In the 7th inning of a correction

Trend Model signal summary
Trend Model signal: Risk-off
Direction of last change: Negative

The actual historical (not back-tested) buy and sell signals of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on this blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

Don't panic, it's only a correction
Last week, I wrote that the market action did not have me convinced that we had seen THE BOTTOM, but I was unsure and remained nervously bearish.

Sure enough, US equities continued to fall in the week just past. We saw a major bearish signal as the SPX violated a major uptrend line that began in late 2011. On the other hand, the market descent moved the index to a rare oversold condition of closing the week below the weekly Bollinger Band, which has generally been a useful signal for a reflex rally in the past (see circles).

I interpret these readings as an oversold condition within the context of a deeper market correction. The medium term path of least resistance is down, but the market is ripe for a short-term bounce.

Broad signs of global weakness

I come to my conclusion that we are entering a deeper corrective period based on signs of broad market weakness and anxiety. Too much damage has been done to the equity outlook for stocks to carry on and grind higher as they have in the last couple of years.

To my mind, the greatest damage to the global equity outlook has nothing to do with any technical indicator. Rather, it was signaled by the single sentence warning by Microchip Technology (MCHP) about a likely semi-conductor inventory correction, which exemplified the picture of slowing global growth. The warning sent shock waves throughout the semi-conductor stocks as SMH cratered by 6.6% on the day:

We believe that another industry correction has begun and that this correction will be seen more broadly across the industry in the near future,

The picture of global weakness is shown by the relative performance of my CapEx Index against the SPX. As regular readers are aware, I have been concerned about the lack of broad based capital expenditures during the current mid-cycle phase of the US expansion. I therefore started monitoring the relative performance of a CapEx Index, consisting of an equal weighted index of cap-weighted Industrial stocks (XLI), equal-weighted Industrial stocks (RGI), because I wanted to measure Industrial performance without the dominance of heavyweight GE, and semi-conductor stocks (SMH), as they are represent a key component of the highly cyclically sensitive capital goods business, relative to the SP 500.

Even before the MCHP warning, the relative performance of the CapEx Index had lagged. But the MCHP announcement was the shocker that made the story of slowing global growth that much more real. Moreover, it highlights the transmission mechanism of how slowing non-US growth can affect US companies.

Moreover, the pattern of weakness in the shares of capital goods companies is not just restricted to the US. The chart below shows the relative returns of European Industrials (they're called "engineering companies" over there) against DJ Europe in the top panel and equal-weighted Industrial stocks vs. the SPX in the bottom panel. Note how the patterns of relative weakness parallel each other, which signals a broad based weakness in this sector.

Technical weakness and anxiety everywhere
From a technical viewpoint, there are signs of market weakness and anxiety everywhere I look. As an example, the chart below shows the monthly chart of the Wilshire 5000, the broadest measure of US equities. The key indicator of further market weakness is the MACD crossover, shown in the bottom panel. Past instances of MACD crossovers in the last 20 years have been fairly rare, but they have always signaled either corrections or bear markets.

I am also seeing other signs of rising anxiety in other asset classes. Both the implied volatility (in orange) and realized volatility (in blue) have spiked for currencies, as exemplified by vol profile of the USD Index:

Commodities have also seen a pattern of a volatility uptrend in the past few weeks:

Here is the vol profile of the US long Treasury bond:

...and junk bonds:

This pattern of rising anxiety has manifested itself in rising risk aversion, as junk bond price performance have rolled over against Treasuries:

Global equity weakness

The Trend Model is flashing signs of global risk aversion and technical damage. In addition to the weakness seen in US equities, the UK equity market, as measured by the FTSE 100, is struggling. As the UK is slightly ahead of the US in its interest rate cycle, the FTSE 100 will be an important index to watch:

Eurozone equities are showing a similar pattern of the violation of a long uptrend. In view of a visible disagreement between the ECB and Germany over fiscal stimulus, the Draghi "whatever it takes" rally seems to be over.

Market based indications of Chinese growth are akso looking iffy. The Shanghai Composite has staged a robust rally, but this index seems to be an anomaly and as it defies gravity when compared to my other China indicators.

The stock indices of Chinese major regional trading partners do not show the similar bullish pattern. Here is Hong Kong, which has been negatively affected by the Occupy Central pro-democracy protests:

The South Korean KOSPI is showing a similar pattern of uptrend violation:

So is the Taiwanese stock market:

Aside from the stock indices of China`s trading partners, another all important real-time market based indicator of Chinese growth, industrial commodity prices, looks weak:

So does the AUDCAD exchange rate, which is important because both Australia and Canada are major commodity producing countries, but Australia is more sensitive to Chinese growth while Canada is more sensitive to American growth.

When I put it all together, there is no escaping the fact that the message from global markets and cross-asset analysis is one of rising anxiety about weakening growth.

Looking for the bottom

Past corrective episodes in the last five years have seen fundamental triggers, such as the Greek default crisis of 2010, the eurozone crisis and Washington budget impasse of 2011. This time, there appears to be no broad based consensus of a fundamental reason for the market weakness. That leads me to believe that we are seeing a correction in risk appetite, which is generally not the pre-condition for a bear market or even a major correction. Most likely, the magnitude of this pullback will be of the 5-10% variety.

