Monday, September 1, 2014

A sweet spot for equities

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

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

Expecting the market to grind higher
The US equity market remains in bull mode on an intermediate term basis. The Trend Model looks at markets globally and conditions have marginally improved from last week, which was at an already "risk-on" signal. The SP 500 remains in an uptrend, with the index staging an upside breakout to new all-time highs.


Despite the disappointing growth outlook and heightened geopolitical risk from Russia-Ukraine, European markets weathered the bad news last week relatively well and remains in a weak uptrend.


Commodity markets were mixed. The broadly-based CRB Index (in black) remains in a downtrend, though it appears to be trying to stage a rally. Industrial commodities, which are even more cyclically sensitive than the CRB, are showing more strength and appears to be undergoing a high-level consolidation.


More encouraging is the bullish engulfing pattern shown by the monthly SPX candlestick chart. This pattern has historically led to further advances in the past.





Sam Eisenstadt`s bullish call
The bull case was bolstered by Mark Hulbert`s column outlining how Sam Eisenstadt remains bullish with an SPX target of 2150 by year-end:
This incredible bull market, which pushed the SP 500 above 2,000 earlier this week, is still alive and well. By the end of the year, the benchmark index may rise to around 2,150, about 8% higher.

So says Sam Eisenstadt, who has more successfully called the stock market in recent years than almost every other market timer I can think of — including many who I have featured in this column.

Eisenstadt, for those of you who don’t know of him, is the former research director at Value Line Inc. Though he retired in 2009, after 63 years at that firm, he continues in retirement to update and refine a complex econometric model that generates six-month forecasts for the SP 500 — and he shares them with inquiring columnists.
Hulbert wrote that one reason Eisenstadt's model is bullish is because of low interest rates:
Though it is proprietary, he does say that one of the most bullish inputs to his model right now is low interest rates. Since the Federal Reserve has signaled that it could begin raising short-term interest rates in 2015, Eisenstadt’s model could as early as next year start forecasting a less rosy six-month outlook.
However. rate pressure might be less than Hulbert postulates. The latest Dallas Fed releases of the Core PCE and Trimmed Mean PCE inflation rates show that these (Fed's favorite) measures of inflation, are moderating. The one-month Core and Trimmed Mean PCE Inflation Rates had been elevated but they have fallen back in June and July. The more annual figures have either remained steady or stayed level for the past four months:


Low inflation readings from the Fed's favorite inflation gauge has the potential to keep the Fed on hold longer, which is bullish for equities on an intermediate term basis.


Growth outlook positive
In addition, the growth outlook remains positive. The latest Q2 GDP report shows a picture of slow and even growth. More importantly for equities, Factset reports that forward EPS estimates continue to climb at a steady rate.


The combination of uptrends in global equities and industrial commodities; a benign interest rate environment and rising EPS growth expectations represent a sweet spot for equities.


Sentiment models are mixed
Last week, I called for either a minor pullback or choppy consolidation as the SPX approached the round-number 2000 level (see The easy money has been made). Instead, the SPX staged an upside breakout through 2000 and consolidated in a tight range during the week. As a result, the overbought conditions that I observed last week remain in place.

The near-term overbought condition doesn't necessarily mean a pullback is a foregone conclusion as short-term sentiment model readings are mixed. The latest AAII survey (via Bespoke) show the percentage of bulls to be above 50 and bears at historical lows - which appear to be a worrisome development. However, these readings are highly volatile and unreliable. As an example, I inserted vertical lines into the Bespoke charts indicating similar extremes in sentiment. While some of these signals were accurate warnings of near-term tops, in other cases the market shrugged off these excesses in the past to advance higher.




We saw a contradictory reading in option sentiment last Thursday, when the put-call ratio spike to an extreme. Such spikes have signaled market rallies in the past. However, previous spikes in the put-call ratio have occurred when the market had been falling, not rising as it had been last week. I therefore interpret last week's put-call ratio as an anomalous reading that could be ignored, despite its bullish implications. One possible explanation for the put-call ratio spike was that traders were seeking protection from negative Russia-Ukraine developments over the long Labor Day weekend - which is a one-time event.


When I see contradictory readings from sentiment models, it's useful to survey what other sentiment readings are showing. Rydex fund flows show a picture of a market that has recovered from a panic with sentiment readings normalizing, but have not moved to the other extreme of a crowded long.


The equity-only put-call ratio (not shown) shows a similar picture of recovery from panic and normalization. I interpret these conditions as a market that could see a minor (1-2%) pullback but the risk of a major correction as being low. The path of least resistance for stocks is still up.


Bottom line: Both my inner investor and inner trader remain bullishly positioned. We are in the middle of a sweet spot for US equity prices. Sit back, relax and enjoy.

You can also follow any updates that I might have on Twitter at @humblestudent, or subscribe to my blog post updates by email here.

Friday, August 29, 2014

Who's afraid of the Big Bad Terrorist?

