Tuesday, October 13, 2015

Could HY distress be a red herring?

I received a lot of skeptical feedback to my last post, probably because of the provocative title (see A "What's the credit limit on my VISA card" buy signal). The pushback can be categorized two ways. A number of chartists were still bearish. As well, there were worrisome signs from the credit market. I want to address the latter issue, as cross-asset, or inter-market, analysis signals are something that I pay special attention to.

HY spreads are blowing out
A number of readers point to articles like this one from Business Insider, in which UBS and Morgan Stanley highlighted recession risk because of widening credit spreads:
Market-watchers have pointed to the recent spike in high-yield bond spreads and noted that this is the kind of move that happens as an economy goes into recession.

The high-yield bond market is particularly sensitive to economic cycles. Commonly referred to as junk bonds, these debt securities are issued by companies with low credit quality. Because of the higher risks that come with lending to such companies, they have to offer higher yields than those of their investment-grade peers. When spreads increase, it's costing more for these junk corporates to borrow.

"US high yield credit has faced one headwind after the next — from significant distress in Energy, to risks of weakening global growth, to significant uncertainty around Fed rate hikes," Morgan Stanley's Adam Richmond said on Friday. "As a result, HY just posted the weakest four-month stretch (Jun-Sep) since the end of 2008, -7.03% in total return. This selloff has driven very negative sentiment, as nothing brings the bears out of hiding more so than low prices, feeding into panicky price action in markets."

"The simple point — it doesn’t happen often — only shortly before recessions or during major growth scares," Richmond said.

All the talk about recession risk got my attention, as recessions are bull market killers. In addition, widening credit spreads are also bad news for stock market bulls, as they are indicative of falling risk appetite. Here is a FRED chart of HY spreads (blue, inverted scale on left) and the SPX (red, scale on right):

How worried should we be about credit spreads? Here is the same chart at around the time of the Lehman Crisis. We can see a positive divergence at the March 2009 low as HY spreads were tighter than they were at the time of the first spike. But then, that effect was somewhat predictable as the fiscal and monetary authorities were taking steps to ride to the rescue, so you would expect credit spreads to begin to narrow.

Here is the same chart in 2011, where we saw HY spreads blowing out to new highs (or lows as the chart is inverted) at the final stock market's  final low. In other words, HY was showing a negative divergence at the equity market bottom.

Are HY spreads a leading, lagging or coincidental indicator of stock prices? The evidence is inconclusive. It seems that credit move approximately in-line with stock prices. The credit market represents a useful indicator of cross-asset risk appetite and it can warn or confirm bull and bear trends. Both positive and negative divergences need to be confirmed by other indicators. By itself, rising credit spreads is a red herring and tell us nothing about where stock prices are going.

Why is EM outperforming US HY?
Still not convinced? Consider this chart of the relative price performance of US HY vs. their equivalent duration US Treasury proxies and EM bonds vs. their equivalent duration US Treasury proxies . You will recall that much of the angst surrounding the current downdraft stemmed from a slowing Chinese economy and worries about emerging market economies. If that's the case, why are EM bonds outperforming US high yield?

The moral of this story is to beware of uni-variate, or single variable, analysis whose results are not confirmed by other models.

Sunday, October 11, 2015

A "What's-the-credit-limit-on-my-VISA-card" buy signal

Trend Model signal summary
Trend Model signal: Neutral (upgrade)
Trading model: Bullish

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

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.

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

A washed-out market
Back in the day when I was a long-only equity portfolio manager, the market would occasionally get hit with emerging market crises. On one occasion, I can remember being in investment meetings discussing how to tweak our stock picking quant models in light of such an event. A manager on the emerging market team made the astute comment that you couldn't possibly model the stocks in a country undergoing a crisis based on anything but technical analysis. At inflection points, it is the technical factors start working first, followed by fast moving fundamental models like estimate revision, then fundamental factors like growth and value.

I remember that insight well and it was based on those comments that after 9/11, I moved my quantitative equity market-neutral portfolio to an all-cash position. I recognized that no quant model was going to work very well in that situation. The fundamental ratios would be all outdated and no sane person would trade off them, but no one quite knew what earnings estimates were until the dust had settled.

I believe that we are at a similar kind of turning point in the market, but on the upside. Market psychology can be revealing, especially when it rallies in the face of bad news. We saw that when the stocks rose on the news of a highly negative Employment Report. We saw a similar reaction last Wednesday, when German trade figures came in below expectations but the DAX Index ended the day in the green.

The (contrarian) negative psychology was exemplified by the behavior of Rydex investors, who added to their crowded short during the initial stages of the recent rally (via Dana Lyons):

At the same time, Mark Hulbert reports heavy insider buying and models indicate a 12-month return of 15%:

By contrast, coincidental indicators such as forward EPS estimates continue to decline (via John Butters of Factset, annotations in red are mine):

This kind of market environment, where sentiment is contrarian bullish and stocks rally in the face of bad news, are the the classic signs of a washed-out market.

The best fundamental and macro explanation of the current environment is that Mr. Market is looking over the valley of near-term weakness to better times ahead. New Deal democrat, who monitors high frequency economic releases and divides them into long leading, short leading and coincidental indicators, finds evidence of near term weakness but no warnings of recession from long leading indicators:
Among long leading indicators, interest rates for corporate bonds and treasuries remained neutral. Mortgage rates, and purchase and refinance mortgage applications are positives. Real estate loans are positive. Money supply is positive.