With that scenario in mind, I tried to look for indicators that may give us a better idea of how to time the bottom in the current bout of stock market weakness.

Even though a number of indicators are flashing oversold conditions, I do not believe that we have seen the bottom yet. The chart below shows the SPX in the top panel and a variety of technical indicators in the other panels. These indicators include: the % of stocks on a point and figure buy in the SPX in the second, % of stocks over the 200 day moving average in the third and a slow overbought-oversold stochastic indicator in the bottom.

The top three charts all indicate that the US stock market has undergone a regime change. We are no longer in the steady uptrend that we have undergone in the last 2-3 years. The SPX trend line has been violated and both the % bullish and % above 200 dma readings have descended to pre-2012 levels, which was before the current bull run began. These conditions suggest that the slow stochastic needs to show a deeper oversold reading before the current bout of weakness is over.

Here is another take on the current market conditions. The chart below shows Rydex bear and money market fund flows as a % of total fund flows. When the line is high, it indicates excessive bearishness and when it is low, excessive bullishness. On one hand, fund flow readings are consistent with levels seen in recent interim bottoms of the last 5 years. On the other hand, we saw increasing bullishness as the market declined on Thursday and Friday, indicating that Rydex investors were buying into weakness. Since sentiment indicators are not precise market timing indicators, I interpret these conditions as the stock market getting near a bottom, but not just yet.

In addition, my trifecta of bottom calling indicators (see A tradable bottom?) are closer than last week to flashing a buy signal, but not yet. These are:

• A inversion in the VIX term structure AND TRIN more than 2
• My favorite overbought-oversold indicator moving below 0.5 (oversold) and then mean reverting above that level

As the chart below shows, the VIX term structure inverted on Friday, but TRIN is only 1.44 and the OBOS indicator is only approaching an oversold reading at 0.58, but still above the critical 0.50 threshold. I have marked with blue vertical lines when all three indicators have been satisfied and in pink when only two of the three have met my conditions. In each of the cases, they have been excellent signals of short-term market bottoms.

Bottom line: We are getting close to a bottom, but not yet.

Ripe for a bounce

In the meantime, short-term technical conditions are screaming "bounce"! As an example, the ISEE equity only call-put ratio of opening option transactions is showing signs of excessive bearishness, which is contrarian bullish:

The SPX is also testing various levels of key support and showing short-term positive divergences. I already indicated that the index is now at the lower weekly Bollinger Band, which usually acts as support. As well, it closed Friday just above its 200 day moving average, which is a support level closely watched by many technicians. At the same time, it is showing positive divergences on short-term indicators such as the 5-day RSI and the NYSE McClellan Oscillator. 

My base case scenario calls for a short-term rally in the coming week, with the market then weakening into a final bottom shortly thereafter. In effect, we are in the seventh inning of a market correction.

In light of the short-term oversold conditions, my inner trader tactically took advantage of last week`s market weakness to reduce his short positions. He anticipates that he will be able to re-enter his bearish positions at higher levels.

My inner investor remains relatively unperturbed at these market gyrations. He believes that investors should be prepared for 20% drawdowns as part of the risk of equity ownership and there is not reason to panic. This is only a correction.

Disclosure: Long SPXU

Get ready for the resource rally

As a matter of practice, when an instrument gets either overbought or oversold, I like to wait for a mean reversion signal into a neutral before taking action. Overbought stocks can get even more overbought and oversold stocks can get even more oversold.

When I wrote that the US Dollar, which is inversely correlated to commodity prices, was overbought on September 17, 2014 (see Overbought USD = Commodities poised to rally), I never dreamed that it would take this long to work off the overbought condition in the USD Index. As the chart below shows, the 14 week RSI of the USD Index reached 70.16 at the close on Tuesday, which is just above the 70 overbought threshold condition for taking action to sell the USD and tactically buy the commodity complex.

In addition, I marked past instances when the RSI reading rolled over from an overbought reading and every case saw a relatively substantial decline in the USD. Indeed, the chart of the CRB Index below shows that it is testing support and starting to move off an oversold reading. These conditions are classic setups for a commodity rally.

As well, the price of gold is also showing a similar pattern of a successful test of support and an upturn in the 14-week RSI.

Stock market implications
While the resource sectors are poised for rallies for the next few weeks, figuring out the wider directional market implications for the equities is more difficult. On one hand, the market leadership will change to the long suffering Energy and Material sectors under such a scenario. The market may interpret that as a bullish reflationary environment.

On the other hand, recent comments from the Fed may spook the markets to give such a development a bearish spin. Consider that the latest FOMC minutes indicated that the Fed was concerned about how the high level of the US Dollar is impeding growth (emphasis added):

In the economic forecast prepared by the staff for the September FOMC meeting, the projection for growth in real gross domestic product (GDP) in the second half of this year was revised down slightly from the one prepared for the previous meeting, primarily because of a somewhat weaker near-term outlook for consumer spending. The staff's medium-term forecast for real GDP was also revised down a little, reflecting a higher projected path for the foreign exchange value of the dollar along with slightly smaller projected gains for home prices.

