let the state know no more than seven days after the move.

Just as the detective in the nondescript office finished typing this information into the system and Josh and I were about to go to lunch, a man with a beard and a badge strode up and said, “Joshua Gravens?”

“Yes.”

“You are under arrest for not alerting the authorities to your new address.” He whipped out handcuffs. “Put your hands behind your back.”

As the man tightened the cuffs, Josh calmly explained he was registering his new address that very minute.

“The law says you you have to register the fact you are going to move seven days before the move, too.”

“I think you're mistaken,” said Josh, as pleasantly as if discussing the weather.

“I was told to arrest you,” was the reply, and that was that. Josh handed me his car keys and followed the man out to his van along with a handcuffed woman who was crying. She was going to jail for having listed her address as a hotel when she actually lives in her car in front of the hotel.

(This statute suggests that the officer was correct: Registrants must report their intention to change addresses seven days before actually moving, according to the statute.)

Under such circumstances, Josh would be charged with a sex crime and the penalties can be severe:

“I might be mistaken,” said Jon Cordeiro, a sex offender registrant and director of a Fort Worth re-entry program for offenders, “but technically he has broken the law and failure to comply with the registry laws is considered a new sexual offense.”

A sexual offense?

Yes. Any registering snafu is considered a sex crime, and depending on the judge, it can be punished as harshly as the original offense. In other words: Josh, at 27, will be treated as if he just touched an 8 year old's vagina again.

“Typically, there's a mandatory minimum of two to five years,” said Cordeiro.

“In Arkansas, he'd be looking at six,” said another attendee.

I recognize that there are elements who want greater control over the Fed, but after hearing these snafus about how rules-based systems, do we really want a robot to manage monetary policy?

Corporations are people too, only better

Scott Grannis wrote a post in defense of tax inversions. In it, he quotes a WSJ Op-Ed by Miles D. White about how the maneuver is legal and the absurdity of the US tax code that taxes corporations on their worldwide income:

The U.S. is among only a handful of countries, and the only one in the Group of Seven, that taxes companies on world-wide earnings rather than the earnings in their home domiciles. It's a double whammy: the highest rate, by far, and it's applied worldwide.

While I agree that this aspect of the tax code is an anomaly, I would point out that the United States taxes people (natural persons) on the basis of citizenship. In fact, if a US citizen were to live in an another country, he is liable for US taxes. On top of that, he has to declare his foreign holdings under FATCA under the pain of extensive penalties.

For example, if your Irish grandmother died and left you a modest inheritance in trust for you when you were 14 (recall that Ireland is a popular location for tax inversions). You forgot to tell the IRS about the trust for ten years (who thinks about those things when they are 14?), the back taxes and penalties could very well be higher than the value of the inheritance itself.

To return to the issue of tax inversions, why should corporations be taxed any differently than ordinary American citizens? Are they somehow better?

Is the MH17 sell-off a gift to the bulls?

When I wrote that the US stock market was vulnerable to a pullback (see A short-term negative divergence), I never dreamed that it would be a geopolitical tragedy that would cause the sort of risk-off response that we are seeing.

The news of the crash of MH17, which was apparently shot down by a missile, caused a market freak-out and risk premiums to spike. Unverified reports of intercepted phone calls and that a pro-Russian rebel commander took credit for downing the aircraft (before he knew it was a civilian airliner) didn't help matters. Further, news of an Israeli invasion of Gaza is underway also served to heighten global geopolitical tensions.


Spiking fear = Buy signal
As a result, VIX spike 3.54, or 34%, in a single day. Moreover, the VIX to VXV ratio, which is a measure of the term structure of VIX, moved from a normally upward sloping term structure to inversion indicating a spike in fear levels. As the bottom panel of the chart below shows, the VIX-VXV term structure soared well above 1. I have also indicated with vertical lines past instances where the term structure inverted. With the exception of episodes in 2008, 2009 (Lehman Crisis) and 2011 (eurozone crisis and US budget impasse), past instances of VIX inversion have marked low-risk entry points into stocks.

