Thursday, June 28, 2012

Read the market reaction, not the Summit statement

As we approach yet another crucial European summit, the bargaining is becoming more intense. While the Merkel quote of "I don't see total debt liability as long as I live" got the headlines, there is no doubt a lot of jockeying behind the scenes. Various proposals are being floated, including a package of "banking union, a fiscal union and further steps towards political union", and intense pressure is being put on the Germans to yield.

The forecasts are all over the map. While the consensus is that Germany will have to eventually bend on the issue of eurobonds, though not necessarily at this summit, others like Ray Dalio (via Zero Hedge) say, "Don't count on it!"

While I am not expecting the Germans to change the lines of their national anthem to Europa, Europa ├╝ber alles, nor do I expect an admission of failure this summit. Most likely, we will see the typical European fudge, or an announcement of "we have a secret plan to have a plan."

While I am mildly interested in the summit statement, I am much more interested in the market reaction. If I am right and we get a "we have a plan to have a plan" kind of announcement, will the market rally or sell off? Gauging the market to news gives me much more important clues as to whether the bulls or bears are in control of this 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.

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.

Wednesday, June 20, 2012

Portrait of the artist as a young slave

Luigi Zingales recently wrote a New York Times op-ed entitled The College Graduate as Collateral in which he suggests an innovative way to finance the exorbitant costs of higher education:
The best way to fix this inefficiency is to address the root of the problem: most bright students do not have any collateral and cannot easily pledge their future income. Yet the venture-capital industry has shown that the private sector can do a good job at financing new ventures with no collateral. So why can’t they finance bright students?

Investors could finance students’ education with equity rather than debt. In exchange for their capital, the investors would receive a fraction of a student’s future income — or, even better, a fraction of the increase in her income that derives from college attendance. (This increase can be easily calculated as the difference between the actual income and the average income of high school graduates in the same area.)
This proposal is in the finest tradition of financial innovation on Wall Street, where product specialists try to securitize anything that's not nailed down in order to make a buck.


Slavery by another name
Think for a minute what Zingales is proposing. In times past, people who were faced with crushing debt sold themselves, or their children, into slavery. How is this any different? The Zingales proposal asks a student to sell their future earnings, or equity if you will, in exchange for cash to finance their education. OK, it's not full slavery in that someone owns all of you, but it is a partial form of slavery. Zingales qualfiied his proposal to state that it is not "indentured servitude":
This is not a modern form of indentured servitude, but a voluntary form of taxation, one that would make only the beneficiaries of a college education — not all taxpayers — pay for the costs of it.

What would you call the transaction where someone, rather than face a mountain of debt, sells all or part of himself to a holder of capital for a lump sum of cash?
 
 
Taking personal responsibility
There are other ways of addressing the problem of student debt. When you have seniors retiring with student loans, there is no denying that there is an enormous problem with student loans and the cost of higher education.  A better solution is to get the student to take some personal responsibility and make an adult decision about the value proposition in his own higher education.
 
True enough, higher education still pays, but at what cost? The Atlantic highlighted these issues in an article that showed the value of higher education. It's charts like the one below that prompt parents to push their kids into university at all costs.  
 
 
The dirty little secret is that not all higher education is the same. The Atlantic article pointed to a Georgetown study that showed the earnings and unemployment rates of different majors. The disparities are striking.  
 
 
 
 
 
So here's my message to students. Take personal responsibility for your own decisions about your life. If you want to specialize in Architecture, Journalism or the Liberal Arts because that's your passion, go for it! On the other hand, you need to manage your own expectations. If you graduate with a degree in Victorian literature or foreign affairs, don't complan when you get your dream job of working for an NGO that pays you 30K a years - because you made your own choice to go into the field of your own volition. There are tradeoffs in life and you made one.
 
On the other hand, proposals like Zingales' to equitize people's earnings amount to slavery. It is so wrong at so many levels that I don't know where to even begin.
 
 
 
 
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.

Tuesday, June 19, 2012

How big a bazooka does the Fed need?



Ben smiled and unveiled it with a flourish, "Let me show you my bazooka."

"Oh!"  _______________  (fill in the blanks)
  1. Her eyes widened, "It's enormous!"
  2. She wrinkled her nose, "Are you sure it's going to do the job?"
  3. She stifled a smile, "Well, it's the thought that counts."
Notwithstanding my bad writing (in the style of other parodies), questions remains ahead of the FOMC announcement. What will the Fed do? Will it be enough?