The WSJ also highlighted comments from Bill Dudley of the New York Fed voicing similar concerns as the reasoning for the current dovish tilt at the Fed (emphasis added):

First, Mr. Dudley has elevated the strength of the dollar and soft global growth as factors affecting the Fed’s policy thinking. He said the strong dollar puts downward pressure on U.S. inflation and dims U.S. near-term export prospects, factors that keep the Fed patient about raising rates even as the job market improves. It’s unusual for a senior Fed official to speak so directly about the impact of the currency on his thinking, in part because the currency is supposed to be the domain of the U.S. Treasury.

Second, Mr. Dudley affirmed that he still sees “significant underutilization” of labor market resources, even after a surprisingly strong September jobs report showed the jobless rate has fallen below 6% for the first time since July 2008. This phrase “significant underutilization” is an important tripwire in the Fed’s policy statement. When officials take it out, it likely will be a signal they see rate hikes as getting closer. Mr. Dudley’s comments strongly suggest it stays in the October policy statement.

Here is the key question for the market and policy makers. If the greenback were to violently retrace its up move in the next few weeks, will that push the rhetoric to be hawkish?

How will these bullish and bearish developments resolve themselves under a scenario of a falling USD and rising commodity prices? I have no idea. For the time being, it appears to be a recipe for volatility.

In a recent post, I wrote that I wanted to see a deeper correction and more volatile condition for the equity market as a way of stress testing my Trend Model, which had seen excellent returns in the past year (see Trend Model September report: +40.1%). I suppose I should have been careful about what I wished for.

A Trend Model anomaly?

I had a fair number of comments on my post last week about the investment results of my Trend Model (see Trend Model September report: +40.1%). Undoubtedly it got attention because of its outsized realized returns for one year.


A puzzling trend following question
I did, however, get a thoughtful response from one reader that I couldn't answer. Specifically, I pointed out that the Trend Model account achieved its returns when the US stock market had risen steadily in the last year with no major corrections. Pullbacks were brief and shallow.

The underlying model is mainly based on the application of trend following techniques to commodity prices and global equity prices. Moreover, trend following models are notorious for subpar returns in trend-less markets which subject them to getting whipsawed in and out of positions. The chart below shows the actual (not back-tested) Trend Model signals and showed periods of whipsaw.

Trend Model Signal History

I wondered out loud that the best stress test for this trading strategy would be when stocks were to undergo a volatile corrective period like 2010-2012.

Is the Trend Model long or short volatility?
Here is the question that I couldn`t answer. Trend following strategies are generally thought of as having a long-volatility characteristic (via Futures Magazine):

Simply stated, trend following is at its core a long-volatility strategy. In other words, it makes money when volatility expands (i.e. during trending moves). Conversely, it suffers frequent but small losses during non-trending periods in exchange for such infrequent but large gains. During non-trending periods the strategy attempts to tread water through the judicial use of stop loss orders until some market movement provides a large outlier move in which the strategy can profit.

Is it ironic that my Trend Model is performing well in an environment where pullbacks are minor and stock market volatility, as measured by VIX, is low, but I wished to see it stress tested in a corrective period when volatility, as measured by VIX, is high? Given the market action in the past few days and the most recent Trend Model market call (see A Yom Kippur bottom? Or just more volatility?), I may get that stress test very soon..

Does the Trend Model have a long or short volatility exposure? Is it behaving in accordance with other trend following systems? What am I missing?


Trend Model performance vs. CTAs
Trend following models have had a difficult time in the last few years. The BarclayHedge CTA Index shows how poorly CTAs did starting in late 2010, though they recovered late last year. The actual performance of the Trend Model account was stellar in the last year (much like the BarclayHedge CTA Index). On the other hand, the above chart of the actual Trend Model signals starting in 2009 were quite good as well (unlike BarclayHedge CTA).

Is there a disconnect here? Is this an anomaly in the characteristic of my Trend Model? If anyone has any thoughts, please either post it in the blog comments or email me at cam at hbhinvestments dot com.

More tail-risk from Asia

There is another newly emergent tail-risk that investors should start to keep an eye on in Asia. No, it's not Hong Kong, which is already in the headlines, but Korea. Over the weekend, a high level North Korean delegation paid a visit to South Korea, ostensibly to attend the closing ceremonies of the Asian Games. Here is the report from the Washington Post [emphasis added]:

North and South Korea have agreed to hold another round of high-level talks after a top-level Northern delegation, including the men thought to be second and third in command behind Kim Jong Un, paid a surprise visit to the South on Saturday.

The unusual and unannounced trip — the first such high-level visit in more than five years — comes at a time of intense speculation about North Korea’s leadership, given that Kim, the third-generation leader of the communist state, has not been seen in public for a month.

It also comes amid a steady stream of disparaging comments from both sides, with South Korean President Park Geun-hye recently calling for the international community to help in “tearing down the world’s last remaining wall of division,” and the North calling Park an “eternal traitor” in response.

“It’s a big deal, it’s really a big deal, because it’s completely unprecedented,” said Andrei Lankov, a North Korea scholar who studied in Pyongyang and now teaches in Seoul.

 This was in all respects a high level North Korean delegation:

The 11-strong group from North Korea was led by Hwang Pyong So, widely considered Kim’s deputy. He’s the top political official in the Korean People’s Army and vice chairman of the National Defense Commission, which is led by Kim.