Among short leading indicators, the interest rate spread between corporates and treasuries remains quite negative, as is the US$. Positives included jobless claims, oil and gas prices, and gas usage. Commodities remain a big global negative. Temporary staffing is negative for the 21st week in a row, and more intensely so for the 3rd straight week.

Among coincident indicators, steel production, shipping, rail transport ex-intermodal, the TED spread and LIBOR all are negative. Tax withholding and consumer spending are weakly positive.

The only changes this week were that October's tax withholding got off to a poor start, and railroad got slightly weaker. Aside from that, the story remains the same as recently. Consumer-related indicators - mortgages, oil and gas, jobless claims, and consumer spending - all remain positive. But those portions of the US economy most exposed to global forces, including the US$, commodities, and industrial production and transportation, are all firmly negative. Employment on net is still a positive, though more weakly so. The US economy is clearly importing weakness, but not enough to overcome domestic positives.
New Deal democrat's conclusion is we have a picture of near-term weakness from abroad, but recovery later and no signs of a recession next year. Should investors be focusing on the bad news today, or the good news tomorrow?

Signs of global healing
Even outside the US, global equities remain upbeat in the face of this bad news. This chart of US, UK and European stocks show that only the Euro STOXX 50 has not rallied and regained its 50 day moving average.

What about China, which was the source much recent market angst? This chart of global stocks (top panel) and the stock indices of major Asian markets that are China`s biggest regional trading partners show that they have all regained their 50 dma.

Within China itself, Tom Orlik of Bloomberg highlighted the following signs of healing. Capital flight has slowed:

...and the spread between the offshore and onshore yuan is reversed itself, indicating that RMB selling pressure has abated:

Even Moody`s was upbeat about the Chinese property market, which has been the source of much financial stress:
Sales growth of China's real estate market will remain resilient for the rest of 2015, according to rating agency Moody's.

"We expect our rated developers to launch more projects for sale and take advantage of the current strong sales momentum," said Stephanie Lau, a Moody's assistant vice president and analyst.

Sales value of commercial housing in the first eight months went up 15.3 percent year on year to 4.8 trillion yuan (755 billion U.S. dollars). The growth rate was 1.9 percentage points higher than that in the first seven months, indicating nascent signs of recovery, according to the National Bureau of Statistics (NBS).

Moody's attributed the growth mainly to the supportive monetary and regulatory policies implemented since the second half of 2014.

Watching the USD for confirmation
Buying equities here is not without risk. As we enter Q3 Earnings Season, the market is likely to be subject to be near term volatility based on the earnings report of the day. Looking forward, however, one of the keys to the earnings outlook is the US Dollar, which is starting look like it`s breaking down on a technical basis. Should the USD weaken further, it would boost the earnings of US companies operating overseas.

Market leadership is already anticipating further USD weakness. The market leaders have been cyclical stocks, which would be beneficiaries of greenback weakness.

To a large extent, the near-term fate of the Dollar depends much on Fed policy. Should we get dovish noises from the Fed at their next FOMC meeting, then it will put downward pressure on the USD. If, on the other hand, the market perceives that the probability of a December rate hike is rising, then Dollar bulls will have the wind at their backs. Right now, the consensus is that the chances of a December liftoff are fading, which is negative for the USD and positive for the earnings outlook of large cap US multi-nationals.

The Zweig Breadth Thrust clincher
For my inner investor, the bullish clincher was the sudden appearance of the Zweig Breadth Thrust on Thursday (see Bingo! We have a buy signal!). Further analysis of the post-WW II performance of this signal has been unabashedly bullish indicating only minor downside risk and high upside potential (see The Zweig Breadth Thrust as a case study in quantitative analysis).

As a consequence, my inner investor has moved from a cautious "accumulate on weakness" to a "what`s the credit limit on my VISA card" buy (with staggered stops at the SPX 1900-1950 range).

Watching for pullback and consolidation
My inner trader, on the other hand, is not as enthusiastically bullish for the next couple of days. Though the ZBT is a longer term bullish signal, the market is very overbought today, as shown by the % of stocks above their 10 dma (via IndexIndicators).

Moreover, the NYSE McClellan Oscillator moved above 90 last week, which is a rare event and signaled near-term weakness in the past.

We saw the same effect at then 2009 bottom, when NYMO surged above 90. That event, incidentally, coincided with the ZBT buy signal. The market pulled back for two days and went on to rally and flash a series of "good" overbought readings indicating rising underlying buying power.

Indeed, with NAAIM sentiment still overly cautious and Rydex investors in a crowded short, the market could be setting up for a FOMO (Fear of Missing Out) rally later this month.

My inner trader is biding his time and he will be averaging into his long positions in the next few days, hopefully on weakness. While he is tactically cautious right now, he agrees with my inner investor that we are on the verge of a "what`s the credit limit on my VISA card" buy signal.

If you are interested in subscribing to content like this when Humble Student of the Markets becomes a subscription site, please register your email address at the poll here to receive an early bird discount. Further details on the transition, pricing, etc. can be found here.

The poll will be open until midnight, Sunday October 11, 2015 (Pacific Time).