Coincidentally, Bank of Canada researchers published a paper entitled Unconventional Monetary Policy: The International Experience with Central Bank Asset Purchases that assessed the effectiveness of "unconventional monetary policy measures", or quantitative easing. Here are their conclusions:
  • Evidence suggests that the implementation of unconventional monetary policy during the recent financial crisis, via credit easing and asset purchases, succeeded in reducing credit spreads and yields, thereby providing further easing of financial and monetary conditions and fostering aggregate demand.
  • These policy measures are most effective when targeted to specific market failures, sufficiently large relative to the targeted market, and clearly communicated.
  • The evidence must be treated with appropriate caution, since the evaluation of the effectiveness of unconventional monetary policy is subject to problems of identification.
  • The ongoing fiscal retrenchment will affect the outlook and therefore the timing of the withdrawal of monetary stimulus.
  • Central banks should account for the potential negative externalities of unconventional monetary policies, which are often neglected in the analysis of their effectivness.
Dave Altig and John Robertson of the Atlanta Fed's macroblog referenced the paper in a post and highlighted what they considered the salient points [emphasis theirs, not mine]:
The effectiveness of unconventional monetary policy measures depends on several factors. Measures appear to have been effective (i) when targeted to address a specific market failure, focusing on market segments that were important to the overall economy; (ii) when they were large in terms of total stock purchased relative to the size of the target market; and (iii) when enhanced by clear communication regarding the objectives of the facility
In other words, you need to adjust the size of the bazooka to the size of the market. If the Fed were to choose to start buying MBS securities, the size of the intervention needs to sufficiently large to push MBS prices up (and yields down). On the other hand, an extension of Operation Twist will likely have limited effect, other than on market psychology, because it only has a limited amount of short-dated securities it can sell in order to extend the maturity of its holdings. Altig and Roberson went on to say:
[T]he accumulated evidence suggests to us that we should be really thinking in terms of something like the stock or accumulated total of Fed purchases relative to the size of publicly held Treasury debt, as the passage from Kozicki and coauthors indicates. That calculation produces a Federal Reserve share of about 16 percent of publicly held Treasury securities for fiscal year 2011, which is up sharply from the 8–10 percent levels seen during the 2008–10 period but very similar to the share of Treasury securities held by the Federal Reserve during the years 2000 through 2007.
They went on to say that the Fed should also consider not how much Treasury securities the Fed holds, but the composition of the supply:
In the shorter term, changes in the magnitude of federal government may not have too large of an independent impact on the stance of monetary policy, although it is noteworthy that current projections indicate the Treasury will sell about $1,450 billion of debt to the public in fiscal year 2012, and $1,060 billion in 2013. In addition there is this, from today's edition of The Wall Street Journal's Real Time Economics:

"The U.S. Treasury intends to continue to gradually extend the average maturity of the securities it issues—a tactic that locks in borrowing costs but potentially dilutes the impact of a Federal Reserve policy intended to boost the economy."
In such an environment, it is probably good to remember that standing pat with central bank asset purchases does not necessarily mean standing still with monetary policy.
Monday's market reaction to the Greek election, where it more or less got what it wanted, is telling. The consensus seems to be for more Twist, but not much else (see one example here). Just keep this in mind as you assess the Fed's announcement Wednesday.





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.

Sunday, June 17, 2012

Don't lose sight of the medium term

Rather than focus on Greece this weekend, I thought that I would write about the medium term path for equities and the global economy. I came upon this BIS paper entitled Characterising the financial cycle: don't lose sight of the medium term! The BIS researchers break economic cycles into two components, a shorter business cycle and a longer financial cycle. Here is the abstract:
We characterise empirically the financial cycle using two approaches: analysis of turning points and frequency-based filters. We identify the financial cycle with the medium-term component in the joint fluctuations of credit and property prices; equity prices do not fit this picture well. We show that financial cycle peaks are very closely associated with financial crises and that the length and amplitude of the financial cycle have increased markedly since the mid-1980s. We argue that this reflects, in particular, financial liberalisation and changes in monetary policy frameworks. So defined, the financial cycle is much longer than the traditional business cycle. Business cycle recessions are much deeper when they coincide with the contraction phase of the financial cycle. We also draw attention to the "unfinished recession" phenomenon: policy responses that fail to take into account the length of the financial cycle may help contain recessions in the short run but at the expense of larger recessions down the road.
The financial cycle is turning down. Ray Dalio of Bridgewater explained the financial cycle using the Monopoly® game as an analogy in this note

If you understand the game of Monopoly®, you can pretty well understand credit and economic cycles. Early in the game of Monopoly®, people have a lot of cash and few hotels, and it pays to convert cash into hotels. Those who have more hotels make more money. Seeing this, people tend to convert as much cash as possible into property in order to profit from making other players give them cash. So as the game progresses, more hotels are acquired, which creates more need for cash (to pay the bills of landing on someone else’s property with lots of hotels on it) at the same time as many folks have run down their cash to buy hotels. When they are caught needing cash, they are forced to sell their hotels at discounted prices. So early in the game, “property is king” and later in the game, “cash is king.” Those who are best at playing the game understand how to hold the right mix of property and cash, as this right mix changes.
Now imagine Monopoly® with financial leverage and you understand what is happening with the financial cycle:
Now, let’s imagine how this Monopoly® game would work if we changed the role of the bank so that it could make loans and take deposits. Players would then be able to borrow money to buy hotels and, rather than holding their cash idly, they would deposit it at the bank to earn interest, which would provide the bank with more money to lend. Let’s also imagine that players in this game could buy and sell properties from each other giving each other credit (i.e., promises to give money and at a later date). If Monopoly® were played this way, it would provide an almost perfect model for the way our economy operates. There would be more spending on hotels (that would be financed with promises to deliver money at a later date). The amount owed would quickly grow to multiples of the amount of money in existence, hotel prices would be higher, and the cash shortage for the debtors who hold hotels would become greater down the road. So, the cycles would become more pronounced. The bank and those who saved by depositing their money in it would also get into trouble when the inability to come up with needed cash.
What happened with Lehman in 2008 and in Greece, Spain and the other eurozone peripheral countries today are symptoms of the downturn in the financial cycle.