Another member of the delegation was Choe Ryong Hae, who has performed both of the roles currently performed by Hwang and is chairman of the State Physical Culture and Sports Commission. That job was previously held by Jang Song Taek, the influential uncle that Kim Jong Un had executed last December, according to NK News, a Web site that monitors the North.

It is virtually impossible to speculate about the intentions of the North Korean delegation, but the likelihood of Korean reunification ticked up with this visit, particularly in light of reports that North Korean leader Kim Jong Un has not been seen in public since September 3. Rumors of coups have swirled around the so-called Hermit Kingdom (via The Independent):

On Friday, Vice News reported that Jang Jin-sung, formerly a key member of Kim Jong-il's propaganda machine, counter-intelligence official and personal poet laureate, had claimed that North Korea was "in the midst of a civil war" in September.

Jang, a defector, was reported to have said members of the OGD had stopped taking orders from the younger Kim. The OGD, Jang said, had effectively taken control of the country, with some seeking to gain wealth through increased foreign trade and open markets. "It's not actually consciously civil war, but there are these two incompatible forces at play," he reportedly said.

The alleged coup is said to have begun last year with Kim Jong-un only serving as a puppet leader while officials from the OGD, including Hwang, pulled the strings. It was, Jang claimed, triggered by the execution in December of Jang Sung-taek, Kim's uncle by marriage, who was a political rival of the OGD.

News of Jang Sung-taek's execution was accompanied by a string of extraordinary insults, branding him a "traitor for all ages" and "despicable human scum" who was "worse than a dog". A 2,700-word state-media report of his trial in a special military tribunal said he had admitted to plotting insurrection and a string of other crimes.

"By Jang dying, Kim Jong-un is now surrounded by the OGD," said Jang Jin-sung of the purge of Kim's uncle.

Upsetting the status quo
Should Korean reunification were to happen, it would upset the current status quo in North Asia and amount to an economic and geopolitical earthquake felt around the world.

First, what would be the cost? Remember the burden to West Germany as it integrated East Germany into a united country? Wikipedia reports that the economic disparities between the two Koreas is much worse than the two Germanys [emphasis added]:

Economic differences between North and South Korea are also a cause of concern. Korean reunification would differ from the German reunification precedent. In relative terms, North Korea's economy is currently worse than that of East Germany in 1990. The income per capita ratio (PPP) was about 3:1 in Germany (US$25,000 for the West, about US$8,500 for the East). The ratio is close to 18:1 in Korea (in 2011: US$31,700 for the South, US$1,800 for the North). While at the moment of German reunification the East German population (around 17 million) was about a third of the West German (more than 60 million), the North Korean population (around 24.5 million) is currently around half of South Korea's (around 49 million).

A recent report states that the cost of unification could amount to 7% of GDP for a decade (via Reuters):

Unification of the two Koreas could cost the South up to 7 percent of annual GDP for a decade though the South would benefit in various ways such as cheap labor and the North's resources, South Korea's Finance Ministry said on Wednesday.

Investors can kiss the Korean growth miracle goodbye for the foreseeable future.

The geopolitical dimensions could be just as ugly. Here is China's view of Korean reunification (via Wikipedia):

In 1984, the Beijing Review provided China's view on Korean unification: "With regard to the situation on the Korean peninsula, China's position is clear: it is squarely behind the proposal of the Democratic People's Republic of Korea for tripartite [between the two Koreas and the United States] talks to seek a peaceful and independent reunification of Korea in the form of a confederation, free from outside interference. China believes this is the surest way to reduce tension on the peninsula."

The Chinese strategic goal of opposing any foreign domination of the Korean peninsula, to prevent an attack on northeast China, resulted in intervention against America and South Korea in the Korean War as "self-defense." The reformist Chinese leader Deng Xiaoping was at times skeptical of Korean unification, remembering that after Vietnamese reunification, Vietnam sided with the Soviet Union in the Sino-Soviet split. However, China's support for North Korea, to prevent it from becoming too pro-Soviet, meant supporting their proposals for reunification, including Kim Il Sung's "Democratic Confederal Republic of Koryo" and Ten-Point Policy.

Translation: China would freak out if American troops were stationed in a bordering country. It would undoubtedly create fresh geopolitical tensions. Consider this account of the friction between a "friendly" China and North Korea, where North Korea referred to the tomb of a Korean king located in modern day China, with implications that it is Korean territory. Now imagine a reunified Korea and raise the level of tension by an order magnitude.

At this point, any speculation about possible coups and Korean reunification is just that, speculation about a low probability event. Nevertheless, investors should keep an eye on how the situation may develop, as it represents a level of tail-risk that's unlikely to be in too many analysts' spreadsheet models.

Meanwhile, despite talk about reunification, the news about the latest incident shows that the status quo remains unchanged.

Carry on, but be aware of the possibility of earth-shattering developments.

A Yom Kippur bottom? Or just more volatility?

Trend Model signal summary
Trend Model signal: Risk-off (downgrade)
Direction of last change: Negative

The actual historical (not back-tested) buy and sell signals of the Trend Model are shown in the chart below:

In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.