Saturday, October 10, 2015

The Zweig Breadth Thrust as a case study in quantitative analysis

Academic financial quantitative analysis began in earnest in the 1970's as a response to the Efficient Market Hypothesis (EMH). EMH proponent believed that you can't beat the market with stock picking because everything about a stock is already known by the market.

As a test of EMH, researchers began to scour the CRSP tapes of stock prices and found "anomalies". They found that you could beat the market with well diversified portfolios of small cap stocks, stocks with low P/B, low P/E and so on. Thus quantitative analysis was born.

Today, we have gone well beyond the early days of anomalies literature. Now technical analysts have embraced quant techniques with gusto, Most of what technical quant research have been in the form of, "What did the market do when X happened?"

Among many others, leaders of this form of analysis include Ryan Detrick, his former employer Schaeffers Research, and Rob Hanna at Quantifiable Edges.

Yet, there are many pitfalls to quantitative technical analysis, as the fundamental quants have learned through many decades of painful experience.

The Zweig Breadth Thrust: A case study
Consider the following example as a case study: Last Thursday, the market flashed a Zweig Breadth Thrust buy signal, which I wrote about (see Bingo! We have a buy signal!) and a number of other technical analysts comment on as well.

What was curious was the differing interpretation of the implications of this signal. Tom McClellan classified the returns of past ZBT signals and came to a lukewarm conclusion:
Signal type Quantity
Great! 11
Meh… 4
Horrible 12

I am one of the biggest believers in the world about the idea of stock market breadth being one of the best tools we have to indicate financial market liquidity. But based on this evidence, I cannot offer much in the way of optimistic commentary about this current ZBT signal, especially since it has occurred at a point that appears to be the early stage of a new downtrend. Robust rallies within downtrends are great opportunities to get ready for the next phase of the downtrend. The problem is that they often disguise themselves that way, when in reality a new uptrend is beginning after a long bear market. This current moment does not seem like the end of a long bear market just yet.
By contrast, Quantifiable Edges had an unabashed bullish take on ZBT signals since 1970:

What's going on? How can two different analysts looking at the same data come up with such vastly different conclusions?

What's the theory behind the signal?
What I will try to do in these pages is to take apart the ZBT signal and identify the differences of interpretation.

First and foremost, what I learned as a quant is to make sure that there is an economic rationale behind a market factor or signal. Consider the following market signal uncovered by Bespoke, which has had an incredible success rate and has been performing quite well this year. But would you really put money on it? (Recall that American Pharoah won the Triple Crown this year).

First lesson: There are spurious correlations everywhere.

In the case of the ZBT, we are betting on breadth and momentum. There is a set of well established academic literature that momentum works, both fundamentally (estimate revision, earnings surprise) and price momentum.

There are a number of nuances to positive breadth and, more importantly, price momentum. Sure, price momentum in stock picking gets you better returns, but the downside volatility can rip your face off. Just ask recent holders of biotech stocks. I call that approach Momentum 1.0.

Here is Momentum 2.0. Researchers at Cass Business School found a better way of approaching price momentum (paper here). Stock level price momentum works much better when the market is going up. Avoid betting on price momentum when the market is falling. I found a similar effect when picking sectors and industries in my own work (link here).

In the case ZBTs, they are powerful bull moves in a very short time, which leaves the market highly overbought. With such an overbought market, should you continue to bet on positive breadth and price momentum?

That`s the next lesson: Really understand what you are betting on.

Don't torture the data until it talks
Quants fall into the trap of "torturing the data until it talks" all the time in their research. If X doesn't give you the results that you want, tweaked the parameters slightly one way, or second or third way until you do. Such an approach can lead to a convoluted set of rules like the Hindenburg Omen (see The hidden message of the Hindenburg Omen).

While researchers can take steps to minimize the backtesting problem of data torture, users of the research don't have that luxury. However, research users can try to understand what a model is really telling them by perturbing the rules to see how the results vary. In the case of the ZBT, we are further hampered by the low number of observations. There are very few instances of ZBTs, so it is equally important to dive into the data to really understand what it is telling us.

In that regard, several points come to mind in the differing viewpoints on ZBT return results. Tom McClellan's analysis, he cited four signals since 2008.

If you look closely, the 2011 signal is missing from Rob Hanna's table. Both the 2011 and 2013 signals are also missing from my own analysis, which is based on Stockcharts.com data. This is a classic case of perturbing the data. Rather than point fingers to say who is right or wrong, data and signal variations can be explained a number of different ways:
  • Differences in data feeds: I have noticed that Stockcharts.com TRIN readings can differ slightly from NYSE published TRIN. This may be caused by a difference in data feeds, e.g. NYSE vs. consolidated tape.
  • Differences in calculation techniques: One of the sources of possible model readings could come from the way the weighting technique used in the calculation of the Exponential Moving Average, or EMA.
What's even more puzzling is that Stockcharts.com has its own ZBT flag and its readings appear to be inconsistent with the observed readings derived from their own EMA calculations. Consider this chart of the most recent signal. Note how the ZBT flag (top panel) went negative as a setup signal, followed by the buy signal shortly afterwards. This can be confirmed by the EMA moving below 0.40 and rising above 0.615 in the bottom panel.