The business cycle turns down
There is no doubt that the financial cycle has been turning down since 2008. What about the business cycle? It's turning down as well. Regular readers know that I use commodity prices as the "canaries in the coalmine" of global growth and inflationary expectations. Consider this chart of the negative divergence between US equities and commodities prices.


The market is also telling a similar story of an economic slowdown. Here is the relative performance of the Morgan Stanley Cyclicals Index against the market. It's in a relative downtrend, indicating cyclical weakness.



Globally, air cargo traffic represents an important real-time indicator of the strength of the global economy (h/t Macronomics). This chart from Nomura shows the correlation of air cargo growth with global industrial production growth. Air cargo growth is headed south as well.


I have written about the Axis of Growth, namely the US, Europe and China and at least two of the three are slowing. Hale Stewart at The Bonddad Blog went around the world and explained why the global economy is slowing:

[T]here are no areas of the world economy that are demonstrating a pure growth environment; everybody is dealing with a fairly serious negative environment. Let's break the world down into geographic blocks:

1.) China is located at the center of Asian economic activity. Recently, they lowered their lending rate largely as result of weakening internal numbers. While these numbers still appear strong to a western observer (growth just over 8%), remember that China is trying to help over a billion people become middle class. To accomplish that goal, the economy needs to have a strong growth rate. Also consider that the news out of India has become darker over the last few months as well. A recent set of articles in the Economist highlighted the issues: a political system that is more or less unable to lead, thereby preventing the action on structural roadblocks to growth. The fact that two of the Asian tigers are slowing is rippling into other regions of the world, which leads to point number 2.

2.) The countries that supply the raw materials to these regions are now slowing. Australia recently lowered its interest rate by 25 BP in response to the slowing in Asia. A contributing factor to Brazil's slowdown is the decrease in exports to China. Other Asian economies that have a trade relationship with China are all experiencing a degree of slowdown, but not recession. Some of these countries (such as Brazil) were also experiencing strong price increases. The price increases are are starting to slow, but they are still above comfort levels.

3.) Russia has dropped off the news map of late. However, it emerged from the recession in far worse shape; it's annual growth rate for the duration of the recovery has been between 3.8% and 5%, which is a full 3% below its growth rate preceding the recession. This slower rate of growth makes Russia a far less impressive member of the BRIC list.

4.) The entire European continent is caught up in the debt story -- underneath which we're seeing some terrible economic numbers emerge. PMIs are now in recession territory, unemployment is increasing and interest rates for less than credit-worthy borrowers are rising. And, the overall credit situation is casting a pall over the continent, freezing expansion plans.

5.) The US economy has experienced 2-3 months of declining numbers. While we're not in recession territory yet, we are clearly in a slowdown with growth probably hovering around the 0% mark.
In addition, I have documented warning signs of rising tail risk in China (see Focus on China, Not Europe, Ominous signs from China and The ultimate contrarian sell signal for China?)In last week's analysis, John Hussman said that the US is in recession now and blamed it on the financial cycle:
By our analysis, the U.S. economy is presently entering a recession. Not next year; not later this year; but now. We expect this to become increasingly evident in the coming months, but through a constant process of denial in which every deterioration is dismissed as transitory, and every positive outlier is celebrated as a resumption of growth. To a large extent, this downturn is a "boomerang" from the credit crisis we experienced several years ago.

 
Regardless of the outcome of the Greek election, my inner investor tells me that the fundamentals of the economic outlook is negative. When the financial cycle and the business cycle both turning down in unison, that's bad news.
 
As for how much of the negative news has been discounted by the markets, I don't know. What can change the trajectory of the outlook in the next few months is intervention, either by the central banks (which was rumored late last week), an announcement of more QE by the FOMC, or the news of some deal cooked up by the European governments, IMF, etc.
 
My inner trader tells me that fundamentals don't matter and the markets will react to short term headline news.
 
 
 
 
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.

Saturday, June 16, 2012

The ultimate contrarian sell signal for China?

It's a sign of the ultimate height of hubris and I have been watching for this for some time, but the Skyscraper Index is flashing a sell signal on China. Here is an explanation of the concept from Wikipedia:
The Skyscraper Index is a concept put forward in January 1999 by Andrew Lawrence, research director at Dresdner Kleinwort Wasserstein, which showed that the world's tallest buildings have risen on the eve of economic downturns. Business cycles and skyscraper construction correlate in such a way that investment in skyscrapers peaks when cyclical growth is exhausted and the economy is ready for recession. Mark Thornton's Skyscraper Index Model successfully sent a signal of the Late-2000s financial crisis at the beginning of August 2007.
Now comes the news that China plans to build the world's tallest building in just three months! It's a contrarian signal that indicates that an economy is topping out.