Was that the bottom?
Last weekend, I wrote that, based on my read of the technical tea leaves, the odds were favoring a "buy Yom Kippur" scenario over a deeper decline (see The Big Kahuna Korrection, or buy Yom Kippur?). Sure enough, the US equity market got oversold, sentiment appeared to get very bearish, as evidenced by the CNN Money Fear and Greed Index. Other market commentators, such Adam Johnson and Dwaine Van Vuuren, showed breadth and option sentiment such as the put-call ratio to be highly oversold and indicative of a short-term bottom. The market saw a bottom on Thursday, the start of Yom Kippur, and rallied hard in reaction to a better than expected Employment Report.

Start of a bounce or deeper correction?
Despite my tilt last weekend towards a tradable bottom in the week just past, I am not fully convinced that last Thursday was THE BOTTOM. First of all, the readings in the Fear and Greed Index seems to be all wrong (also see Tom Brakke`s quibbles about that index here). The index incorporates a number of sentiment and short-term technical indicators to arrive at a composite score.

Conceptually, I am having some trouble with the scaling. Is last week`s extreme reading, which is associated with a minor pullback of less than 5%, be truly comparable to the Eurozone Crisis of 2011 and Taper Tantrum of 2012, which were far more substantial corrections? While I am cognizant of the oversold nature of many breadth indicators,

While it is true that many market breadth indicators reached deeply oversold conditions last week, I believe that we have to put those readings into some perspective. The chart below shows the SPX in top panel, bullish point and figure % in the middle panel and % above 200 dma in the bottom panel for the last four years. While the two indicators reached levels that are consistent with market bottoms seen in the last two years, I would also point out that the stock market has more or less risen in a straight line with only minor pullbacks in the same period. Moreover, the SPX appears to have breached an uptrend line last week, which may foreshadow a deeper corrective period. The key question then becomes: "Is this the start of a bounce or a much deeper correction?"

Not enough fear?
Good practice in market analysis dictates that the analysts specify the buy and sell criteria beforehand, so that he is not moving the goal posts and winging his decisions. In that spirit, I go back to my trifecta of bottom calling indicators that I wrote about in the past (see A tradable bottom? and reiterated in The Big Kahuna Korrection, or buy Yom Kippur?). They consist of:

1. The combination of TRIN greater than 2 AND an inversion of the VIX term structure; and
2. An oversold condition in my favorite overbought-oversold indicator and it starts to mean revert back to a neutral reading.

As the chart below shows, past instances of this trifecta of conditions, which are marked by the dotted vertical lines, have yielded buy signals with a 100% success rate. Currently, we saw TRIN rise above 2, but the other two conditions, namely VIX term structure inversion and an oversold reading in the OBOS model were not achieved. To be sure, the absence of these conditions do not necessarily preclude a market bottom, but the success rate of such a call will be less favorable.

As well, readings from Investors Intelligence are not supportive of a capitulation bottom either. The chart below shows II Bulls in green, II Bears in red and the Bull-Bear ratio in purple at the bottom. In the past few weeks, the number of II bulls have been in retreat and such readings are not the characteristics of a sentiment washout indicating a crowded long.

As the market rallied on Friday, it seemed that market bulls were high-fiving each other everywhere. Josh Brown made the following observation:

Amidst the excitement of the day, I saw and heard a lot of people chirping about how the huge one-day rally was some sort of proof that all is well again. I don’t think most people realize that large one-day stock market gains are actually not typical of bull markets necessarily. The truth is that the typical bull market advance is more of an upward grind, not a string of explosive rally days. In fact, the data suggests that the largest one-day gains throughout history have actually occurred during downturns.

The data below comes from the Wall Street Journal. In it, you’ll note that almost all of these “great” days for the Dow occurred at the beginning, middle or end of a bear market or downtrend. Ten of these top twenty occurred in the teeth of the 2008 meltdown, as things had gotten temporarily oversold (on their way toward eventual lower prices):

The other thing is that huge one-day gains are typically clustered closely together with huge one-day losses. It’s rare to see one without the other. We certainly had these clustered together this time, as this past week featured one of the worst days of the decade.

I am watching to see if short-term trader sentiment turns bullish. In particular, I am watching the Ticker Sense blogger sentiment poll (I voted bearish) and the Bespoke sentiment poll to see if sentiment has turned sharply bullish. The preliminary indication from the Bespoke poll shows that sentiment has flipped bullish as when bears outnumbering bulls last week to a preponderance of bulls this week. Similarly, the Ticker Sense blogger poll showed an astounding reading of bears outnumbering bulls 59% to 18%. If these readings suddenly turn bullish, then it may be time to be skeptical about the longevity of the rebound.


Trend Model: Not out of the woods
In the meantime, my Trend Model reading has fallen from Neutral last week to Risk-Off this week as many of the model components have been deteriorating. As a reminder, the Trend Model applies trend following techniques to commodity prices and global equity prices to form a composite score.

Commodity prices continue to slide. More importantly, the cyclically sensitive industrial commodity complex remains in a downtrend. Much of the weakness in industrial commodities is reflective of slower growth in China.

