Monday, June 25, 2012

More constructive on stocks

Regular readers know that I've been fairly bearish in the last few weeks, but this may be the time to start getting more constructive on stocks. Let me get this straight, I am not turning bullish, but neutral on the market's near-term outlook for the following reasons:
  • Market psychology
  • Signs of turnaround in China and Europe
  • My institutional fund flows model has turned positive

A turnaround in psychology
First of all, you can often get an idea of the tone of a market by seeing how it reacts to events. Last weekend, when the pro-European factions won the Greek election, the market rallied on Monday but faded, which was bearish. On the other hand, when the FOMC disappointed markets on Wednesday with just an extension of Twist, stocks fell initially, rallied and deflated again on an intraday basis to end the day with a small loss. That was bullish. This kind of market action tells me that neither the bulls nor the bears appear to be in control.

The bearish rush to safety appears to be getting a little overdone. In discussions with other investors, it was pointed out to me that the trailing P/E on Technology (13x) is lower than the trailing P/E on defensive sectors...

like Consumer Staples (16x)...

or Utilities (15x).

Despite Jeremy Grantham's comment that stocks aren't all that exciting, there may be upside room for equities based on a sector rotation trade.

Turnaround in China, Europe
I've been watching China closely because that's where I think the real negative surprise could be coming from (see Watch China, not Europe and Ominous signs from China). While Chinese official statistics are opaque and may be manipulated, there are hopeful signs from secondary indicators of a stabilization and turnaround. The Shanghai Composite resolved a triangle wedge formation negatively with a bearish downside breakout at the end of May and it is now testing support, indicating signs of stabilization:

The AUDCAD cross rate is signaling a turnaround. The AUDCAD exchange rate is important because both the Australian and Canadian economies are similarly commodity sensitive, but Australia is more sensitive to the Chinese economy while Canada is more exposed to the US economy.

Commodity prices, as represented by the CRB Index, is telling a similar story of stabilization. They aren't in a downtrend anymore and appear to be stabilizing at these levels.

In a sign of a turnaround in Europe, even the Spanish stock market is turning up against the German one.

Funds flow turning positive
Several months ago, I constructed a funds flow model based on this writeup on "measuring the skew of a multi-asset spread ratio of large cap equity returns vs liquid bond returns". In my own research, I describe a short-term trading model, whose time horizon is 3-4 days and not useful for anything but short-term trading, and a slow turnover long-term model that appears to measure long term institutional fund flows. I spent most of my career dealing with institutional investors like pension funds. Asset shift decisions tend to be made by committee and once they move, they move glacially but the shift is highly persistent.

That model was in neutral and trending positive since early April and finally flash a buy signal last week. If institutions are shifting into equities, this will at the very least provide a floor on prices.

The next 5% is up, but don't count on the next 10-15%
Putting it all together, this tells me that the market is poised for a turnaround. With expectations so low for the eurozone, we just need some positive news out of the European summit at the end of the week to spark a rally. As Jeff Miller over at A Dash of Insight points out:
When it is least expected, something might go right.
All this suggests to me that the next 5% move in stocks is likely to be up because the bearish psychology is getting a little overdone, but the current backdrop does not suggest that this is an intermediate term bottom. Don't count on the next 10-15% move being to the upside.

Significant risks remain. The American economy is showing signs of slowing (as an example, see Consumer Spending Probably Stalled in May). We are approaching Earnings Season and Street estimates continue to fall. Greece isn't out of the woods. Neither is China. Numerous macro events could jump up and bite investors.

The picture I am seeing is a choppy sideways market.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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