On Friday, the UK government raised its terror threat from "substantial" to "severe" as Home Secretary Theresa May warned of threats from jihadists from Iraq and Syria. Global stock markets sold off initially on the news, but recovered later in the day.

The answer is an emphatic "yes". As investors and traders, we should be focusing on fundamentals. Aside from the tragedy of injury and loss of lives, market participants should be asking what impact a terrorist attack would have on the growth outlook and interest rates. In most cases, the answer is "not very much."

Consider these three examples of how the market reacted to past terrorist events. Here is the market reaction to the Boston Marathon bombing. Blink and you would have missed the disruption.


Here is the market reaction of the FTSE 100 to the July 7 London bombings. Again, blink and you would have missed it.



Here is the market reaction to the Madrid train bombings of 2004. In this case, the story was a little complicated. Wikipedia explains the sequence of events this way:
The bombings occurred three days before general elections in which incumbent José María Aznar's PP was defeated. Immediately after the bombing, leaders of the PP claimed evidence indicating the Basque separatist organization, ETA (Euskadi Ta Askatasuna) was responsible for the bombings, while Islamist responsibility would have had the opposite effect as it would have been seen as a consequence of the PP government taking Spain into the Iraq War, a policy extremely unpopular with Spaniards.

Nationwide demonstrations and protests followed the attacks. The predominant view among political analysts is that the Aznar administration lost the general elections as a result of the handling and representation of the terrorist attacks, rather than because of the bombings per se.
In this case, the charts show that the markets were reacting to the news of the bombing and the election, which occurred on the weekend three days later:


The moral of the story: Don't just react to headlines, focus on fundamentals.



Thursday, August 28, 2014

What if the Horatio Alger's story hero is named Rajiv?

In this Age of Piketty, there have been more and more writing about the issue of income and wealth inequality. Three articles particularly resonated with me.


Equality of opportunity, not wealth
The first was a piece from Richard Reeves of the Brookings Institute called Saving Horatio Alger: Equality, Opportunity and the American Dream.

The article cited the lack of the equality of opportunity as a problem with America today. Simply put, your success depended a large extent on the wealth of the family you were born into (emphasis added):
Lack of upward mobility is souring the national mood. As horizons shrink, anger rises. The political right has done a better job, so far, of converting frustration into political gain, by successfully—if implausibly—laying the blame for many of America’s woes at the door of "Big Government". Much of the political energy on the left has been directed against the highest earners—the top 1 percent of the income distribution. But while Occupy Wall Street generated plenty of headlines, it has produced precious few votes, and only a trivial change in the tax system: since 2013, married couples making more than $450,000 a year have had to pay just an extra nickel of tax on each dollar above that level.

The problem is not that the United States is failing to live up to European egalitarian principles, which use income as a measure of equality. It is that America is failing to live up to American egalitarian principles, measured by the promise of equal opportunity for all, the idea that every child born into poverty can rise to the top.

Take one standard indicator of mobility: the likelihood that children will, as adults, ascend to a higher rung on the income ladder than their parents. In a completely mobile, fluid society, a child raised on the bottom rung of the income ladder (usually defined as the bottom fifth of the distribution) would theoretically have as good a chance as any of making it to the top, and no greater risk of remaining trapped at the bottom. But the U.S. suffers from a high degree of intergenerational "stickiness" at the bottom of the income distribution. Children born on the bottom rung have a four in 10 chance of remaining stuck there in adulthood (between 36 percent and 43 percent, depending on the dataset), and a very slim chance (between 4 percent and 10 percent) of making it to the top.


Alan Kreuger called this inter-generational wealth stickiness effect the Great Gatsby Curve,



Reeves concluded not with an exhortation towards re-distribution, but for a plea to equalize opportunity again so that the American Dream could be realized:
On the political left, there are plenty of people who think it is time to consign Horatio Alger to the dustbin of history. For them, the Alger myth is little more than a cultural conjuring trick, providing an illusion of opportunity to distract the masses from gross inequalities of income and wealth. It can also act as a convenient untruth for the elite, who can rest assured of their intrinsic superiority: “Born on third base … thinking they hit a triple,” in football coach Barry Switzer’s vivid phrase.

But abandoning Alger—giving up on the American Dream—is not an option. While Bellamy and Piketty provide rich seams of ideas to mine, there is no prospect of a Euro-egalitarian turn in American politics. The American body politic would simply reject a graft of European-style social democracy. It’s pointless for progressives to get frustrated about this. Attachment to the ideal of equal opportunity is not a blind spot in the vision of voters. Americans do have strong egalitarian instincts, but they go hand-in-hand with a fierce commitment to individualism. The ideal of merit-fueled mobility is a fixed feature of American politics and ideology. It comes, almost literally, with the territory. Even if it were possible to retire the Alger myth, it would be a mistake. The national commitment to the principles of natural equality, opportunity, and upward mobility is an American strength. Only a politics that goes with this American grain stands any chance of creating a more equal nation.