Market sentiment on China seems to have turned from bullish to bearish in a relatively short time. The chart below shows the relative performance of the regional stock markets of the three main global engines of growth, the US (SPY), Eurozone FEZ) and Greater China (equal weighted China, FXI, Hong Kong, EWH, Taiwan, EWT, and South Korea EWY) relative to the MSCI All-Country World Index (ACWI). All returns are in USD so there are no currency effects. As the chart shows, Great China markets staged a relative rally but they are now faltering and remain in a long-term relative downtrend.

The above relative performance chart also shows that the Eurozone markets are now rolling over in relative performance while the US remains in a relative, though extended, uptrend.

I am finding that the absolute performance of European stock markets confirm the relative performance chart shown above. The STOXX 600 appears to be making a broad top by rolling over. The recent violation of the 200 day moving average is not a good sign for the European equity bull case.

In the face of mounting deflationary pressures, the ECB appears to be handcuffed in its efforts to implement a Quantitative Easing program to stimulate the eurozone economy (via The Telegraph):

European stocks have suffered the steepest one-day fall in 15 months after the European Central Bank retreated from pledges for a €1 trillion blitz of stimulus and failed to clarify the scale of quantitative easing.

The sell-off came amid a mounting political storm in Europe as leading German economists and jurists reacted with fury to the ECB’s first asset purchases, denouncing the move as monetary debauchery, and threatening a blizzard of lawsuits in the German courts. “Our worst fears are being fulfilled,” said Hans Werner Sinn, head of Germany’s IFO Institute...

Mario Draghi, the ECB’s president, seemed unable to secure backing for far-reaching measures from Germany’s two ECB members or from the German finance ministry, forcing him to play down earlier hints for a €1 trillion boost to the ECB’s balance sheet.

Bloomberg reported that in addition to German opposition, the ECB's QE program also faces opposition from France's Noyer,. Such indecision is serving to create further uncertain in Europe and headwinds for the global growth outlook.

In the US, the better than expected Employment Report was a welcome relief to the bull camp. However, the SPX remains in a minor downtrend and, despite Friday`s relief rally, has not overcome the technically important 50 day moving average.

As we approach Q3 Earning Season, Factset reports that profit warnings have been declining, which should be positive news (via Marketwatch):

However, I was surprised to see a poll (though unscientific) of mainly CFA charterholders showing that earnings expectations of beats are high compared to misses. This raises the bar for the reporting period and heightens the odds of disappointment:

Poll analysis
Entering the third-quarter earnings season, the world finds itself suffering high levels of uncertainty amid simmering geopolitical crises in Ukraine, the Middle East and Hong Kong. Further, many major economies, such as the EU, the U.S. and Japan, are seeing declining business and consumer confidence, as well as increasing income inequality. China too is seeing a slowdown in its residential housing. In other words, global corporate earnings have a backdrop of worry. Yet when we asked CFA Institute NewsBrief readers, 43% of respondents indicated they believe businesses will meet earnings expectations. For those thinking that profits will deviate from expectations, respondents believe corporations are likely to outperform those that underperform by 2.3 to 1 (40% : 17%). Investors are confident of a good earnings season, and perhaps the profit picture of global business will ameliorate some of the economic doubts. Yet even if businesses deliver, it seems that the corporate earnings season and its gyrations have diminished in importance since 2008-2009. Instead, the market drivers will most likely be interest rates and geopolitical predictions.

-- Jason A. Voss, CFA, Content Director, CFA Institute
Poll results are as of 3:30 p.m. EDT Thursday.

A neutral to negative global growth outlook
This chart from Schwab summarizes the global macro outlook as neutral to negative (h/t Jeff Miller at A Dash of Insight):

If your head is spinning, it’s not your fault. The world’s major economies have taken different paths and are headed in different directions as the third quarter comes to a close.

• The United States’ leadership has been reinforced by the sluggishness in most other major economies that is helping keep inflation, oil prices, and interest rates low.
• China’s solid start to the quarter deteriorated quickly. The most dramatic example was the 6.9% growth in industrial production in August, the worst reading since the financial crisis of five years ago.
• Japan’s economy suffered from the aftermath of the April tax hike. However, the economy showed some improvement during the quarter as the impact of the tax hikes began to fade and the aggressive economic stimulus supplied by the Bank of Japan was increasingly felt.
• Europe remains stuck in a negative spiral on the brink of the third recession in six years and is dangerously close to deflation with the year-over-year pace of inflation coming in at just 0.4% in August.

Markets tend to respond to how actual data compare to expectations, rather than whether that data is strong or weak in an absolute sense. For example, even a weak data point may inspire a lift to stocks if it was better than generally expected. The chart below depicts how actual data has been faring relative to expectations over the past three months and in what direction the data is trending relative to those expectations for the world’s major economies.

Major economies on different paths

Note that in the above chart, the US is the only global region whose growth path is above Street expectations, but it is weakening and has moved from a position of accelerating growth to neutral.

To underline the weakness observed by the Trend Model, analysis from GaveKal showed that a significant deterioration in the global Advance-Decline ratio, which cannot be viewed as bullish for the global equity outlook:

A recipe for more volatility
Putting it all together, current conditions suggest a volatile period for equities with a somewhat bearish bias. Sam Stovall analyzed historical SPX monthly seasonality and found that the October and, indeed, Q4 had a bullish bias. But there is a catch - October turned out to be a very volatile month.