Now look at the 2011 "signal", or non-signal: There was no negative setup signal in the ZBT flag in the top panel, but it did flash a buy signal afterwards. However, the bottom panel indicates that EMA did not actually exceed 0.615, though it got close.

It`s the same story with the 2013 "signal", or non-signal. The ZBT flag (top panel) did not flash a negative value to signal a setup, though it did show a buy signal shortly after. The EMA (bottom panel) did not reach 0.615 when the ZBT flag showed the buy signal.

Another observation I found from Tom McClellan's analysis is that most of the poor performance of ZBT occurred in the 1930's and before the Second World War. Using McClellan's own classifications, ZBT would have had this record in the post-war period:
Signal type Quantity
Great!  9
Meh… 3
Horrible 1

Conclusion: ZBT = Buy
What can we conclude from examining the data? Perturbing the data can yield different ZBT signals, Even discounting the different versions of the ZBT buy signals, I think that everyone can conclude that we saw a bona fide ZBT buy signal last week.

The question then becomes one of what subsequent returns were and how much can we rely on ZBT to take action in our portfolios. My conclusion, which agrees with Rob Hanna, is that the stock market tends to rise after ZBT buy signals. At worse, stocks didn't go up, so a long position really doesn't hurt you very much. The poor ZBT returns from the 1930's represent a market environment from a long-ago era that may not be applicable today and therefore those results should be discounted.

Even McClellan's observation of the single bad return in the post-War period isn't that bad:

Bottom line: ZBT = Buy the market.

For my last word to quants everywhere: Learn to apply a critical eye and common sense sanity checks to your analysis. Read the Financial Modelers' Manifesto and always remember The Modelers' Hippocratic Oath:
~ I will remember that I didn't make the world, and it doesn't satisfy my equations.
~ Though I will use models boldly to estimate value, I will not be overly impressed by mathematics.
~ I will never sacrifice reality for elegance without explaining why I have done so.
~ Nor will I give the people who use my model false comfort about its accuracy. Instead, I will make explicit its assumptions and oversights.
~ I understand that my work may have enormous effects on society and the economy, many of them beyond my comprehension.

If you are interested in subscribing to content like this when Humble Student of the Markets becomes a subscription site, please register your email address at the poll here to receive an early bird discount. Further details on the transition, pricing, etc. can be found here. The poll will be open until midnight, Sunday October 11, 2015 (Pacific Time).

Friday, October 9, 2015

Humble Student lives

I want to thank everyone who participated in the poll about the future of Humble Student of the Markets (see Humble Student turns 8 in Nov, time to retire?). It is gratifying to see that my writing has gathered such a following over the years. Thank you to each and one of you.

About half of the people who answered the survey, which is admitted a biased sample, said that they would pay for my writing. Based on the feedback that I got, I will be turning this blog into a pay-site, which I will detail later in this post.

A personal journey
First, I want to recount the personal journey that I underwent to write this blog and how I got to the point today. The story began in early 2007 when I left Merrill Lynch in New York to return to Vancouver, where I grew up. This was the parting email that I wrote friends and colleagues, entitled "am REALLY IS leaving to spend more time with his family":
After close to 30 years of being involved with the marketsI have decided to take early retirement and move to Vancouver with my family.
I went on to quote Todd Harrison of Minyanville:
Others have expressed my sentiments better than me:
I'm not going to say that success is insignificant, we know that's not true, but I can tell you, from experience, that if you look for happiness in a bank account, you're missing the bigger trade.
I have no immediate plans other than taking my daughter to school and helping her with her homework. We plan on moving in the summer when school is out and will be in the NY area until then.
I could claim that I was prescient and saw financial storm clouds gathering in early 2007, but the truth was, I was just lucky in my timing. We moved back to Vancouver and I settled into a daily routine. The first few weeks and months were relaxing. I will always be grateful for the last eight years, when my routine changed to getting up in the morning to make my daughter breakfast and school lunch. Then I would watch the markets (stock market opens at 6:30 am on the west coast and closes at 1:00 pm) over the day. Few people who work on Wall Street can experience that kind of father-daughter bonding. No amount of money can replace being present during that key period of our children`s formative years. I have never regretted making the decision to leave Merrill and slow down the pace of my life.

Nevertheless, I still had a passion for the markets. I found that I had all these opinions and comments to get out, but no one to talk to. Thus Humble Student of the Markets was born, mainly as a vehicle for me to talk out loud.

It was also very difficult to shake a lifetime of habits. I was used to be part of a team writing an extensive weekend market commentary. The lead analyst (and friend) of the team was Mary Ann Bartels. While everyone on Wall Street is hyper-competitive, I felt a special responsibility as we were walking in the footsteps of the legendary Bob Farrell. Even though our focus was technical analysis, our analysis was technical analysis with a quantitative flavor. For example, I pioneered techniques to reverse engineer the real-time exposures of hedge funds.

Thus the weekly market commentary was born and evolved. It grew and acquired a degree of following that I never expected.

Days turned into months and months turned into years. The tipping point for me was early September, when we took a brief trip to celebrate our 20th wedding anniversary and to re-visit the site of our wedding (see A geek's view of love and marriage). I found that I was on a laptop in the middle of nowhere posting on my blog.

