In praise of human, over machine intelligence

The late Milton Friedman was famous for his quip that monetary policy should be run by a computer. It was likely with Friedman's views in mind that Republican legislators challenged Janet Yellen to conduct monetary policy using a preset formula, which she resisted (according to this WSJ report):

Ms. Yellen, responding to some of the toughest questioning she has faced on Capitol Hill since becoming the Fed's leader in February, said provisions in a recently introduced House bill would lead to greater political meddling in the Fed's affairs, curtailing its independence and constraining the ability of policy makers to manage crises.

"It would be a grave mistake for the Fed to commit to conduct monetary policy according to a mathematical rule," Ms. Yellen told the House Financial Services Committee on Wednesday, amplifying her message in testimony to the Senate Banking Committee a day earlier.

The House bill would require the Fed to adopt a mathematical formula for determining the appropriate level for its benchmark short-term interest rate, which influences other borrowing costs across the economy. The bill's proponents cite as an example the so-called Taylor rule, devised by Stanford University economics professor John Taylor, which calculates the ideal level of the rate based on changes in several economic variables.

What's better? A rules based approach or a discretionary one? The debate rages on:

Economists have been debating for years the relative merits of basing interest rate policy on rules versus discretion—that is, whether they should adhere to a mathematical formula or maintain some flexibility to respond based on circumstances and judgment. Mr. Taylor and some Fed officials are in the first camp, saying rules-based policy-making creates more predictability and transparency, leading to better economic outcomes. Ms. Yellen and other Fed officials are in the latter camp. She said Wednesday that the recent recession would have been deeper if the Fed had stuck closely to the Taylor rule.

The trouble with robots
I have long been an advocate of an intelligent application of rules. That's why I describe myself as a "left and right brained modeler of quantitative systems" in my LinkedIn profile. I don't agree with Yellen on a number of issues (more in a future post), but human intelligence is far more flexible than rules-based machine intelligence and you need human oversight over machine intelligence.

While rules-based quantitative systems can be great, they have their limitations. They do exactly what you tell them to do, but at the same time they can be very stupid.

Consider this Kenny Polcari CNBC commentary of what happened on Thursday when news of the downing of MH17, followed by the Israeli invasion of Gaza. The first selling wave came in the wake of the MH17 tragedy and the selling appeared to have caused by trading algos:

The first "sell" reaction was actually created by algorithms. The speed at which the market took the hit indicates that the order flow was generated and then delivered — or really sprayed out — across the 70+ venues that exist in current market structure by high-speed algorithms designed to react to words in a headline.

Recall the "hacked Associated Press" Tweet last summer —"Breaking: Two Explosions in the White House and Barack Obama is injured" — this caused a swift 200-point selloff that quickly reversed itself when the AP announced that they were hacked and it was a false headline. The speed at which the market sold off and then re-balanced is only possible with the help of high-speed automated order generation and delivery.

So yesterday's headlines to the effect of "Malaysian Airliner Shot Out of the Sky" or "Russian Forces Down Malaysian Air Passenger Flight 17" clearly weren't positive and triggered the high-speed algorithms to have a field day.

News of the Israeli incursion caused the next wave of selling:

Then came the news that Israel had begun the invasion of Gaza as a result of Hamas not respecting the temporary ceasefire. Once again, the computers kicked in, causing the market to immediately plunge 50 more points in their "take no prisoner" style, taking the Dow down 125 points as traders and investors assessed the new news.

We built the technology to quickly profit on news and it`s causing unexpected adverse effects:
Technology today allows for a computer with artificial intelligence to make a determination as to the meaning of the headline and then shoot first, ask second. This is the state of affairs for the U.S. capital markets thanks to the Internet, the social media, and the need to know.

As a result, we see the markets get whipped around on just the headline alone, and then once the human being gets to read and digest the news, the move is either confirmed or not. So, did traders believe in the end that this was an act of terrorism or an act of stupidity? The jury says: stupidity.

The next day, the market recovered all of the losses from the previous day. As for the previous day's volatility? Oh, well. Life goes on.


How bad paperwork becomes a sex crime
Rules-based systems, however intelligently designed, can go horribly wrong. Consider this account of how someone became a sex offender at the age of 12 because he played ”doctor” with his 8 year old sister:

Josh became a sex offender at age 12. That's when he touched his sister's vagina, twice. His sister told their mom, Josh said it was true (he was too embarrassed at the time to mention that he himself had been raped as a young boy by three local high school kids), and their mom called a counseling service for advice. The counsellor said Josh's mother was required to report his crime to the authorities and the next day, he was arrested.