A modern Archduke Ferdinand moment?
I would caution, however, that Ian Bremmer of the Eurasia Group indicated that the MH17 incident could prove to be a spark for further escalation on both sides of the simmering Russia-Ukraine dispute (via Business Insider):

• Ukraine's new government, led by President Petro Poroshenko, will feel more intensified pressure to conduct military operations to push back pro-Russian separatists in southeastern regions of Ukraine.

• More countries could get involved, and in a broader scope. There could be a new push by the Ukrainian government to get military support from the U.S., which has so far resisted, as well as more nonmilitary aid from the European Union.

• During the months-long conflict, Russia has long asserted its right to intervene on behalf of Russian-speaking citizens. The Pentagon said Wednesday that Russia was again building up its forces along the volatile Russia-Ukraine border.

"Ukrainian government now under much more pressure to remove the separatists by force. There's a better chance that they secure meaningful military support (including weapons) from the U.S. and nonmilitary from the EU," Bremmer wrote in an email to BI.

"But the Russians will deny any involvement and demand protection of the Russians on the ground. Likelihood of escalation has just increased significantly."

There are two scenarios at play here:

1. These tensions will blow over in a few days and this market freak-out will be a gift for market bulls to buy stocks at a discount.
2. This incident turns out to be a modern "Archduke Ferdinand in Sarajevo" moment for the relationships between Russia and the West.

Now ask yourself::

• Which scenario is more likely? 
• Is the market pricing risk correctly?

Correction: The VIX curve did not invert, though it did get close to inverting. The apparent inversion shown is the result of a bad data feed. I apologize for the error and any inconvenience caused.

A short-term negative divergence

This is a quick short-term note for swing traders and not addressed to intermediate or long-term investors. I took a look at the NYSE McClellan Oscillator (in black) after the close today and I was surprised to see how weak the reading was:

Such weak breadth readings are more consistent with markets that are pulling back, not with a market that came within a few points of all-time highs today. As well, when I analyze the absolute levels of the McClellan Oscillator over the last two years, these levels are more typical of the bottom of minor corrective periods (shown as vertical lines) or the start of a minor pullback.

Given these kinds of negative divergences, the weight of the evidence suggests that US equity markets are likely to see a minor (1-2%) pullback in the next week or so. Nevertheless, I remain bullish on an intermediate term basis (see my recent post The good stock market mania).

My family history as a lesson in long-term return expectations

Occasionally, I come across charts like these of long-term asset returns - and they drive me crazy because of the lapses made in the underlying assumptions.

I`ve written about this before and the problem is survivorship bias (see What actually happens in the long run). This chart of equity returns likely referred to US equities, but that`s really a form of cherry picking the successful markets.

Consider that a little over 100 years ago, the Archduke Ferdinand, heir to the Austro-Hungarian throne, was assassinated in Sarajevo and that event sparked the First World War Great War. At that time, the major powers and markets of the world were: Britain, France, Germany, Austria-Hungary and Russia. Smaller developed powers included Italy and the Ottoman Empire, or Turkey. How would you have performed if you had bought into a diversified portfolio of these "developed markets" and held your positions over the last 100 years? Would the results have in any way resembled the chart above?

What about emerging markets? At the time, the major EM markets consisted of the US, Canada, Argentina and Japan. What would have that kind of diversification bought you?


Risk of war and confiscation
What people seem to forget is one long-term risk of investment is the risk of the permanent loss of capital from war and confiscation. The story of my own family is a vivid illustration of that point.