Why? Is this blog that I was writing, which began as a simple hobby, taking over my life and taking time away from my family? I made the decision back in 2007 to slow down and spend more time with my family and now I was back at it again?

I had to rationalize the decision to continue spend time blogging, both to myself and my family. It was a fork in the road. The expressions of support that I received allowed me to turn my writing and analysis into a business venture gave me the focus to both keep writing and justify the use of my time to my wife and daughter.

I am listening
Many readers took the time to either comment on the blog post or took the time to write me emails. I heard one key message over and over again. What you valued the most about my analysis is the eclectic left and right brained multi-disciplinary approach to market analysis.

One of the best compliments that I received from another investment professional came from Bill Luby, of VIX and More, who wrote the following comment when I blogged on the policy costs of Spain's recent stellar economic performance:

Yet another excellent piece of analysis. I could have attached this comment to many other posts, but this one in particular caught my attention.

I want to reiterate that I appreciate all the wide-ranging issues that appear on this blog and the best part about it is that, unlike many other writers, I never know what to expect from you next.

Keep 'em coming!
Many are experts in their own silos of market analysis. Bill Luby is well versed in the nuances of the option market. Others are far better chartists than I am. What you appreciate about my analysis is my mutli-faceted approach, which can be found in a couple examples of posts written in the last week:
Less valued, for example, were my technical analysis and tactical market calls.

Based on these comments, the focus of future posts will shift in the following way:
  • The weekly market comments will continue, as they seem to be the prime attraction.
  • More commentaries from my inner investor, such as on topics of investment policy, investment process and quantitative analysis. That is to say, the blog will have a greater strategic, rather than tactical focus.
  • Fewer commentaries from my inner trader and tactical market calls. When I do trading suggestions, I will be also focus on when they should closed, which is something I haven`t done in the past.
I did also receive a small number of comments to the effect that they would happily pay for trading recommendations, either on my service or on various online platforms. I decided against that course for several reasons. First and foremost, I agree with Charles Kirk when wrote that shadow trading doesn't help investors and traders learn and grow. I would therefore be doing a disservice to my readers by offering such a service:
If you engage in shadow trading, you must recognize and understand that there are some significant problems in doing so. For one thing, most of us can’t find someone who trades in a manner that also matches our own strategy, personality and goals. This results in inconsistent trading at best as we fight against or only selectively follow some recommended trades. And, even if we can find a good match, then we often just pick up the same bad habits and faulty process of those who we try to copy on top of our own weaknesses. You already have enough weaknesses right now that you certainly don’t need to add on top of those you already have.

Most importantly, the process of shadow trading itself can often retard if not serve as a major obstacle to what you really need to do to become truly successful in the markets. For many, it is ok to do this to some minor extent especially those just getting started and have no idea what they need to do to learn, but to really get where you need to go,you’ll need to venture out on your own.
Moreover, that kind of service is highly labor intensive and would take time away from  my core competence of a left and right brained approach to market analysis. As well, the going rate for similar trading advisory services seems to be about $100 per month, which is well beyond the budget of many readers. (For the tactically inclined, consider this list of people to follow - and they're free.)

Details of the new site
Based on the feedback that I received, the preliminary pricing schedule will be four access levels:
  1. Annual subscription: An annual subscription for $199 (all amounts are in USD).
  2. Monthly subscription: Monthly subscriptions for $20.
  3. Daily pass: Get a one-day pass for $5.
  4. Free: All content will be available to the public two weeks after posting. Anyone can subscribe to get email notifications of free content as they are released.
I believe that the pricing to be quite reasonable. Subscriptions to the WSJ or FT is over $300 a year. Investor's Business Daily is considerably higher. The basic level Value Line subscription is $199.

I am currently aiming for a December launch and will have further details as they develop. I will be migrating to a new website, but I will keep this site and its archives active for anyone who is interested in the old posts.

If you are interested in subscribing and haven't taken part in the poll, please do so as I will be offering an early bird discount coupon for anyone indicating an interest right now. I will leave the poll open until midnight, Sunday October 11, 2015 (Pacific Time).

Thank you for your support in keeping Humble Student of the Markets alive.

If you have any further comments, please email me at cam at hbhinvestments dot com.

Thursday, October 8, 2015

Bingo! We have a buy signal!

In my weekend post, I highlighted a possible setup for a Zweig Breadth Thrust buy signal (see Sell in May, ______ in October). The Zweig Breadth Thrust is an extremely rare buy signal that generally signals the start of a new bull market (see A possible, but rare bull market signal).

Steven Achelis at Metastock explained the indicator this way (emphasis added):
A "Breadth Thrust" occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A "Thrust" indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.

According to Dr. Zweig, there have only been fourteen Breadth Thrusts since 1945. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.
As of the close today (Thursday October 8, 2015), we have another ZBT buy signal.

Learning from 2009
The last ZBT that I can find occurred at the market bottom in March 2009.

While history doesn't always repeat itself exactly, I can see a number of similarities that may give usa road map to how the market is likely to behave in the next few months. Here is what happened in 2009:

We can observe that breadth was improving when the market bottomed in March 2009. A ZBT is a powerful exhibition of buying momentum and RSI(5) has not unexpectedly flashed an overbought reading. Right after the signal, the market weakened and pulled back for two days and continued upwards, showing a series of "good" overbought readings as it advanced.