The Skyscraper Index is admittedly an imperfect indicator, largely because there are so few data points and the results could be attributable to data fitting. Nevertheless, the ideas are highly intuitive, as Wikipedia explains:
The intuitively simple concept, publicized by business press in 1999, has been cross-checked within the framework of the Austrian Business Cycle Theory, itself borrowing on Richard Cantillon's eighteenth-century theories. Mark Thornton (2005) listed three Cantillon effects that make skyscraper index valid. First, a decline in interest rates at the onset of a boom drives land prices. Second, a decline in interest rates allows increase in average size of a firm, creating demand for larger office spaces. Third, low interest rates provide investment to construction technologies that enable developers to break earlier records. All three factors peak at the end of growth period
Interestingly, the market peak and financial crisis that follow seems to occur sometime between the planning of the building and its completion. Consider, for example, the Empire State Building, which began in January 1930 - after the stock market crash. The Petronas Towers in Malaysia was completed in 1998, a year after the onset of the Asian Crisis. Here is more about the Skyscraper Index from Barclays (via The Big Picture).

To be sure, a peak indicated by the Skyscraper Index doesn't mean that the lights have permanently gone out on the country which constructed the world's tallest building. The United States went on to continue its growth and assume the mantle of global leadership after the Great Depression. The Malaysian economy of today, or the economy of Asia, can't exactly be characterized today as a black hole either.

For today's investor, I remain of the belief that, in terms of the effect on markets, China is at center stage and Europe is the sideshow (see Focus on China, not Europe). This latest signal from the Skyscraper Index confirms that view. If Europe were to stabilize itself but China lands hard, what happens in Greece or Spain won't matter very much.



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.

Friday, June 15, 2012

The G20 endorse SYRIZA

The story came across the tape in the last hour of trading yesterday. Central banks ready to combat Greek market storm:
Central banks from major economies stand ready to stabilize financial markets and prevent a credit squeeze should the outcome of Greek elections on Sunday cause tumultuous trading, G20 officials told Reuters.
I nearly fell off my chair! Did the G20 really say that ahead of the Greek elections this weekend? Apparently, the answer is yes.
"The central banks are preparing for coordinated action to provide liquidity," said a senior G20 aide familiar with discussions among international financial diplomats. His statement was confirmed by several other G20 officials.
In effect, the G20 just told the Greek population, "Don't worry about how you vote this weekend, the world won't fall apart whatever you do. Everything will be fine."
 
Isn't that just encouragement for Greeks to vote for SYRIZA? The G20 just told them that any adverse consequences of a SYRIZA government won't be that serious and the fallout will be contained.
 
 
Not enough capitulation
Here's is what I worry about. While most sentiment models are indicating excessive bearishness, which is contrarian bullish, I am concerned that there hasn't been enough capitulation for the market to make an intermediate bottom.
 
I have heard anecdotally that investment advisors are getting calls from their individual clients asking if it's time to buy. That's generally not a sign that sentiment has been washed out and not the sign of a capitulation bottom.
 
In addition, the latest BoAML fund manager survey was encouraging and discouraging from a sentiment viewpoint. On one hand, fear is definitely rising, which is bullish.
Fears of a global economic slowdown have come sharply back into focus, and expectations of decisive action by policy makers have grown, according to the BofA Merrill Lynch Survey of Fund Managers for June.
 
A net 11 percent of the global panel believes that the global economy will deteriorate in the coming 12 months – the weakest reading since December 2011. Last month, a net 15 percent believed the economy would strengthen and the negative swing of 26 percentage points is the biggest since July-August 2011 as the sovereign crisis built. The outlook for corporate profits has suffered a similarly negative swing. A net 19 percent of the panel believes that corporate profits will fall in the coming 12 months. Last month, a net 1 percent predicted improving corporate profits.
 
Investors have adopted aggressively “risk off” positions. Average cash balances are at their highest level since the depth of the credit crisis in January 2009 at 5.3 percent of portfolios, up from 4.7 percent in May. The Risk & Liquidity Composite Indicator fell to 30 points, versus an average of 40. Asset allocators have moved to a net underweight position in global equities and increased bond allocations.
On the other hand, investors haven't capitulated yet, which is bearish [emphasis added]:
Investors have taken extreme ‘risk off’ positions and equities are oversold, but we have yet to see full capitulation. Low allocations in Europe are in line with perceptions of growing risk levels in the eurozone,” said Gary Baker, head of European Equities strategy at BofA Merrill Lynch Global Research.
What's more, central bank intervention is almost taken as a given. That begs the question, how big a bazooka will the Fed, ECB et all have to unveil this next round?
“Hopes expressed last month of a policy response have now become expectations. Markets are keenly anticipating decisive action from key policy meetings in June,” said Michael Hartnett, chief Global Equity strategist at BofA Merrill Lynch Global Research.
Another BoAML analyst, Mary Ann Bartels, also wrote that she was not seeing sufficient capitulation [emphasis added]:
The Volume Intensity Model (VIM) has had a negative reading since 09 April, but last week accumulation (up volume or buying) rose while distribution (down volume or selling) declined, narrowing the spread between distribution and accumulation. Since VIM remains negative and VIGOR continues to decline, this mild improvement in the VIM only supports the case for a tactical rally.

One concern is that distribution did not reach the “capitulation” readings near 80 seen in May 2010 and August 2011. The risk is that sellers are not yet completely exhausted and an adverse macro news event could trigger a future shakeout.

Announcements like the one Thursday by the G20 are not helpful in the current environment for investors. They prevent the sentiment washout that is necessary for a new intermediate term bull market to start. All the G20 Put does is prolong this agony of choppy Summit-Advance the half/baked idea-Market selloff and Summit cycle again and again.