He spent the next four years in juvenile prison: the Texas Youth Commission, as it is officially called.

The charge was “aggravated sexual assault,” because any sex offense against a person under age 14 is automatically “aggravated.” He got out at age 16 and was put on the sex offender registry, which, in Dallas, requires him to report in person to the authorities once a year, as well as anytime anything in his life changes.

Here is the story of he became a re-offender at the age of 27:

Today he is 27, married with children, and smiley. We met up, had a jolly breakfast (except for the fact he said he felt too pudgy to start a speaking tour), and then we went off to the registry, because his family had just moved to a new house and he had to let the state know no more than seven days after the move.

Just as the detective in the nondescript office finished typing this information into the system and Josh and I were about to go to lunch, a man with a beard and a badge strode up and said, “Joshua Gravens?”

“Yes.”

“You are under arrest for not alerting the authorities to your new address.” He whipped out handcuffs. “Put your hands behind your back.”

As the man tightened the cuffs, Josh calmly explained he was registering his new address that very minute.

“The law says you you have to register the fact you are going to move seven days before the move, too.”

“I think you're mistaken,” said Josh, as pleasantly as if discussing the weather.

“I was told to arrest you,” was the reply, and that was that. Josh handed me his car keys and followed the man out to his van along with a handcuffed woman who was crying. She was going to jail for having listed her address as a hotel when she actually lives in her car in front of the hotel.

(This statute suggests that the officer was correct: Registrants must report their intention to change addresses seven days before actually moving, according to the statute.)

Under such circumstances, Josh would be charged with a sex crime and the penalties can be severe:

“I might be mistaken,” said Jon Cordeiro, a sex offender registrant and director of a Fort Worth re-entry program for offenders, “but technically he has broken the law and failure to comply with the registry laws is considered a new sexual offense.”

A sexual offense?

Yes. Any registering snafu is considered a sex crime, and depending on the judge, it can be punished as harshly as the original offense. In other words: Josh, at 27, will be treated as if he just touched an 8 year old's vagina again.

“Typically, there's a mandatory minimum of two to five years,” said Cordeiro.

“In Arkansas, he'd be looking at six,” said another attendee.

I recognize that there are elements who want greater control over the Fed, but after hearing these snafus about how rules-based systems work, do we really want a robot to manage monetary policy?

Corporations are people too, only better

Scott Grannis wrote a post in defense of tax inversions. In it, he quotes a WSJ Op-Ed by Miles D. White about how the maneuver is legal and the absurdity of the US tax code that taxes corporations on their worldwide income:

The U.S. is among only a handful of countries, and the only one in the Group of Seven, that taxes companies on world-wide earnings rather than the earnings in their home domiciles. It's a double whammy: the highest rate, by far, and it's applied worldwide.

While I agree that this aspect of the tax code is an anomaly, I would point out that the United States taxes people (natural persons) on the basis of citizenship. In fact, if a US citizen were to live in an another country, he is liable for US taxes. On top of that, he has to declare his foreign holdings under FATCA under the pain of extensive penalties.

For example, if your Irish grandmother died and left you a modest inheritance in trust for you when you were 14 (recall that Ireland is a popular location for tax inversions). You forgot to tell the IRS about the trust for ten years (who thinks about those things when they are 14?), the back taxes and penalties could very well be higher than the value of the inheritance itself.

To return to the issue of tax inversions, why should corporations be taxed any differently than ordinary American citizens? Are they somehow better?

Is the MH17 sell-off a gift to the bulls?

When I wrote that the US stock market was vulnerable to a pullback (see A short-term negative divergence), I never dreamed that it would be a geopolitical tragedy that would cause the sort of risk-off response that we are seeing.

The news of the crash of MH17, which was apparently shot down by a missile, caused a market freak-out and risk premiums to spike. Unverified reports of intercepted phone calls and that a pro-Russian rebel commander took credit for downing the aircraft (before he knew it was a civilian airliner) didn't help matters. Further, news of an Israeli invasion of Gaza is underway also served to heighten global geopolitical tensions.