Today, we can observe similar conditions. Breadth measures have improved since the "bottom" last week, though the low last week did not exactly test the August panic lows.

The market has also become overbought on RSI(5). These series of charts from IndexIndicators (with my own estimate shown as a dot) also shows how overbought the market is on a 1-3 day time horizon:

...and longer term indicators with a 1-2 week time horizon, based on a net 20 day highs-lows measure. I would remind you, however, that overbought conditions can stay overbought (see the reference to "good" overbought readings above) and the market got off the charts oversold in the way down in August.

We see similar readings on an intermediate term 1-2 week basis using the average 14-day RSI indicator as well:

A powerful "buy" signal
If history is any guide, the Zweig Breadth Thrust is signaling that stocks are about to embark on another upleg. While the market is very overbought and I have no idea of what might happen in the next few days given the volatility seen during Earnings Season, these conditions are highly suggestive that downside risk is extremely limited and stocks will be significantly higher by year-end.

Tuesday, October 6, 2015

Margin pressures = Subdued L-T equity returns

In a recent post (see Why this is not the start of a bear market), I raised the question of how a maturing economic cycle might pressure margins. My thesis was mainly based on analysis from Jim Paulsen of Wells Capital Management who believed that operating margins face a lose-lose situation in 2016 (emphasis added):
Earnings performance is well past its best for this recovery and investors need to consider whether earnings growth will prove sufficient to support current stock market valuations. The rapidly aging earnings cycle is perhaps best illustrated by an economy nearing full employment with corporate profit margins near record highs. Should global growth remain tepid and overall sales results modest, since profit margins are unlikely to rise much, earnings trends will also likely prove disappointing. Conversely, should global growth and corporate sales results accelerate, because the U.S. is nearing full employment, companies may soon face cost-push pressures and margin erosion which will likely off set improved sales results.

Essentially, it is difficult to see how earnings growth will be adequate during the rest of this mature recovery to support current price/earnings multiples. Is a relatively modest earnings growth against a backdrop of rising inflation and higher interest rates sufficient to support
The Atlanta Fed`s Labor Market Spider Chart shows the continued robustness of the US labor market as metrics have improved in the last six and twelve months, despite the disappointing Employment Report last Friday.

Indeed, the Atlanta Fed Wage Growth Tracker shows that wage pressures have been rising at a healthy clip, with prime age wage growth, which adjusts for the the demographic effects of aging Baby Boomers, up at 3.4% in August.

With the labor market still tight, you have to wonder to what extent rising wages are going to squeeze operating margins.

More long-term headwinds
So far, the case for margin compression has been an investment story for 2016. A Bloomberg article recently came across my desk indicating longer term global pressures on corporate margins.

That's because the demographic tailwind from a rising global labor supply is turning into a headwind:
Goodhart argues that since roughly 1970, the world has been in a demographic sweet spot characterized by a falling dependency ratio, or in plainer terms, a high share of working age people relative to the total population. At the same time, globalization provided multinational companies the ability to tap into this new pool of labor. This positive supply shock was a negative for established workers, forcing down the price of labor as capital flowed to these areas.

"Naturally, and quite properly, the West supplied much of the management; the East supplied the labor," wrote Goodhart.

Outsourcing labor to less costly locales kept wages at home from rising too fast. This, in turn, entailed that inflationary pressures were benign, as best depicted by the concept of the Great Moderation, or the idea that central bankers were better able to stabilize the business cycle.

As companies were encouraged to boost capacity with workers rather than capital equipment, this put downward pressure on the cost of the latter.

"Access to a new reserve army of cheap global labor through globalization has encouraged companies to invest in this workforce rather than in capital at home. A garment company, for example, could choose to build a highly automated, capital-intensive factory in the U.S. or build a low-tech, high-labor factory in the Far East," said Toby Nangle, who published a column on the connection between labor power and interest rates in May. "For years, companies have been choosing the latter option, which reduces the requirement for capital in the West, thereby reducing the price of that capital."

The positive operating margin effects of globalization are coming to an end as global population is aging.

Such a demographic development translates into wage and inflationary pressures (emphasis added):
Unlike many other economists, Goodhart does not believe the demographic backdrop of an aging population is inherently deflationary. The pool of labor around the globe that kept wages suppressed domestically on the island nation has nearly run dry; Japan, in other words, was a victim of circumstance. More generally, in order to meet the obligations of the state, the shrinking pool of workers will be forced to pay higher taxes at the same time that they'll be in a position to haggle for better wages.

"This is a recipe for a recrudescence of inflationary pressures," wrote Goodhart. "The present concerns about deflation are fleeting and temporary; enjoy it while it lasts."
Please note that the points raised in the article refer to long term forces affecting corporate profitability that stretch out decades into the future.

The McKinsey view
A Harvard Business Review article, which was adapted from work from the McKinsey Global Institute, told a similar story of a negative reversal in the effects on corporate operating margins from globalization:
[T]he favorable cost drivers that Western multinationals were able to exploit have largely run their course. Interest rates are now so low in many countries that borrowing costs simply can't fall much further and might even be starting to rise. The big tax-rate decline of the past three decades also seems to have ended. Indeed, tax inversion schemes, offshoring, and the use of transfer pricing are drawing political flak in several deficit-ridden countries.