My father`s family is ethnic Chinese from Vietnam. My great-grandfather, the Old Man, made his fortune when he went to Vietnam as a penniless immigrant from China. Over time, the family became one of the more prominent Chinese families in Vietnam and owned about one-quarter of the property in Saigon Ho Chi Minh City. Indeed, a visitor to HCM City today can visit the old family compound and still see the family crest on the gates around the compound, which occupied a city block and is roughly the size and equivalent location of Rockefeller Plaza in Manhattan. In the our heyday, the family name would have been as recognizable as a Rockefeller or duPont.

Not that I am complaining, but I hardly had an upbringing that was equivalent to one of the Rich Kids of Instagram. That`s because the vast majority of family wealth vanished because we fell victim to the risk of war and confiscation.


Imagine a diversified portfolio...
Going back 100 years, consider how a diversified balanced portfolio of stocks and bonds invested in then blue-chip "developed markets" might have performed, either on a capitalization or equal-weighted basis. The only one that survived relatively intact was the UK. The others, France, Germany, Austria-Hungary (yes, remember them?), Russia suffered tremendous hardship, *ahem* involuntary changes in governments and capital destruction.

So whenever someone shows me a chart of long-term equity returns and tries to use those figures as their assumption to calculate either equity return assumptions or the equity risk premium, I shake my head.

The moral of this story is: When you build models, you have to think hard about your assumptions. Don`t get blinded by either cultural or survivorship biases.

The "good" stock market mania

Recently, there have been a number of bearish warnings about the equity markets. No doubt there have been signs of froth, but how much frothier can the stock market get? Cutting to the chase, my conclusion is we are seeing the initial stages of a stock market mania and that it will have a lot longer to run. Just as my former colleague Walter Murphy termed "good overbought" to describe overbought conditions in an uptrend, I believe that we are seeing the start of a "good" stock market mania.

But first, let me detail some of the concerns about stock prices.


Long-term valuation warnings
Long-term valuations issues remain front and center. Mark Hulbert echoed many of the problems I raised about US equity valuations as I cited that market PE, PB and dividend yields are elevated (see More evidence of a low return equity environment). Hulbert also highlighted the high levels of other long-term valuation ratios such as CAPE and Q-ratio to make the point that 10-year returns are likely to be disappointing.

I agree with the general conclusion that long-term equity returns are likely to be muted, but does this necessarily mean that stocks go down right away (see "Ending in tears" doesn't mean the market goes down right away). The question is, what is the intermediate term outlook?


Intermediate term red flags
Recently, Mark Hulbert also highlighted some warnings about the intermediate term outlook as well. He cited declining share buybacks and companies using their "expensive" paper to fund acquisitions as signs that the current bull is maturing:

New stock buybacks fell to $23.2 billion in June, the lowest level in a year and a half, according to fund tracker TrimTabs Investment Research. In May, the total was just $24.8 billion, and the monthly average in 2013 was $56 billion.

That’s worrisome, according to TrimTabs CEO David Santschi, because “buyback volume has a high positive correlation with stock prices.”

Corporations recognize that their stock is expensive and, in aggregate, starting to fund acquisitions with their own paper instead of cash, another worrisome sign:

Hedge-fund manager Douglas Kass, president of Seabreeze Partners Management, relates the slowdown in buybacks to the recent M+A wave. He says that both activities represent the implicit recognition by corporate managements that their internal operations are unable to produce sufficient revenue growth to maintain their stock prices.

Over the past five years, for example, per-share sales growth for S+P 500 companies has been an annualized 2.4%, lagging far behind the 20% annualized earnings per share growth rate. One of the ways in which corporate managers have been able to extract that much EPS growth out of such anemic sales growth, Kass argues, is through share repurchases.

As their share prices become more and more inflated, however, corporate managers become increasingly reluctant to buy them. The logical thing to do instead is buy up other companies, paying with shares of their inflated stock.

That’s what is happening now, Kass argues: “There’s a baton exchange from buybacks into M+A activity.”

Regular readers will recognize that I highlighted similar concerns about the combination of falling buyback plans and falling operating margins (see "Ending in tears" doesn't mean the market goes down right away). I am carefully watching the report cards and forward guidance from the current Earnings Season for signs of EPS growth weakness.