The pitchforks are coming
The second was an article in Politico by Nick Hanauer, a billionaire, to his brethren called The pitchforks are coming...for us plutocrats. He begins his article with the story of his success:
You probably don’t know me, but like you I am one of those .01%ers, a proud and unapologetic capitalist. I have founded, co-founded and funded more than 30 companies across a range of industries—from itsy-bitsy ones like the night club I started in my 20s to giant ones like Amazon.com, for which I was the first nonfamily investor. Then I founded aQuantive, an Internet advertising company that was sold to Microsoft in 2007 for $6.4 billion. In cash. My friends and I own a bank. I tell you all this to demonstrate that in many ways I’m no different from you. Like you, I have a broad perspective on business and capitalism. And also like you, I have been rewarded obscenely for my success, with a life that the other 99.99 percent of Americans can’t even imagine. Multiple homes, my own plane, etc., etc. You know what I’m talking about. In 1992, I was selling pillows made by my family’s business, Pacific Coast Feather Co., to retail stores across the country, and the Internet was a clunky novelty to which one hooked up with a loud squawk at 300 baud. But I saw pretty quickly, even back then, that many of my customers, the big department store chains, were already doomed. I knew that as soon as the Internet became fast and trustworthy enough—and that time wasn’t far off—people were going to shop online like crazy. Goodbye, Caldor. And Filene’s. And Borders. And on and on.

Realizing that, seeing over the horizon a little faster than the next guy, was the strategic part of my success. The lucky part was that I had two friends, both immensely talented, who also saw a lot of potential in the web. One was a guy you’ve probably never heard of named Jeff Tauber, and the other was a fellow named Jeff Bezos. I was so excited by the potential of the web that I told both Jeffs that I wanted to invest in whatever they launched, big time. It just happened that the second Jeff—Bezos—called me back first to take up my investment offer. So I helped underwrite his tiny start-up bookseller. The other Jeff started a web department store called Cybershop, but at a time when trust in Internet sales was still low, it was too early for his high-end online idea; people just weren’t yet ready to buy expensive goods without personally checking them out (unlike a basic commodity like books, which don’t vary in quality—Bezos’ great insight). Cybershop didn’t make it, just another dot-com bust. Amazon did somewhat better. Now I own a very large yacht.
The difference is that this so-called "self-made man" does not see himself as anything special. In many ways, he just got lucky, which makes him fear for the future of America (emphasis added):
But let’s speak frankly to each other. I’m not the smartest guy you’ve ever met, or the hardest-working. I was a mediocre student. I’m not technical at all—I can’t write a word of code. What sets me apart, I think, is a tolerance for risk and an intuition about what will happen in the future. Seeing where things are headed is the essence of entrepreneurship. And what do I see in our future now?

I see pitchforks.
Hanauer sees a class war on the horizon and he wants to defuse it before it begins:
The oldest and most important conflict in human societies is the battle over the concentration of wealth and power. The folks like us at the top have always told those at the bottom that our respective positions are righteous and good for all. Historically, we called that divine right. Today we have trickle-down economics.

What nonsense this is. Am I really such a superior person? Do I belong at the center of the moral as well as economic universe? Do you?

My family, the Hanauers, started in Germany selling feathers and pillows. They got chased out of Germany by Hitler and ended up in Seattle owning another pillow company. Three generations later, I benefited from that. Then I got as lucky as a person could possibly get in the Internet age by having a buddy in Seattle named Bezos. I look at the average Joe on the street, and I say, “There but for the grace of Jeff go I.” Even the best of us, in the worst of circumstances, are barefoot, standing by a dirt road, selling fruit. We should never forget that, or forget that the United States of America and its middle class made us, rather than the other way around.
Hanauer`s solution is to pay Americans more, starting with a minimum wage increase. He believes that a better paid Middle America would have more money to spend and therefore corporate income, leading to a virtuous cycle of growth.


An emerging class system in America
If the idea of the American Dream is equality of opportunity and the idea that anybody can make it, as opposed to the class system left behind in Old Europe, what is disturbing is an essay by Noah Smith showing evidence of an emerging class system in America:
If there’s one political idea most people agree on these days, it’s the rule of law. We argue endlessly about income inequality, wealth inequality, or inequality of opportunity, but we take it as given that equality under the law is a prerequisite for a just society. And the consequences of private law are dire. The original system of French privilege was one of the main causes of that country’s bloody, chaotic revolution.

Now here’s the problem: The U.S. is looking more and more like it has a real privilege system. We are enforcing laws differently based on race, but also based on class. This is un-American, and it has got to stop.