Spiking fear = Buy signal
As a result, VIX spike 3.54, or 34%, in a single day. Moreover, the VIX to VXV ratio, which is a measure of the term structure of VIX, moved from a normally upward sloping term structure to inversion indicating a spike in fear levels. As the bottom panel of the chart below shows, the VIX-VXV term structure soared well above 1. I have also indicated with vertical lines past instances where the term structure inverted. With the exception of episodes in 2008, 2009 (Lehman Crisis) and 2011 (eurozone crisis and US budget impasse), past instances of VIX inversion have marked low-risk entry points into stocks.

A modern Archduke Ferdinand moment?
I would caution, however, that Ian Bremmer of the Eurasia Group indicated that the MH17 incident could prove to be a spark for further escalation on both sides of the simmering Russia-Ukraine dispute (via Business Insider):

• Ukraine's new government, led by President Petro Poroshenko, will feel more intensified pressure to conduct military operations to push back pro-Russian separatists in southeastern regions of Ukraine.

• More countries could get involved, and in a broader scope. There could be a new push by the Ukrainian government to get military support from the U.S., which has so far resisted, as well as more nonmilitary aid from the European Union.

• During the months-long conflict, Russia has long asserted its right to intervene on behalf of Russian-speaking citizens. The Pentagon said Wednesday that Russia was again building up its forces along the volatile Russia-Ukraine border.

"Ukrainian government now under much more pressure to remove the separatists by force. There's a better chance that they secure meaningful military support (including weapons) from the U.S. and nonmilitary from the EU," Bremmer wrote in an email to BI.

"But the Russians will deny any involvement and demand protection of the Russians on the ground. Likelihood of escalation has just increased significantly."

There are two scenarios at play here:

1. These tensions will blow over in a few days and this market freak-out will be a gift for market bulls to buy stocks at a discount.
2. This incident turns out to be a modern "Archduke Ferdinand in Sarajevo" moment for the relationships between Russia and the West.

Now ask yourself::

• Which scenario is more likely? 
• Is the market pricing risk correctly?

Correction: The VIX curve did not invert, though it did get close to inverting. The apparent inversion shown is the result of a bad data feed. I apologize for the error and any inconvenience caused.

A short-term negative divergence

This is a quick short-term note for swing traders and not addressed to intermediate or long-term investors. I took a look at the NYSE McClellan Oscillator (in black) after the close today and I was surprised to see how weak the reading was:

Such weak breadth readings are more consistent with markets that are pulling back, not with a market that came within a few points of all-time highs today. As well, when I analyze the absolute levels of the McClellan Oscillator over the last two years, these levels are more typical of the bottom of minor corrective periods (shown as vertical lines) or the start of a minor pullback.

Given these kinds of negative divergences, the weight of the evidence suggests that US equity markets are likely to see a minor (1-2%) pullback in the next week or so. Nevertheless, I remain bullish on an intermediate term basis (see my recent post The good stock market mania).

My family history as a lesson in long-term return expectations

Occasionally, I come across charts like these of long-term asset returns - and they drive me crazy because of the lapses made in the underlying assumptions.

I`ve written about this before and the problem is survivorship bias (see What actually happens in the long run). This chart of equity returns likely referred to US equities, but that`s really a form of cherry picking the successful markets.

Consider that a little over 100 years ago, the Archduke Ferdinand, heir to the Austro-Hungarian throne, was assassinated in Sarajevo and that event sparked the First World War Great War. At that time, the major powers and markets of the world were: Britain, France, Germany, Austria-Hungary and Russia. Smaller developed powers included Italy and the Ottoman Empire, or Turkey. How would you have performed if you had bought into a diversified portfolio of these "developed markets" and held your positions over the last 100 years? Would the results have in any way resembled the chart above?

What about emerging markets? At the time, the major EM markets consisted of the US, Canada, Argentina and Japan. What would have that kind of diversification bought you?


Risk of war and confiscation
What people seem to forget is one long-term risk of investment is the risk of the permanent loss of capital from war and confiscation. The story of my own family is a vivid illustration of that point.

My father`s family is ethnic Chinese from Vietnam. My great-grandfather, the Old Man, made his fortune when he went to Vietnam as a penniless immigrant from China. Over time, the family became one of the more prominent Chinese families in Vietnam and owned about one-quarter of the property in Saigon Ho Chi Minh City. Indeed, a visitor to HCM City today can visit the old family compound and still see the family crest on the gates around the compound, which occupied a city block and is roughly the size and equivalent location of Rockefeller Plaza in Manhattan. In the our heyday, the family name would have been as recognizable as a Rockefeller or duPont.