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.

Tuesday, June 12, 2012

A tactical warning for bulls

Well, that market reaction to the Spanish banking bailout was underwhelming! I wrote last week that seeing a market's reaction to an event can be an important clue to future direction, as it is an indication of investor expectations and what news is priced in.

We now know the path of least resistance for stocks is down. We got the first hint last week from the lukewarm market reaction to the ECB announcement and Draghi press conference; and later the reaction to the Bernanke testimony (see my comment Is the QE glass half full or empty?).

Now that the bias for equities is bearish, what's the short-term downside from here? Consider this note from Todd Salamone of Schaeffer's Research published on the weekend, which suggests that technical selling by option market makers could exacerbate the downturn as we draw closer to Friday's option expiry [emphasis added]:
The current open interest configuration on the SPDR S+P 500 ETF (SPY - 133.10) is very put-heavy, setting up the potential for short-covering related to the expiring put open interest at strikes immediately below the current SPY price. The odds are in the bulls' favor, absent a negative outcome with respect to Spain over the weekend. That said, a poor start to the week spurred by ongoing euro-zone concerns could create the kind of delta-hedge selling that occurred last expiration month, when put strikes acted as "magnets" once the ball got rolling to the downside.
Here is how he explained the mechanics of delta hedging as it related to the option market and market makers may have contributed to the market decline in May:
As popular put strikes were violated one after another during expiration week, sellers of the puts may have been forced to short futures to keep a neutral position, creating a steady but sure stream of selling. The heavy put open interest strikes essentially act like "magnets," as one strike after another is taken out. Delta-hedging risk certainly grows during expiration week if the market gets off to a weak start, as it did last Monday, and there is heavy put open interest just below current prices.
Salamone postulated that the SPX could find some support at the 1,280 and 1,250 level:
It's usually the big put strikes that act like magnets, so 128 (which corresponds to SPX 1,280) would be a possible support area. There's a smaller-probability risk of a move down to 125 (or SPX 1,250), which is the next strike with significant put open interest. On the upside, a move into heavy call strikes at 134 and 135 would be a possibility in the event of a short-covering rally. These areas correspond to SPX 1,340 and 1,350, respectively, which we cited above as potential chart resistance.
Given Monday' market action, it is evident that the bears have the upper hand. Salamone's comments put some further context to the short-term downside that US equities face this week.



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.

Monday, June 11, 2012

Ominous signs from China

As I write these words, markets are surging in the wake of the news of a bailout of Spanish banks. I had written before that the principal macro risk wasn't coming from Europe, but China (see Focus on China, not Europe). I had expected that the eurozone would lurch in a crisis to rescue to crisis cycle and the Spanish banking rescue is more of the same. Already, there is a chorus of voices of why the bailout won't work (see examples from Goldman Sachs, BoA and Bruce Krasting). For now, it doesn't matter as the markets have interpreted the move as a stay of execution - as the cycle of crisis and rescue continues.

What is more ominous are the signs coming from China.


Technical outlook negative
First of all, the technical outlook has turned negative as the Shanghai Composite is in a wedge formation that has resolved itself bearishly.


Next door in Hong Kong, the Hang Seng Index is in a downtrend, which confirms the bearish technical outlook for China.



China's economy is weakening
The signs of weakness in China's economy are becoming more evident. There was a dump of economic data over the weekend and most of the numbers came in below expectations. The weakness is likely to spill over to the Chinese stock market. Thomson Reuters reports that StarMine expects severe negative earnings surprises out of Chinese stocks [emphasis added]:
StarMine models suggest that it’s still too early to embark on any bargain-hunting expeditions in Asia, where stock prices have underperformed most other regions of the world. In China alone, stock prices are down 16% from their March highs, but the value created by that selloff comes with big risks attached. Now, a new analysis of the most recent data suggests that the picture doesn’t appear likely to change any time soon. The “Predicted Surprise” – for earnings – the percentage difference between StarMine’s SmartEstimate, which puts more weight on recent forecasts and top-ranked analysts, and the mean estimate of all analysts – for emerging Asian markets earnings as a whole, currently stands at -1.6%. Among all markets in the region, China’s Predicted Surprise is -2%, second only to that of Sri Lanka, which comes in with a -2.8% Predicted Surprise.
No wonder we saw the surprise rate cut last week. Dong Tao of Credit Suisse (via Also Sprach Analyst) believes that actions by the PBoC won't be enough, because the central bank is in a liquidity trap and rate cuts are pushing on a string:
However, we believe that a cut in the lending rate will only have limited impact in stimulating investment. We believe China is in a liquidity trap. With a low interest rate environment, further cuts in interest rates may not get much of an additional impact. Today’s problem in China is not about funding cost or bank liquidity, but demand for loans for real businesses. As companies in the real businesses struggle with surging costs, over-capacity, and weakened demand, the incentive to conduct real investments is low. It would take some structural changes to jump-start the momentum of investments in the private sector, instead of just through easing monetary policy.
As the economic picture deteriorates, expect more cranky commentaries like this one from John Hempton (The Macroeconomics of Chinese kleptocracy):
I start this analysis with China being a kleptocracy – a country ruled by thieves. That is a bold assertion – but I am going to have to assert it. People I know deep in the weeds (that is people who have to deal with the PRC and the children of the PRC elite) accept it. My personal experience is more limited but includes the following:
(a). The children and relatives of CPC Central Committee members are amongst the beneficiaries of the wave of stock fraud in the US,

(b). The response to the wave of stock fraud in the US and Hong Kong has not been to crack down on the perpetrators of the stock fraud (so to make markets work better). It has been to make Chinese statutory accounts less available to make it harder to detect stock fraud.