First, there is race privilege. The tragic shooting of an unarmed black teenager by a police officer in Ferguson, Missouri, has put this issue front and center, but the facts bear repeating. Our police officers enforce the law differently for different races. They arrest a much higher percentage of black people for using drugs, even though blacks and whites use illegal drugs at about the same rates and whites use the most harmful drugs -- cocaine and heroin -- at higher rates. That is an injustice.
We have all heard about the offence of "driving while black":
Our courts are no less of a problem. Blacks are 30 percent more likely to be thrown in prison than whites who were convicted of the same crime. Furthermore, our Constitution guarantees citizens the right to a trial by a jury of their peers, but many black defendants are prosecuted by all-white juries, which are significantly more likely to return a guilty verdict against blacks. Finally, racial profiling is so rampant that black Americans who have committed no crimes at all have to live in constant fear of getting stopped by the cops. White Americans don't have to live with this fear.
The whites aren`t immune to the class system either, according to Smith. There is one set of laws for the rich and another set for the "great unwashed masses":
White Americans can be complacent about racial disparities in law enforcement, thinking that at least they themselves are safe. Except that in modern America, the law now seems to be different for people of different income levels as well.

In 2010, Martin Erzinger, a private-wealth manager for Morgan Stanley Smith Barney, was the driver in a hit-and-run of a bicyclist in Eagle, Colorado. The victim suffered spinal injuries and brain bleeding. But the prosecutor dropped felony charges against Erzinger, giving the following justification:
Felony convictions have some pretty serious job implications for someone in Mr. Erzinger's profession, and that entered into it," [prosecutor] Hurlbert said. "When you're talking about restitution, you don't want to take away his ability to pay.
In addition to the story of Martin Erzinger, Noah Smith had a number of other examples of how the rich got off easily with a slap on the wrist from the justice system when faced with serious offences.

Notwithstanding the ideas of a class system runs counter to the founding myth of America, what is more disturbing is that it can lead to economic stagnation. The FT had a very good article about the two different paths taken by Argentina and the US about a hundred years ago:
A short century ago the US and Argentina were rivals. Both were riding the first wave of globalisation at the turn of the 20th century. Both were young, dynamic nations with fertile farmlands and confident exporters. Both brought the beef of the New World to the tables of their European colonial forebears. Before the Great Depression of the 1930s, Argentina was among the 10 richest economies in the world…

There was no individual event at which Argentina’s path was set on a permanent divergence from that of the United States of America. But there was a series of mistakes and missteps that fit a general pattern. The countries were dealt quite similar hands but played them very differently.
The article is well reading in its entirety. The main point is: Class systems choke off growth.


Equality in a global world
Reeves, Hanauer and Smith all make good points about inequality in America. Equality of opportunity is becoming a barrier to the American Dream that anyone can succeed. Should that Dream and social consensus shatter, the cultural dynamics of growth in the United States would be changed forever. However, this kind of thinking about inequality models American equality as a closed system. The United States is part of the world - and the nature of global inequality has been changing.

In a landmark study, Branko Milanovic of the World Bank showed how global inequality has been changing. The chart below shows who won and lost in the inequality race globally. The x-axis on the bottom splits the world population from the poorest on the left in subsistence economies to the richest on the right, while the y-axis shows the real income growth in PPP terms between 1988 and 2008.


Milanovic went on to show that the country that you were born matters a lot more now than the social class that you were born into. In 1988 to 2008 30-year interval, the winners in the inequality race were the middle class in emerging economies, because of the effects of globalization, and the very rich, who engineered the globalization revolution. The losers were the very poor in subsistence economies, who weren't able to benefit from and the middle class in developed economies, who did not receive the benefits of the productivity gains in the last few decades. The latter represents the disaffected group that Reeves and Hanauer wrote about.

So, is the American Dream still alive? Well sort of. It got globalized and the winners of the American Dream are not likely named Joe, but Rajiv.

As to the question of whether this represents a bug, or a feature, of economic policy, that question is way beyond my pay grade.

Wednesday, August 27, 2014

An open letter to Bill Gates on gun control

Dear Bill:

I see that you and Melinda have donated $1 million to the Washington Alliance for Gun Responsibility, a gun control advocacy group. Media accounts indicate that:
The Alliance is backing a ballot measure in the state this November that would require background checks for all gun purchases in the state, including those made at gun shows and online. The measure is opposed by a local group known as Protect Our Gun Rights, which has raised $1.1 million and has its own measure on the ballot to try to block background checks.
I understand the history of the Bill and Melinda Gates Foundation is to take incremental steps to better the world with small but high impact contributions to worthy causes. The tragedy of gun violence in America is deplorable. However, your latest contribution marking an approach towards gun control political advocacy, regardless of your intent, cannot be regarded as a high impact act given the entrench gun culture in American society.

Instead, might I suggest a Third Way of achieving your goals of a safer America while achieving a political consensus about gun ownership (see my previous post Is more government the answer?). There is no question that gun ownership involves risk, as shown by most recent incident of the nine-year-old accidentally killing her instructor, Gun control advocates believe that it introduces too much risk into American society, while gun owners believe that the benefits of gun ownership and the right to self-protection far outweigh the risks.