It's not just equity volatility is likely to rise, Analysis from Thomson-Reuters indicates that currency volatility has spiked as well.

Given the current environment, increased volatility appears to be a reasonable bet.

My inner trade remains bearishly positioned, with tight stops. I could be wrong on my tactical market call and this could turn out to be a short-term market bottom, but that's why risk control is important at times like this.

My inner investor is cautiously looking to dial back some risk by raising cash in rallies, but he is not in panic mode as the current episode is, at worst, likely to be a relatively minor correction.


Disclosure: Long SPXU, TZA

Trend Model September report: 1 year +40.1%

I have been writing about a long-short account based on my Trend Model signals for several months now (see An intriguing Trend Model interim report card) and I finally have a one-year track record for that investment account, whose inception date was September 30, 2013 (though the history of actual model signals goes back considerably further).

I am pleased to report that the one-year return for the Trend Model account was 40.1%.

I reiterate my disclaimer that I have nothing to sell anyone at this time. I am not currently in a position to manage anyone`s money based on the investment strategy that I am about to describe. However, I have had preliminary discussions with interested parties about featuring the Trend Model as part of an advisory service. I may canvass for expressions of interest of such a service through this blog. Please stay tuned!


Trend Model description
For readers who are unfamiliar with my Trend Model, it is a market timing, or asset allocation, model which uses trend following techniques as applied to commodity and global stock market prices to generates a composite Risk-On/Risk-Off signal (risk-on, risk-off or neutral). I have begun updating readers on the Trend Model signals on a weekly basis (for the last comment, see The Big Kahuna Korrection, or buy Yom Kippur) and via Twitter (@humblestudent) as new developments occur.

The chart below shows the actual (not back-tested) changes in the direction of the signal, which are indicated by the arrows, overlaid on top of a chart of the SP 500. You can think of the blue up arrows, which occurred when the trend signal changed from negative to positive, as buy signals and the red down arrows, which occurred when the trend signal changed from positive to negative, as sell signals.

Trend Model Signal History

A proof of concept
While the results from the above chart representing paper trading is always interesting, there is no substitute for actual performance. As a proof of concept, I started to manage a small (about 100K) account that traded long, inverse and leveraged ETFs on the major US market averages and, on occasion, sector and industry ETFs. Trading decisions were based on Trend Model signals combined with some short-term sentiment indicators. The inception date of the account was September 30, 2013 and the chart below represents an interim report card of that account.

When evaluating the performance of this trading account, keep in mind that this is intended to be an absolute return vehicle. While I do show the SPY total return, which includes re-invested dividends, for illustrative purposes, the SP 500 is not an appropriate benchmark for measuring the performance of this modeling technique.


September: 6.7%, YTD: 25.1%, 1 year: 40.1%
We saw another solid result in September as the account was up 6.7%, during a period when SPY dropped by -1.3% on a total return basis.  The account was up 25.1% YTD and 40.1% for one year, or from inception. However, I would also like to point out that turnover averaged about 190% per month, so this strategy is not for everyone, especially the faint of heart.

In line with the results for the last few months, the results continue to be promising:

• Returns are strong and the Trend Model is performing as expected.
• Returns are highly diversifying compared to major asset classes. They are uncorrelated with equities (correlation of -0.18 with SPY) and bonds (-0.28 with AGG).

Still not ready for primetime

While these results are promising, I consider the Trend Model to be untested by stressful markets. I continue to be concerned about how the Trend Model would behave at major market turning points. In the past year, equities have more or less been rising steadily without a correction of 10% and pullbacks have mostly been short and shallow. While account performance has been admirable during these minor market hiccups, the biggest test for the Trend Model is how it performs during the volatility seen in major corrections. In particular, how will the Trend Model navigate the initial downturn, the volatility of the bottoming period and the subsequent rally?

My concern is based on a feature of the underlying design principles of the Trend Model, whose buy and sell decisions are based on the application of trend following models to commodity and global equity prices, supplemented by some shorter term sentiment indicators. Trend following models suffer from a well-known problem as they are subject to whipsaw in sideways trend-less markets. While the addition of the short term sentiment models mitigate those effects, they do not entirely eliminate them.

To illustrate my point, the chart of the actual historical signals of the Trend Model shows a number of episodes when returns were negatively affected by whipsaw, which last occurred in Q1 2014:

Trend Model Signal History

As the above chart also shows, the stock market has been rising more or less at a steady rate since late 2012. The key test of the Trend Model will occur when it is faced with choppier markets such as the ones seen during the 2010-2012 period (though the above chart of actual model signals does show promising results for 2011 and 2012).

If the current bout of stock market weakness does turn into a more sustained downdraft, we may see a more meaningful stress test of this model.


Limiting losses, but allowing winners to run?
Notwithstanding these concerns, I continue to find these results promising as the Trend Model may be showing the desirable highly characteristic of being able to limit losses but allowing winners to run.

The chart below shows a histogram of the distribution of the monthly returns of the Trend Model account. While the sample size is still quite small (n=12) and therefore the conclusions highly conjectural, the distribution of returns is intriguing.