(c). When given direct evidence of fraudulent accounts in the US filed by a large company with CPC family members as beneficiaries or management a big 4 audit firm will (possibly at the risk to their global franchise) sign the accounts knowing full well that they are fraudulent. The auditors (including and arguably especially the big four) are co-opted for the benefit of Chinese kleptocrats.

This however is only the beginning of Chinese fraud. China is a mafia state – and Bo Xilai is just a recent public manifestation. If you want a good guide to the Chinese kleptocracy – including the crimes of Bo Xilai well before they made the international press look at this speech by John Garnaut to the US China Institute.
Hempton concluded that Chinese State Owned Enterprises (SOEs) depend on negative interest rates as a source of cheap funding and falling inflation is the real economic threat to the Chinese economy [emphasis added]:
The Chinese kleptocracy – and indeed several major trends in the global economy – depend on copious quantities of savings at negative expected rates of return by middle and lower income Chinese...
The more serious threat is deflation – or even inflation at rates of 1-3 percent. If inflation is too low then the SOEs – the center of the Chinese kleptocratic establishment will not generate enough real profit to sustain the level of looting. These businesses can be looted at a negative real funding rate of 5 percent. A positive real funding rate - well that is a completely different story.

The real threat to the Chinese establishment is that the inflation rate is falling - getting very near to the 1-3 percent range.

Low Chinese inflation rates will mean reasonable returns on savings for Chinese lower and middle income savers. Good news for peasants perhaps.

But that changing division of the spoils of economic progress will destroy the Chinese establishment (an establishment that relies on a peculiar and arguably unfair division of the spoils). The SOEs will not be able to pay positive real returns to support that new division of spoils. The peasants can only receive positive real returns if the SOEs can pay them - and paying them is inconsistent with looting.

If the SOEs cannot pay then the banks are in deep trouble too.
If the banking system gets into trouble, then we are not just looking at a hard landing scenario, defined as sub-par economic growth, but a crash landing, which I define as zero or even negative GDP growth.


Ursa Minor romps in China?
For now, the good news is that the risk of a crash landing appears to be off the table. I had written in my previous post that systemic risks in the Chinese shadow banking could result in a crash landing and speculated about the possibility of Chinese capital flight.
 
Those risks appear to be contained for now. I had written that I was watching the share price of HSBC as a barometer of financial risk in China. A Hong Kong based investment banker informs me that HSBC is not thought of as a good gauge of the risks to the Chinese financial system as the bank had diversified its exposure. Better to watch the Chinese banks listed in Hong Kong, such as:
  1. Agricultural Bank of China (1288.HK)
  2. Bank of China (3988.HK)
  3. China Merchant Bank (3968.HK)
  4. ICBC (1398.HK)
Right now, none of the shares of these banks are falling in a way that suggests market fears of an uncontrolled implosion of the shadow banking system. But watch this space!

Current conditions are suggestive of an attack by Ursa Minor, or a minor bear market, in China. Nevertheless, such a scenario is one that hasn't largely been discounted by the global financial markets. So watch out.



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.

Thursday, June 7, 2012

Is the QE glass half-full or empty?

How the market reacts to news can be an important clue of future direction. In my last post, I wrote that you shouldn't expect too much from the ECB or Fed this week. The European Central Bank certainly disappointed the bulls with their inaction, not only on interest rates, but on the prospects for "extraordinary measures".

Now it's Ben Bernanke's turn.

We already have a clue on what Bernanke will say from Jon Hilsenrath's WSJ article entitled Fed Considers More Action Amid New Recovery Doubts. Here is what I am watching for. Will the markets key on the comment that action is not likely in the June FOMC meeting?
The Fed's next meeting, June 19 and 20, could be too soon for conclusive decisions. Fed policy makers have many unanswered questions and have had trouble forming a consensus in the past. Top Fed officials have said that they would support new measures if they became convinced the U.S. wasn't making progress on bringing down unemployment. Recent disappointing employment reports have raised this possibility, but the data might be a temporary blip. Moreover, the Fed's options for more easing are sure to stir internal resistance at the central bank if they are considered.
Or will the market key on the fact that the Fed is considering further quantitative easing [emphasis added]?
Their options include doing nothing and continuing to assess the economic outlook—or more strongly signaling a willingness to act later if the outlook more clearly worsens. Fed policy makers could take a small precautionary measure, like extending for a short period its "Operation Twist" program—in which the Fed is selling short-term securities and using the proceeds to buy long-term securities. Or, policy makers could take bolder action such as launching another large round of bond purchases if they become convinced of a significant slowdown.
What Hilsenrath wrote is not that different from what New York Fed President Dudley said in late May in the WSJ, that the Fed will act should it see signs of economic weakness:
Expectations for U.S. economic growth, while “pretty disappointing” at around 2.4%, is sufficient to keep the central bank from easing monetary policy, Federal Reserve Bank of New York President William Dudley said.