Instead of arguing over whether the benefits outweigh the risks, why not allow the market to price the risks of gun ownership? Here is what I wrote in 2012:
Just as everyone above a certain age is allow to own a car, everyone who is qualified could be allowed to own a gun. Just as car ownerships are required to have insurance, gun owner should be required to carry a large level of liability insurance in case the guns under his control are used improperly.

That way, we can let the market regulate gun ownership rather than the government. Insurance companies are in the business of pricing risk and they should be able to price the cost of gun ownership properly. That way, the market can create barriers to the "crazies" owning guns.

No doubt, the level of gun ownership will decrease under such a proposal, but the "right kind" of gun ownership, i.e. responsible ones, will be largely unaffected. In America, everyone who is qualified is allowed to own a car, but not everyone is owns one because of the costs involved. Under this proposal, the free market would tend to weed out the higher risk cases.

If America is the embodiment of the embrace of free markets, then this would be an important step in the application of this principle pertaining to the gun ownership and control debate.
Driving cars is virtually a universal right in America. Nevertheless, drivers have responsibilities in the operation of a vehicle and laws requiring liability insurance. If we apply the same principles used for cars to guns and allow the market to price the risk of gun ownership, it is a proposal that could see strong bipartisan support from both sides of the gun control debate.

That would fit with the profile of a low cost, but high impact initiative in the tradition of the Bill and Melinda Gates Foundation of making the world a better place.


Tuesday, August 26, 2014

CapEx is still MIA

Ho hum! Another month, another miss on core capital goods orders release.

I have been writing about this topic for several months (see What equity bulls need for the next phase, CapEx: Still waiting for Godot and Financial engineering as a CapEx substitute). In the current mid-cycle phase of the economic expansion, companies typically ramp up their capital expenditures, which seems to have gone MIA this time.


Healthy borrowing, but not for CapEx
So where is the CapEx? Credit conditions are easy and capacity utilization is creeping up, so this is a perfect time for a CapEx revival. A WSJ article recently blared a headline indicating that US bond issuance was nearing $1 trillion on a YTD basis. Where did all that borrowing go?
Investors and analysts say companies are raising funds partly with an eye to investing in fresh projects as the U.S. economy gains pace, a move that can further help along economic growth. Acquisitions have about doubled in the U.S. from last year to a recent $1.1 trillion, and U.S. bond sales earmarked for capital spending—purchases or upgrades of long-lived assets such as plant and equipment—have risen 90% from a year earlier to $40 billion, Dealogic said.
The article reveals much of the borrowing occurred because rates are low:
Much of the cash is being used to refinance existing debt, being sent back to shareholders as dividend payments and share buybacks, or banked in the corporate treasury as executives consider how to potentially deploy funds as the economy expands.
The previously cited capital spending figure being up 90% from a year ago sounds encouraging. Digging further:
About $315 billion of corporate bonds have been sold in the U.S. to repay or refinance existing debt, an approximately 35% increase over last year, according to Dealogic...

According to Dealogic, about $109 billion in bonds has been sold globally this year that identified mergers as a use of proceeds, up from $84 billion at this time last year...

Share buybacks have been another popular use of bond proceeds. SP 500 companies bought back about $158.4 billion in the first quarter, the third-largest quarterly amount since 2005, according to FactSet...
In that context, $40 billion for capital expenditures pales in comparison.


A Jim Chanos warning
Jim Chanos recently voiced his worries about the current trend of substituting financial engineering for actual physical capital investment (via Business Insider):
Add Jim Chanos' to the number of voices worried that American companies are running out of gas and in need of real consumer demand to create revenue.

In an interview with Bloomberg's Masters in Business, hosted by Barry Ritholtz, Chanos explained how corporate buybacks were less a sign of strength and more a cry for help from American companies.

He said: "What worries me is that corporate America in aggregate, has pre-tax returns on capital in the mid to high teens. The long-term expected rate of the equity markets, is roughly half that. And when corporations embarked on massive buybacks across all industries and all companies, in effect these CEOs are buying the stock market. So what they’re telling you then, is unequivocally that they think that either they’re happy to earn the stock market rate of return or maybe something hopefully better. Or their rate of return on the margin of any new capital project is much much lower, in fact half or less of what is stated. And that does not bode well for the future of profits, or for the quality of earnings reported as current profits."
He concluded:
Chanos says that corporate balance sheets are looking healthier because analysts aren't deducting acquisitions from a company's cash flow as they should.

“Increasingly we’re seeing acquisitions, which are not taken out of most analysts for cash flow numbers, acquisition are replacing CapEx or R+D," Chanos said. "So companies are buying their R+D or their capital, and that should [be] properly deducted from cash flow, because in aggregate corporate America is not growing. So by buying each other and buying divisions of each other, in effect, they’re capitalizing their R+D … and that particularly applies for big tech, which are perceived as very cheap companies. If you actually look at them, the only reason their revenues aren't declining at a reasonable rate is because they’re buying other companies.”
Is Chanos right? Is Corporate America substituting financial engineering for actual capital spending, which should be occurring during this phase of the economic expansion? Are there insufficient number of capital projects that beat their WACC (weighted average cost of capital) to warrant investment?