As for labor costs, wages in China and other emerging markets are rising.

Rather than continuing to reap gains from labor arbitrage, companies will fight to hire skilled people for management and technical positions. New jobs require disproportionately greater skills, especially in science, engineering, and math. In China, once the main source of new workers, the demographic pressures of an aging population and falling birth rates could further increase the country's labor costs. And most other emerging markets do not yet have the high-quality rural education systems required to build a disciplined workforce.
If the world is becoming global, then global wage pressures are likely to rise:
The result is an intensifying global war for talent. In a recent McKinsey survey of 1,500 global executives, fewer than one-third said that their companies' leaders have significant experience working abroad-but two-thirds said that kind of experience will be vital for top managers in five years.
Companies are seeing other challenges. The business models of many companies have changed. New entrants are not necessarily focused on profitability, but market share:
The growth of these players has been supported by their ownership models.

Major U.S. and European companies' broad public ownership, board structure, and stock exchange listings typically enforce a sharp focus on near-term profitability and cost control. But many emerging-market firms are state- or family-owned and so have different operating philosophies and tactics. Many of the new competitors take a longer-term view, focusing on top-line growth and investment rather than quarterly earnings. Growth can be more important than maximizing returns on invested capital: Chinese firms, for example, have grown at a blistering pace-four to five times as fast as Western firms over the past decade, particularly in capital-intensive industries such as steel and chemicals.
It`s not just the emerging market players, many of which are state-owned, that go into a market and drive down prices by focusing on market share, but western companies in the technology space, such as Amazon.com and numerous tech start-ups intent on grabbing as much virtual real estate as they can:
Tech firms share some intriguing similarities with the new emerging-market giants. Both can be brutal competitors, and both often have tightly controlled ownership structures that give them the flexibility to play the long game. Many tech firms are privately held by founders or venture capital investors who prioritize market share and scale rather than profit. Amazon, Twitter, Spotify, Pinterest, and Yelp are on the growing list of companies that focus on increasing revenue or their user networks even while losing money over extended periods. That mindset-and the control of founders-sometimes persists even after the companies go public. Among NASDAQ-listed software and internet companies, founder-controlled firms have 60% faster revenue growth and 35% to 40% lower profit margins and returns on invested capital than do publicly held firms.
The study concluded that, much like the internet boom of the late 1990s, the benefits may accrue to the end user rather than the corporate provider of the new services:
But whereas the outlook for revenue growth is good, the profits picture looks less promising. Consumers could be the big winners, as could some workers-especially those in emerging markets and those with digital and engineering skills, which are in short supply. As we've seen, many companies' profit margins are being squeezed. Hospitality, transport, and health care have all experienced price declines in recent years because of the emergence of new platforms and tech-driven competitors. Similar effects could soon play out on a larger scale and expand to sectors such as insurance and utilities. Nobody is immune, but companies particularly at risk include those that rely on large physical investments to provide services or that act as intermediaries in a services value chain. Large emerging-market firms in less traded capital-intensive industries such as extraction, telecom, and transportation have been relatively protected so far, but that is changing, in part because of greater deregulation. Profits are not only shrinking but also becoming more uncertain. Since 2000 the return on invested capital has been about 60% more volatile than it was from 1965 to 1980.
These factors all combine to squeeze operating margins.

For investors looking out for 10 years or more, such a scenario translates into rising inflationary pressures (bonds will be poor performers) and lower corporate margins (diminished equity returns).

Don't abandon stocks!
While the apparent long-term outlook appears dire for both equity and fixed income, all is not lost. What demographics takes away, it can give back as well. In a past post, I had highlighted rising demographically driven for equity investments (see A new golden age of demographic growth).

A San Francisco Fed study showed that P/E ratios are influenced by age demographics. It projects a bottom in P/E ratios around the end of this decade and a rise afterwards.

History doesn't repeat, but it does rhyme. When I put it all together, the combination of rising margin pressures and demographic changes suggest that returns for equity investors will reasonable and not disastrous in the 2020s. On the other hand, don't expect a repeat the secular bull that we experienced in the 1980s and 1990s.

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Sunday, October 4, 2015

Sold in May, ______ in October

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bullish

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

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.

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

Karmic re-balancing?
I have been saying for the past few weeks that while the technical picture for the stock market looked shaky, the macro and fundamental outlooks appeared constructive and that's why I remained constructive on stock prices (see Why this is not the start of a bear market). Now we are seeing a reversal of those trends, perhaps in a Cosmic Karmic re-balancing sort of way. The technical indicators are improving, but we are seeing signs of macro and fundamental deterioration.

While I am still believe that equity prices are likely to be higher by year-end, this change may mean that there may be some more near-term weakness ahead. Weakness in macro and fundamental factors can be triggers for slow, but big money, institutional investors to de-risk.

Let`s go to the numbers.

Macro disappointments
Last week saw a couple of disappointments in big headline macro releases for the US economy. It wasn't that the big miss in the Employment Report that was disturbing, but the ISM Manufacturing number came in below expectations as well.

The Citigroup Economic Surprise Index, which measures whether high frequency economic releases are beating or missing expectations, tell the story well. US macro have begun to deteriorate relative to expectations. This may presage a period of near-term softness in the US economy.