“My view is that, if we continue to see improvement in the economy, in terms of using up the slack in available resources, then I think it’s hard to argue that we absolutely must do something more in terms of the monetary policy front,” Dudley said in an interview with CNBC, aired Thursday.
Now that we know what Chairman Bernanke is likely to say, watch the market reaction. Is the QE glass half-full or half-empty?



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.

Monday, June 4, 2012

Time for the Draghi and Bernanke Puts?

This week is an important week for investors who are watching for central bank action in the wake of market angst over Europe and the American economy. On Wednesday, the ECB will announce its interest rate decision and Mario Draghi will hold the customary press conference afterwards. On Thursday, Ben Bernanke will be testifying before Congress.

What will they say?


Don't expect too much
While I do expect that the ECB and Federal Reserve will intervene eventually, I do think that the markets may be getting ahead of themselves in anticipating another round of LTRO from the ECB or QE from the Fed. After all, Mario Draghi said last week that the ECB was reaching the limits of what it could do and it's now up to the politicians:
Draghi told a European Parliament committee in Brussels that without more aggressive action by policy makers the euro “is being shown now to be unsustainable unless further steps are being undertaken.”

He said it wasn’t his job to make up for the failures of policy makers. “It’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front,” he said.
The ECB is likely to reduce interest rates in the face of economic weakness in the eurozone, but don't expect too much more. If Draghi were to reverse course from last week and announce some extraordinary measure like another round of LTRO, it would not only erode the ECB's credibility, but could paradoxically have a negative effect on the markets as it asks, "What looming disaster does the ECB know about that we aren't aware of?"


QE3 in June?
Across the Atlantic, there is a lot of expectation built up that we are due for another round of QE at the June FOMC meeting in the wake of last week's ugly NFP report. Veteran Fed watcher Tim Duy disagrees  [emphasis added]:
Bottom Line: At this point, the direction of US data, the pathetic state of Europe, and the evolving slowdown across the rest of the world all point toward additional action by the Federal Reserve. Assuming this continues, it is an issue of timing and tools. My baseline is steady policy at the June meeting (depending, of course, on the usual financial turmoil disclaimer), with a possibility of an extension of Operation Twist. The latter option is something of a tough sell for me; it is cheap, but will prove to be ineffective. If the Fed needs to move, they need to reverse course back into quantitative easing. They need time to build internal support for such a move, which argues for action later in the summer or early fall, much as we have seen in the past two years. I just don't think they have enough to shift policy at this juncture.
Don't forget that Bernanke and the Bernanke Fed is made up largely of conservative academics, who tend to wait for definitive evidence of a slowdown before acting. As I wrote before about the difference between the Bernanke and Greenspan Fed (see Yes to QE3, but not yet), both the Greenspan Put and Bernanke Put exist, the difference is in reaction time:
[P]ut yourself in Bernanke's head. His academic reputation was built on the study of central bank action during the Great Depression. This is probably a little voice in his head telling over and over again, "Don't let another Great Depression happen on your watch." As a result, we have the Bernanke Put.
Greenspan had a long career on the Street as a forecasting economist and tended to be more proactive:
Greenspan's approach as Fed Chairman was to stimulate whenever he saw signs of weakness - and he was far more market savvy than Bernanke. Therefore the Greenspan Fed tended to be more proactive and tended to get ahead of events. The Great Moderation was the result of the Greenspan Put - and those policies worked well, until they went overboard with the stimulus (and we are still paying the price for those policies).


My guess is that investors looking for hints of another round of QE from the Fed on Thursday are likely to be disappointed.




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.

2012 = 1998?

Weekends are a good time to think and reflect. After last week's carnage in the stock market, some thinking and reflection was more than overdue. The question I had was, "What is the market headed?"

When I consider the different dimensions by which investors evaluate equities, they present a mixed picture that is, while bearish, does not point to disaster:
  • Sentiment: bullish
  • Valuation: neutral to slightly bearish
  • Momentum: bearish
  • Macro: bearish, but subject to policy-induced whipsaw

Sentiment models are screaming "buy"!
Let's go through each of these one at a time. Martin T. over at Macronomics noted that Wall Street strategists are off the charts bearish, which is contrarian bullish.


As well, US 10yr yields are trading 3 standard deviations from the 30+ year downtrend, which indicates a crowded long in the Treasury safe haven trade.


 
Scott Grannis has noted the same level of exuberance when he asked "What record-low Treasury yields tell us". His take:
If I had to sum up what all this means, I would say that the evidence of market prices points to a very high level of fear, uncertainty and doubt among global investors. Today's record-low 10-yr Treasury yield is just the latest sign that investors are consumed by fears. When emotions reach such heights, as they did in the early 1980s and in late 2008/early 2009, investors willing to bear risk stand a good chance of being rewarded, provided the future turns out to be less awful than the market expects.

Valuation: Neh!
Typically, when sentiment is this bearish, Value investors are all crawling out of the woodwork and shouting, "I can't believe that there are so many bargains!"
 
While I have heard that comment directed at a number of European companies, i.e. these are real world-class companies trading at bargain prices (see one example at the FT article While all around ar panicking...buy), the same couldn't really be said of most markets. The Value investors just aren't there.
 