I have no idea. What I do know is that Mr. Market is reacting to these developments. The chart below of the performances of the capital goods intensive Industrial sector, cap weighted or equal weighted (which reduces the effects of heavyweight GE), is rolling over relative to the SPX.


Should this trend in listless capital spending continue, it will hollow out Corporate America and stunt its long-term competitiveness.

Monday, August 25, 2014

What keeps me awake at night

This is the second part of a two-part comment about the US equity market. Yesterday's comment (The easy money has been madewas based on technical analysis, while this comment has a top-down macro orientation. I welcome any comments about the new format at cam at hbhinvestments dot com. You can also follow any updates on Twitter at @humblestudent, or subscribe to my blog posts by email here.


Even though I remain relatively bullish on US equities (see A tradable bottom? and The easy money has been made), it's the job of every good investor to think look skeptically at his own views and examine the other side of the coin. When I do, here is the bearish scenario that keeps me awake at night.

The basic theme comes from David Levy of Levy Forecast:
Employers in the U.S. are creating jobs at the fastest pace since the late 1990s and the economy finally looks ready to expand at a healthy rate. But sluggish growth in France, Italy, Russia, Brazil and China suggests that the old truism, "When the U.S. sneezes, the rest of the world catches a cold," may need to be flipped.

Maybe the rest of the world will sneeze this time, and the U.S. will get sick.
David Levy comes from a family with a pedigree of calling the big turns in the market:
His grandfather, Jerome, didn't just call the Great Crash of 1929, he sold all his stock and liquidated his wholesale goods business in anticipation of it. Immediately after World War II, when many experts thought the U.S. was sure to fall into another depression, his father, Jay, accurately predicted a rapid expansion instead. In late 1999, his uncle, Leon Levy, a hedge fund manager and collector of antiquities, invited this reporter into his office, pointed to a bust of a rich Roman near his door and mused on the fleeting nature of fortune. He then predicted a new generation of wealthy would be laid low soon in a coming dot-com crash.
Those stocks began their long dive a few months later.
Levy himself called the last downturn:
Nearly a decade ago, the now 59-year-old economist warned that U.S. housing was a bubble set to burst, and that the damage would push the country into a recession so severe the Federal Reserve would have no choice but to slash short-term borrowing rates to their lowest levels ever to stimulate the economy. That's exactly what happened. Now, Levy says the United States is likely to fall into a recession next year triggered by downturns in other countries, the first time in modern history
Now he is forecasting a recession that begins abroad which eventually spreads to the US:
Levy says the U.S. is in decent shape. Like most economists, he's not worried about the nation's 2.9 percent drop in economic output in the first quarter, attributing it to harsh winter weather. He expects growth to return, but not for long, as a recession in either Europe or emerging markets spreads to the U.S.

Levy says the U.S. is more vulnerable to troubles abroad than people realize. Exports contributed 14 percent of U.S. economic output last year, up from 9 percent in 2002. That sounds like a good development, but it also makes the country more dependent on global growth, which, in turn, relies more on emerging markets. Those markets accounted for 50 percent of global output last year, up from 38 percent in 2002.
Indeed, the weakness in Europe and China are evident to see. The latest global PMIs show that while the US and Japan are accelerating, Europe and China are slowing.


Ed Yardeni recently outlined his concerns about the major non-US economies:
(1) China. Social financing during July was remarkably weak. It fell from $321 billion during June to $44 billion last month. That was the slowest pace of lending since October 2008. Bank loans dropped from $175 billion during June to $63 billion during July. We think this is a one-month aberration. However, it may be that lending to residential property builders has hit a brick wall as a glut of housing units is depressing prices. In any event, on a y/y basis, bank loans are up 13.4% y/y, in line with M2 growth.

(2) Japan. Real GDP fell 6.8% (saar) during Q2 in Japan. That’s after increasing 6.1% during Q1. Despite Abenomics, real GDP was unchanged on a y/y basis, and up just 2% in nominal terms. Private consumption plunged 18.7% during Q2. It’s not obvious why it wasn’t obvious to the government that mixing massive monetary and fiscal stimulus with a major tax hike was akin to stepping on the accelerator and the brakes at the same time. It’s a sure way to wind up in a ditch. Even capital spending fell 12.3%. Despite the weaker yen, exports fell 1.8%. It’s dismal.

(3) Eurozone. It’s also dismal in the Eurozone. That’s evident in bond yields, which continue to fall to historical lows. The German 10-year government bond yield fell below 1.0% for the first time in history, down to only 0.97% on Friday. Perhaps the biggest shock last week was that Germany’s real GDP fell 0.6% (saar) during Q2. But that’s after it rose 2.7% during Q1, which was boosted by mild winter weather. However, weakness in the rest of the Eurozone is weighing on the region’s biggest economy and biggest exporter. So is the Ukraine crisis, which has been a slow-motion train wreck so far.