CYNK a sign of froth
In the very short term, the poster boy for froth has to be the moonshot-like rise of CYNK, a company with no revenues and one employee, which was then suspended and investigated by the SEC for possible manipulation.

Too early to panic
Is this time to sell everything and go to cash? I think that David Merkel had the right perspective when he described the credit cycle in the following fashion:

The credit cycle tends to be like this: in the bull phase, a long period (4-7 years) with few defaults and low loss severity followed by a bear phase, a shorter period (1-3 years) with high defaults and high loss severity. This is a phenomenon where history may not repeat exactly, but it will rhyme very well.

In the bull phase of the credit cycle there are a few defaults, but when you analyze the defaults, they occur for reasons unrelated to the economy as a whole. What do the failures look like? Fraud (think Enron), bad business plans from a megalomanic (think Reliance Insurance, ACH, Southmark, etc.) , a sudden shift in relative prices (think Energy Future Holdings), etc. Bad banking — think Continental Illinois in 1984.

In the bull phase, companies that fail would fail in any environment. But now let’s talk about the transition between the bull and bear phase — that is the “pop, Pop, POP.”

As the credit cycle shifts, a few companies fail that are closely related to the crisis that will come. They are your early warning. Think of the subprime lenders under stress in 2007, or the failure of Bear Stearns in early 2008. Think of LTCM in 1998, or the life insurers that came under stress for writing too many GICs [Guaranteed Investment Contracts] in the late 80s and invested the money in commercial mortgages.

As the cycle moves on defaults become more closely related to the financial economy as a whole. Fed policy is tight, and a bunch of things blow up that borrowed too much money short term. This is when the correlated failures happen.

Right now, Merkel believes that we are starting to see the first "pop" (emphasis added):

The present is always confusing. I get it right more often than most, but not by a large margin. We have companies threatening to fail in China and Portugal, but I don’t see much systemic lending risk in the US yet, aside from what is leftover from the last crisis.

It is worth noting that deleveraging has occurred more in word than in deed over the last five years. Yes, debt has traveled from public to private hands, but that only defers the problems, as governments will either have to inflate, tax more, or default to deal with the additional debts.

I am not trying to sound the alarm here. I am trying to tell you to be ready. During the intermediate phase between bull and bear, the weakest companies fail from unrecognized systemic risk. Personally, I think I have heard the first ‘pop.” It is coming from nations that did not delever, and that may suffer further if the bad debts overwhelm the banking systems.

His advice is to be careful, but it's too early to dive into the foxhole:

Are you ready for the bear phase of the credit cycle? Screen your portfolios, and look for weak names that will not survive a general panic where only the best names can get credit.

I would tend to agree. The kinds of excesses that we are seeing are starting to get worrisome, but they are a natural part of the expansion, where caution gives way to exuberance. I can recall that in the late 1990`s, one of the greatest value of Deutsche Telekom was its valuation and the ability of that company to use its stock for acquisitions. Those excesses did not mark the top of the cycle, but those signs of froth lasted for a couple of years before the market collapsed.


A mania is developing
All of these issues that have been raised - excessive valuation, companies using overvalued paper to fund acquisitions, the kinds of CYNK silliness that show up on occasion are part of a developing mania for risk (see this commentary from Matt Levine about what the more likely story on CYNK was). For this stock market to truly top out, you have to wait for excesses to really, really get out of hand. We are nowhere at that point of the market cycle yet.

One of signs of a top is the irrational exuberance exhibited by the retail investor. Public (retail) participation is still relatively low and individual investors remain cautious. This chart from Patrick O'Shaughnessy shows that the individual retail investor starting to tiptoe back into equity mutual funds after the devastating sell-off in the wake of the Lehman Crisis, but sentiment can hardly be described at extreme levels.