Consider, for example, this Barron's interview with Jeremy Grantham, who is known to have a value bias, on February 25, 2012 when the SPX was about 1360, which is about 6% above Friday's close of 1278.
We do a seven-year forecast every month. On a seven-year forecast, global equities outside the U.S. are boring. They've been so nervous the last year that they mostly reflect the right degree of fear about European problems. Emerging markets and developed markets outside the U.S. are within nickels and dimes of fair value. This is very unusual. We are in the asset-allocation business, and we like to see horrific roller coasters: It gives us something to get our teeth into. What could be more boring than global equity markets at fair value?
About a quarter of the U.S. equity market—the high-quality, boring, great companies—is about fair price, too. The other three quarters are overpriced, and based on our numbers have a slight negative imputed return.
While Grantham doesn't represent the final word in stock market valuation, he is a good bellwether for what Value investors think. As of the end of February, he believed that non-US equities were roughly at fair valuation. US equities are overpriced, with only a quarter, i.e. high quality stocks, at fair value.
 
His comments were not a stunning endorsement for the stock market.
 
 
A Dow Theory sell signal
The Dow Theory is one of the original trend following models, which is based on price momentum and looks for confirmations from different sectors of the market: industrials, transportation and utilities. Long-term market analyst and Dow Theorist Richard Russell recently flashed a major sell signal for stocks [emphasis added]:
IMPORTANT --- Dow Theory -- The D-J industrial Average recorded a high of 13,279.32 on May 1, 2012.  This Dow high was not confirmed by the Transports.  The two averages then turned down and broke below their April lows.  This action confirmed that a primary bear market is in progress -- it was a textbook bear signal.
Could you be a little more clear, Richard?


Macro picture gets worse
Last week, the news flow from Europe continued to deteriorate. The latest Greek tracking polls have SYRIZA on top again:

Not only that, the markets are now getting concerned about Spain - a country that's too big to fail. In the meantime, ECB head Mario Draghi stood aside last week and said that the ECB can't do much more. It's all up to the politicians:
Draghi told a European Parliament committee in Brussels that without more aggressive action by policy makers the euro “is being shown now to be unsustainable unless further steps are being undertaken.”

He said it wasn’t his job to make up for the failures of policy makers. “It’s not our duty, it’s not in our mandate” to “fill the vacuum left by the lack of action by national governments on the fiscal front,” on “the structural front, and on the governance front,” he said.
Last week, I wrote that investors should focus on China, not Europe. The news out of China is headed south. The latest PMIs are signaling a global slowdown, not just in China but in Europe as well. I raised the issue of when investors might focus on the question of capital flight out of China, when Tim Duy picked up on the same story. Should the market start to price in the tail-risk of capital flight, look out below!

Then we have the ugly US Non-Farm Payroll Friday. The only good news is that more data points of economic weakness will give the Fed political cover to act and unveil another round of QE. Despite what the central bankers say, don't forget that when things get bad enough, there will a policy response. As an example of the anticipated response, Mark Dow at Behavioral Macro believes that the IMF is putting on the face paint for a rescue of Spain. While the response may not fully solve the problem, it will kick the can down the road and spark a stock market rally.


A repeat of 1998 in 2012?
Putting it all together, what does it all mean? The market is supported by washed out investor sentiment, but not by valuation. The macro backdrop and momentum looks ugly. Is this the start of another cyclical bear?

Probably not. Valuations don't look excessively stretched, but they aren't screaming "buy" either. Major bear markets generally don't start with these kinds of valuation metrics.

My best wild-eyed-guess is that we will see a major air pocket like 1997 (Asian Crisis) or 1998 (Russia/LTCM Crisis) in which some macro event sparks a major selloff, but turns around based on policy response. There are plenty of macro triggers out there. Greece, Spain, China, etc.

Market analogues have limited uses, but look at the chart of the stock market in 1998. The market had an initial dislocation (Greece), stabilized and rallied (as we did a couple weeks ago) and started selling off again. At the nadir of the Russia Crisis that threatened to sink Long-Term Capital Management, the Fed came in and knocked some heads together to save the system.


Now look at the chart of the market this year and last year. See any parallels?


Don't misunderstand me. This is not a forecast that stocks are going to plunge this week. Analogues are analogies and they are imperfect. Markets are extremely oversold on a short-term basis and I don't think that we've actually seen the macro trigger for a waterfall decline yet, though there are lots of potential triggers.


Not enough pain
Nevertheless, were this scenario were to play out, it suggests that we haven't quite seen enough pain and we need one more capitulation down leg to equities. For now, my Asset Inflation-Deflation Trend Model remains at a deflation reading, indicating that the model portfolio should be primarily positioned in the US Treasury market. I will be primarily using that model and some short-term timing tools to try to spot the turn. Here is what I am watching. The chart below of the Euro STOXX 50 is falling, but not quite at the lows delineated by the 2009 and 2011 lows. Wait until the index approaches that zone and watch for signs of a "margin clerk" liquidation forced selling in the panic.

Here in Canada, I am also watching the ratio of the junior TSX Venture Index to the more senior and established TSX Composite. While there is a lot of pain, utter and blind panic hasn't quite set in yet.



When the blood starts to run in the streets, official intervention will be all but inevitable. At that time, that will be the opportunity to buy the pain in Spain.




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.