The eurozone is becoming a basket case
Thomson-Reuters comments that not only is eurozone GDP growth slowing, Germany, which has been its locomotive, is seeing its growth roll over:


Despite the ECB`s efforts, non-performing loans continue to rise and put pressure on the financial system:



China is slowing again
As China appeared to started to grow robustly after a mini-stimulus package, the July money supply and credit growth figures shocked the market (emphasis added):

  • New Yuan Loans 385.2bn (vs. expected 780.0bn and prior was 1080.0bn)
  • Aggregate Financing 273.1bn yuan (vs. 1500.0bn expected and prior was 1970.0bn)
  • Money Supply M0 5.4% y/y (vs. +5.7% expected and prior was 5.3%)
  • Money Supply M1 +6.7% y/y (vs expected 8.6% and prior was 8.9%)
  • Money Supply M2 +13.5% y/y (vs expected 14.4%, prior was 14.7)

As Sober Look pointed out, Chinese property prices continue to plummet:


Diana Choyleva of Lombard Street Research recently outlined a nightmare scenario of how a slowdown in China could spread to Europe (emphasis added):
The alternative (scenario) is a stalling of reforms, with either major intervention to weaken the renminbi or an investment binge. The result is likely to be a re-run, on a greater scale, of the selling of long-dated Treasuries witnessed in 2012. Yields could rise 10bp. These outcomes would slow but not derail the US recovery – yields rose by almost a percentage point in the second half of 2013.

Moreover, these scenarios assume all other things are equal. But they are not. Renminbi devaluation and higher US yields would be a lethal combination for the eurozone . Most European countries have modestly improved their trade positions with China thanks to stronger German capital exports and soft consumer spending, which has capped imports. But a much weaker renminbi would reverse the trend, thus subtracting from growth.

The eurozone’s peripheral economies would be hurt most because they have a larger export share of lower value-added manufactures and are more likely to compete with China. But Germany’s export-led growth would also suffer if China reduced its excessive reliance on investment.

In addition to the currency effect, a rise in US yields transmitted to the eurozone would represent just the “unintended tightening of monetary conditions” that Mario Draghi, European Central Bank president, has identified as one of three contingencies that would warrant a monetary policy response.
Already, some of the adverse adjustments that Choyleva wrote about may be taking place. Ambrose Evans-Pritchard wrote that recent data showed that Chinese exports to Europe were growing, which is hurting peripheral eurozone countries:
The 17.5pc rise in exports to Europe is probably real (since that data is harder to fiddle). Far from being healthy, it is alarming. Euroland is clearly not booming. A wealth of data suggests that the eurozone already has one foot in recession.

Hans Redeker from Morgan Stanley said the 5pc-6pc fall the Chinese yuan against the euro in the first half of the year is undercutting southern Europe.

Portugal and Italy – among others, with Spain a borderline case – have a great number of small companies in textiles, shoes, furniture, tiles, and increasingly electrical goods, machinery, and telecommunications that compete toe-to-toe with China. They are famously “fishing in the same pool”, mostly mid-tier technology.

The complementary index for European and Chinese exports shows that the EU is in direct competition with China on 35pc of 5,775 types of goods covered, up from 15 per cent in 2000. Germany is hit too, of course. Its solar industry has been largely wiped out by cheap Chinese copies. But it is southern Europe that is suffering the worst damage.

Can the US decouple?
If China and Europe were to slow, what would the effect be on America? Can the US decouple?

This is where my opinion departs from David Levy. While Levy believes that weakness in Europe and China is likely to pull the US into recession, I believe that the American economy is somewhat insulated from a slowdown overseas because of the relatively weak trade linkages. However, the American stock market is not well insulated from a non-US growth pause because of the high degree of foreign exposure seen in large cap multi-national companies.

First, consider that Mebane Faber recently noted that foreign sales accounted for roughly 40% of sales for SP 500 companies. Now consider that David Bianco of Deutsche Bank analyzed the improvement in US corporate net margins and found that a considerable amount of the improvement in margin came from foreign operations (via Business Insider):


To put it very simply, stock prices depend on three elements:
  • Earnings growth
  • Interest rates
  • Risk appetite, or risk premium
So what happens if global growth started to slow? What would happen to large cap earnings growth?

While the characteristics of US large and small capitalization stocks are not directly comparable, this chart from UBS shows the differential in EBIT margins between the two. Should foreign growth start to slow, large and small cap EBIT margins will likely start to converge, with large cap margins falling toward their small cap counterparts for cyclical reasons.


Should we start to see an operating margin squeeze because of a weakening economic cycle, large caps will likely see a double whammy of reduced risk appetite, which would then see PE ratios compress.


Bearish tripwires
I had this scenario in the back of head when I observed that commodities and European stock markets were struggling (see Global growth scare = Trend Model downgrade). While European markets have started to recover somewhat, commodity prices remain under pressure and we are not out of the woods yet. Given the kind of macro downside risk, the consequences of a policy mistake is heightened.