To explain, the x-axis of the chart shows the monthly returns of the account, while the y-axis shows the number of times, or frequency, of the monthly returns during the test period. As with most financially based returns, you would expect a bell-shaped Gaussian return distribution, which I have sketched out in black. The anomaly to the chart is the relatively high count of negative returns at about the -2% level, but note the zero frequency to the left indicating that there were no large monthly draw-downs. My preliminary (and highly conjectural) conclusion is that this return distribution shows the Trend Model is able to limit monthly losses while allowing winners to run (on the right of the chart).

One possible problem with that conclusion is that the occasions when the negative returns occurred were consecutive, which resulted in a total draw-down of roughly 7%. that occurred in the whipsaw period that I described before in Q1 2014 If the three draw-down months were to be compressed together into a single month, the chart would then look like the one below, which incidentally preserves the bell-shaped Gaussian distribution of the chart.

These results are highly preliminary as the data is limited, but the results remain intriguing. I will be monitoring and reporting on them in the months to come.

Readers who want to monitor the signals of the Trend Model to subscribe to my blog posts here, which include Trend Model updates, or follow me via Twitter @humblestudent.

Can the public be apathetic AND be all-in on stocks?

I recently highlighted some figures indicating that the US public was at or near a crowded long in equities (see 3 reasons to get more cautious on stocks). Here is the chart from Lance Roberts showing AAII equity allocations at levels roughly equal the pre-2008 top and cash levels at low extremes roughly equal to the pre-Lehman Crisis lows.

As well, there was the chart from Dana Lyons indicating a similar crowded long reading in US equities:

An apathetic public?
By contrast, Russ Koesterich of The BlackRock Blog told a story of Americans who are afraid of the stock market (via Business Insider):

During the bull market of the last five years, U.S. stocks, as measured by the SP 500, have generated total returns of 233%. So, you would think most investors would be embracing equities.

But while stocks represent a larger share of household financial assets than they did five years ago, the share of U.S. adults who own stocks remains stuck at multi-year lows.

Share of US households holding stocks

As well, Josh Brown recently wrote a post entitled How can you have euphoria when nobody gives a sh*t? Unlike the Tech Bubble of the late 1990`s when everyone was partying like Qualcom would go up 1000% a year, Brown cited a Gallup poll indicating that only 7% of Americans knew that the stock market was up 30% last year:

This week we learned that only 7% – SEVEN PERCENT – of Americans are aware that the US stock market went up by 30% last year.

This is quite a mania – a mania of apathy.

Subsequent to that post, Brown tweeted the following contradictory message:

An apparent contradiction

How can both sets of analysis be true? Can individual investors BOTH be in a crowded long AND be afraid and apathetic about the stock market?

The superficial explanation is that while individual investors are long equities, they remain jittery and are quick to bail whenever risk aversion rises. That`s why we have seen frequent short but shallow pullbacks marked by spikes in fear.

I came up with a better explanation once I started to dive into the data. In effect, both assertions are true. The average American remains apathetic and unaware of the bull market while fully invested. That`s because surveys like Gallup are equal weighted, that is to say they survey all Americans, while surveys like the AAII Asset Allocation Survey is more tilted towards a population who matter - those with money.

The Federal Reserve Survey of Consumer Finances is very revealing in that respect. Koesterich pointed out that US household holdings of equities have hardly budged since the Great Financial Crisis, I will use the period from 2007 to the present as my framework for analysis.

The chart below expands on the chart shown by Koesterich above by breaking down the Percent of families with stock holdings by income groupings. For the period from 2007 to 2013, only the top 10% of households saw holdings rise, while all other groups saw their holdings fall. Since outfits like AAII measure overall equity allocations and it's the 10% that have most of the stock holdings, it is no surprise that we see weighted equity holdings rise.

The above chart shows the percentage of households with stock holdings. The chart below shows the median value of stock holdings for households that reported non-zero holdings by income group. First of all, note the disparity in the magnitude of holdings. The value of the holdings of the top 10% group dwarves all other groups, including the next 10% by income.

Since the vertical scale of the above table is a little hard to read as you go down the income group, here is the same data in table form. From 2007 to 2013, only the top decile and the second quartile of households that reported stock holdings saw their median portfolio value increase. Given the pattern shown by the other charts and tables, the gain by the second quartile is likely a statistical anomaly.

Since:

• The top 10% have most of the money;
• Surveys like the AAII Asset Allocation Survey focuses on the people with the money; and
• The bottom 90% appeared to have lost ground in their equity portfolio holdings since 2007

To summarize, this chart from the Fed, which is weighted by dollar invested and not equal weighted by population, tells the story:

My conclusion is the people who matter, i.e. those with the money, are fully invested in equities. By contrast, those who don't have any money are either apathetic or possibly afraid of stocks. There may be further room for more increased public participation by other 90% as the economic recovery strengthens, but that would be a long-shot scenario.

Could public participation widen?

Consider the long-term trend in income gains. Neil Irwin, writing in the New York Times, pointed out that the trend has been that income gains have accrued more and more to the top 10%:

In fact, most of the income gains have gone to the top 1%:

This post is not intended to be a discussion about inequality or fairness of how the pie is sliced up. However, given the trends in the post-war era, and the fact that the richest segment of America are already fully invested in equities, do you really want to bet on widening public participation as incremental demand to drive equity prices higher from here?