No doubt, I will get emails and comments about the elevated readings from Investors Intelligence, etc. I would note that II polls are opinion polls, which ask newsletter writers their opinions, while hard numbers like mutual fund flows show what people are actually doing with their money. The chart below shows the SPX on the top panel and the II Bull-Bear ratio on the bottom. The vertical lines show the instances where the bull-bear ratio has risen above 3, indicating a crowded long. As the chart shows, while this indicator has shown some value, it has also flashed too many false positives to be useful as an effective market timing tool.

Remember - opinions can change on a dime, but asset allocations generally do not. Actions speak louder than words when it comes to sentiment analysis.

Indeed, the AAII weekly sentiment poll paints a picture of a highly jittery public. While the bull and bear sentiment readings have been volatile, they have been relatively low compared to the level of neutral (read: unsure) opinions, which indicate a high level of uncertainty. This comment from Bespoke hit the mark on the issue of public sentiment (emphasis added):

While bullish sentiment only saw a small decline, bearish sentiment spiked to 28.65% from 22.39%. This was the largest one week increase since April 10th. This week's trend in bullish and bearish sentiment readings is a continuation of the trend that has been in place for much of this bull market. Individual investors are slow to embrace the bull, but at the first signs of trouble are quick to exit.

By contrast, the TD-Ameritrade IMX Index, which tracks what TD-Ameritrade customers are actually doing with their money, shows that even as the stock markets advanced to new highs, individual investors have stayed cautious and been slow to embrace the bull:

Funds flow positive
For now, my inner trader remain cautiously bullish. For some time, I have relied on a funds flow model based on this study of skew analysis. The funds flow model measures the skew of the relative returns of equities (SPY) compared to long Treasuries (TLT) and sees what the shape of the distribution looks like.

If the distribution is symmetric (top chart), then funds flows are normal. If it is skewed to the left or right, it would indicate either significant flows into either stocks (risk-on) or bonds (risk-off). Late last week, it flipped bullish indicating funds flow into risky assets. This model does not identify the source of the flows, whether it is retail, institutional or fast money (hedge funds), only that there are significant flows.

The chart below shows the funds flow model signals in the last three years. Buy signals are marked by blue arrows and sell signals are marked by red arrows. The circles indicate a return to a neutral condition, which would indicate a move to cash signal. Overall, it appears that buy signals have performed better than sell signals:

Funds Flow Model signal history

Key risk: EPS growth scare
In conclusion, the weight of the evidence suggests that intermediate path of least resistance for stock prices is still up. My inner investor is getting somewhat cautious, but he remains long the market. My inner trader believes that the party thrown by the Fed and ECB is just getting going and he is fully enjoying himself.

While these conditions suggest that a major bear market is nowhere close to starting, it does not mean that stock prices cannot correct. The one key risk and weak link to the current bull phase is the EPS growth outlook. Analysis from Ed Yardeni shows that Street consensus estimates are still rising, which indicates an equity friendly environment.

However, more recent data from Brian Gilmartin shows that forward EPS growth estimates slipped this week and this is the second week of decelerating growth (emphasis added):

The year-over-year growth rate on the SP 500 slipped to 8.51% from last week’s 8.66%. The y/y growth rate of the forward estimate is still at the higher end of its recent range, and the highest y/y growth rate since 2012.

Recently, I also outlined my concerns that the combination of falling profitability, which affects the numerator in EPS, and declining share buyback plans, which affect the denominator in EPS, are top-down warnings that EPS growth may stall out (see "Ending in tears" doesn't mean the market goes down right away). That's why I believe that the reports from this Earnings Season is so critical to the short-term equity market outlook as these series of earnings reports will serve as a bottom-up verification of that top-down analysis. That's why the earnings reports will bear watching very carefully.

For now, my inner trader is giving the bull case the benefit of the doubt, but he is keeping his stops tight in case we see a series of negative EPS disappointments and guidance.