Indeed, the Atlanta Fed "nowcast" of GDP growth has been tanking as well. GDPNow fell to 0.9% last week, which is well below the consensus forecast.

Mid-cycle pause?
Last week, I highlighted a downtick in forward EPS estimates, which I viewed as a cautionary sign but could have been just a blip in the data. The latest update from John Butters of Factset shows that forward EPS fell again for another week (annotations in red are mine).

The combination of weakening macro and a deterioration in Street EPS expectations can be red flags for institutional investors, the big but slow money in the market. Ed Yardeni found that forward EPS to be correlated with coincidental economic indicators. This may signal a period of greater cautiousness among the big money players as we await developments from Earnings Season.

I remain optimistic on the US economy. The excellent summary provided by New Deal democrat of high frequency economic releases puts the current macro and fundamentals into context, as he dissects macro releases into long leading, short leading and coincidental indicators. Long indicators remain relatively strong, but short leading indicators and coincidental indicators are mixed:
Among long leading indicators, interest rates for corporate bonds and treasuries remained neutral. Mortgage rates, and purchase and refinance mortgage applications are positives. Real estate loans are positive. Money supply is positive.

Among short leading indicators, the interest rate spread between corporates and treasuries remains quite negative, as is the US$. Positives included jobless claims, oil and gas prices, and gas usage. Commodities remain a big global negative. Temporary staffing is negative for the 20th week in a row, and more intensely so for the 2nd straight week.

Among coincident indicators, steel production, shipping, rail transport ex-intermodal, the TED spread and LIBOR all are negative. Tax withholding and consumer spending are now uniformly positive if weakly so.
Slicing and dicing differently, he concluded that the global economy is weak while the American consumer remains strong, which is consistent with his call a few months ago for a weak industrial recession:
We continue to have a stark bifurcation. Consumer-related indicators - mortgages, oil and gas, jobless claims, and consumer spending - all remain positive. But those portions of the US economy most exposed to global forces, including the US$, commodities, and industrial production and transportation, are all firmly negative. Employment on net is still a positive, though more weakly so. Housing and cars, those two most leading sectors of the US economy remain positive (with a post-recession record for motor vehicle sales last month), and thus so do I.
In other words, this is shaping up to be a mid-cycle pause in growth. On the other hand, the current patch of softness in the data may be reflective of that bifurcation.

Gavyn Davies analyzed the slowdown in global industrial activity and found that there are signs for optimism (emphasis added):
This month we introduce a new feature that examines the growth of the global industrial sector, with the latest month (September in this case) being estimated from our “nowcast” models. The full set of graphs for all the major EM and DM economies is attached here for reference.

Although the industrial sector is typically around 20-30 per cent of GDP, it is more volatile than the rest of the economy, and it therefore accounts for a large part of the quarterly swings in global activity. Furthermore, the marked weakness of manufacturing in the middle of 2015 raised serious concerns about global recession risks. It therefore offers a good cross-check for our nowcast estimates for overall economic activity.

The most interesting feature of these industrial production figures this month is that the growth rate has now bounced to a monthly rate of 0.2 per cent, up from zero in 2015 Q2. While many commentators have been worrying about industrial growth in China, the main contributor to recent fluctuations in global industrial growth has been the US, where the collapse in the energy sector, and inventory shedding in the manufacturing sector, have had a marked effect. As these negative impacts on growth have faded, the global industrial sector has bounced back a little, which is reassuring.

In other words, there is no need to panic. Neither the world nor the US is rolling over into recession. My inner investor remains constructive on the longer term fundamental outlook and he continues to buy stocks on weakness.

An improving technical outlook
The biggest surprise to me was how the stock market reacted to the big miss in the Employment Report. The numbers looked terrible on all dimensions, from the headline number to participation rate. The fact that stocks rallied in the face of bad news is an indication of a washed-out market.

The technical signs were there. The SPX fell last week and appeared to be nearing a test of the panic lows of August, though those support levels were never reached. We saw positive divergence in RSI(5) and RSI(14) at the time of the near-test of the lows - which is a bullish sign.

The broader Wiltshire 5000 Index did test the August lows last week and the same positive RSI divergences were observed.

I would also mention that sentiment models remain at a crowded short, which is contrarian bullish. The latest reading comes from NAAIM (via Ryan Detrick):

At the same time, Barron's reports that insiders are still buying stocks hand over fist:

Another tantalizing clue came in the form of a setup for a Zweig Breadth Thrust. I highlighted the possibility of a ZBT in late August but that setup failed (see A rare but possible bull market signal), I would note that while a ZBT would confirm a bullish reversal, stock prices can rise without one, as they did during the 2011 bottom.

Will the Breadth Thrust succeed and signal a new upleg? That's the challenge the bulls face next week and they only have a mere ten days to complete the task. This chart from IndexIndicators show that short-term breadth is nearing overbought levels on a 1-3 day time frame. Will we see a pause and pullback as institutions get cautious, or will momentum carry the day and signal a ZBT?

My inner trader is sitting this one out for now. He got faked out/stopped out of his long position on Friday on the Employment Report sell-off early in the day. He has gone to cash and he is waiting a few days to see how the market resolves this short-term tension between the bulls and bears.

My inner investor is asking, "Regardless of what happens next week, if you sold in May and went away, what should you be doing in October?"

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