Here is what I am watching as my "bearish tripwires" for the US stock market:
  • What is the effect of the ECB TLTRO program on the eurozone economy and financial system? How will peripheral bond risk premiums react? Is the European consensus shifting away from the all-austerity-all-the-time viewÉ How will European stock prices, which are a component of my Trend Model, react to these initiatives?
  • Were the China July figures indicating a slowdown a blip, or the start of a new trend? The chart below shows the relative performance of the stock markets of Greater China, which consist of China (FXI in red), Hong Kong (EWH in black), Taiwan (EWT in green) and South Korea (EWY in orange) relative to ACWI. Is the recent episode of outperformance the start of a rally, or will these markets roll over as evidence of the ephemeral nature of the rebound emerge? How will commodity prices, another key real-time indicator of Chinese growth, react?

  • Most importantly, how are the Street's consensus SP 500 EPS estimates evolving? On the last question, Ed Yardeni's analysis showed that consensus EPS estimates continue to rise, which is a relief for the bulls.

So far so good and I remain cautiously optimistic. However, these three tripwires bear watching as they could warn of the start of either a serious correction or the start of a bearish impulse in US equities.

Sunday, August 24, 2014

The easy money has been made

Weekly Trend Model signal
Trend Model signal: Risk-on (upgrade)
Direction of last change: Positive

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


The low-hanging fruit is gone
In retrospect, calling the bottom two weeks ago was relatively easy (see A tradable bottom?). Signs of panic was evident and the stock market had become oversold. The historical experience of the last two years showed that these kinds of rebounds have lasted roughly two weeks. Last week, I wrote that the SP 500 was forming an inverse head and shoulders pattern, with an upside target of 1985 (see Onwards and upwards).

Now that the two weeks are up and the SPX has rallied past its IHS target, the low hanging fruit is gone and it will be harder for directional traders to make money. In response to the brief rally, performance chasing individual investors have piled back into US equity mutual funds (via Business Insider):


Bespoke reports that the number of AAII bulls have spiked in the week:


As well, Ryan Detrick pointed out that the ISE equity call-put ratio, which is ratio that uses only opening long customer option trades, had risen to a crowded long reading with the ratio at 200% or more for three consecutive days (I tend to interpret 200% as an excessively bullish reading and 120% as an excessively bearish reading):


Such conditions have shown to be short-term bearish in the past. One data point that I would draw your attention to is the difference between the average and median returns, as well as the percent positive figure. Such disparities indicates that, on average, that the market tends to chop sideways (as indicated by the median and and percent positive figures), but it has the potential to drop precipitously (negative average return):


Given these kinds of short-term overbought conditions, my base case scenarios calls for either choppy sideways market action for the next week or so, or a minor pullback to begin. Should the market see a hiccup, the logical first support level for the SPX would be roughly 1960, which is the intersection of the 38.2% Fibonacci retracement and the 50 day moving average.


Bear in mind, however, that 1960 represents only a 1.4% pullback from Friday's closing levels for the SPX.


Worried about a 1.4% market squiggle?
For swing traders, a potential 1.4% pullback is a playable scenario. For the vast majority of investors, a 1.4% squiggle in the stock market is something to be ignored.

On an intermediate term basis, the technical rebound that began two weeks ago appears to be intact and my Trend Model readings remains firmly bullish. Market conditions were highly oversold and washed out two weeks ago and, if history is any guide, rebounds from such readings tend to go much further. In other words, we need sentiment readings to move from extreme fear to greed - and that hasn't happened yet.

Consider, for example, my favorite overbought-oversold indicator, which is shown in green in the chart below. I am looking for this indicator to move back up to the shaded target zone, where past oversold rallies have petered out in the past.

Overbought/Oversold Indicator

As well, the chart below shows the history of the term structure of the VIX (middle panel) and the VIX Index (bottom panel). After the kinds of panic conditions observed two weeks ago, I would look for the term structure to fall further to more complacent levels in the target zone. Similarly, I am watching for the VIX Index to descend further to a reading with a 10-handle.


I am also watching the chart below of the Rydex fund flows of bear funds + money market funds as a % of total Rydex flows. After the extreme fear readings seen two weeks ago, I would watch for readings to normalize and fall to more bullish readings in the target zone.


The weekly report of insider transaction from Barron's tells a similar story. While insider activity have moved into "neutral" territory from a "buy" signal, readings are nowhere in "sell" territory.
For now, the intermediate trend in my Trend Model remains bullishly oriented and I will stay that way until the readings change. My base case scenario therefore calls for a week of choppy consolidation or weakness, to be followed by further rallies to new all-time highs. After that, my technical analysis crystal ball gets a bit cloudy. While my outlook is tilted bullishly, I will write a further post tomorrow detailing my macro concerns about the health of the US equity bull.


You can also follow any updates that I might have on Twitter at @humblestudent, or subscribe to my blog post updates by email here.


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