Not that I am complaining, but I hardly had an upbringing that was equivalent to one of the Rich Kids of Instagram. That`s because the vast majority of family wealth vanished because we fell victim to the risk of war and confiscation.


Imagine a diversified portfolio...
Going back 100 years, consider how a diversified balanced portfolio of stocks and bonds invested in then blue-chip "developed markets" might have performed, either on a capitalization or equal-weighted basis. The only one that survived relatively intact was the UK. The others, France, Germany, Austria-Hungary (yes, remember them?), Russia suffered tremendous hardship, *ahem* involuntary changes in governments and capital destruction.

So whenever someone shows me a chart of long-term equity returns and tries to use those figures as their assumption to calculate either equity return assumptions or the equity risk premium, I shake my head.

The moral of this story is: When you build models, you have to think hard about your assumptions. Don`t get blinded by either cultural or survivorship biases.

The "good" stock market mania

Recently, there have been a number of bearish warnings about the equity markets. No doubt there have been signs of froth, but how much frothier can the stock market get? Cutting to the chase, my conclusion is we are seeing the initial stages of a stock market mania and that it will have a lot longer to run. Just as my former colleague Walter Murphy termed "good overbought" to describe overbought conditions in an uptrend, I believe that we are seeing the start of a "good" stock market mania.

But first, let me detail some of the concerns about stock prices.


Long-term valuation warnings
Long-term valuations issues remain front and center. Mark Hulbert echoed many of the problems I raised about US equity valuations as I cited that market PE, PB and dividend yields are elevated (see More evidence of a low return equity environment). Hulbert also highlighted the high levels of other long-term valuation ratios such as CAPE and Q-ratio to make the point that 10-year returns are likely to be disappointing.

I agree with the general conclusion that long-term equity returns are likely to be muted, but does this necessarily mean that stocks go down right away (see "Ending in tears" doesn't mean the market goes down right away). The question is, what is the intermediate term outlook?


Intermediate term red flags
Recently, Mark Hulbert also highlighted some warnings about the intermediate term outlook as well. He cited declining share buybacks and companies using their "expensive" paper to fund acquisitions as signs that the current bull is maturing:

New stock buybacks fell to $23.2 billion in June, the lowest level in a year and a half, according to fund tracker TrimTabs Investment Research. In May, the total was just $24.8 billion, and the monthly average in 2013 was $56 billion.

That’s worrisome, according to TrimTabs CEO David Santschi, because “buyback volume has a high positive correlation with stock prices.”

Corporations recognize that their stock is expensive and, in aggregate, starting to fund acquisitions with their own paper instead of cash, another worrisome sign:

Hedge-fund manager Douglas Kass, president of Seabreeze Partners Management, relates the slowdown in buybacks to the recent M+A wave. He says that both activities represent the implicit recognition by corporate managements that their internal operations are unable to produce sufficient revenue growth to maintain their stock prices.

Over the past five years, for example, per-share sales growth for S+P 500 companies has been an annualized 2.4%, lagging far behind the 20% annualized earnings per share growth rate. One of the ways in which corporate managers have been able to extract that much EPS growth out of such anemic sales growth, Kass argues, is through share repurchases.

As their share prices become more and more inflated, however, corporate managers become increasingly reluctant to buy them. The logical thing to do instead is buy up other companies, paying with shares of their inflated stock.

That’s what is happening now, Kass argues: “There’s a baton exchange from buybacks into M+A activity.”

Regular readers will recognize that I highlighted similar concerns about the combination of falling buyback plans and falling operating margins (see "Ending in tears" doesn't mean the market goes down right away). I am carefully watching the report cards and forward guidance from the current Earnings Season for signs of EPS growth weakness.


CYNK a sign of froth
In the very short term, the poster boy for froth has to be the moonshot-like rise of CYNK, a company with no revenues and one employee, which was then suspended and investigated by the SEC for possible manipulation.

Too early to panic
Is this time to sell everything and go to cash? I think that David Merkel had the right perspective when he described the credit cycle in the following fashion:

The credit cycle tends to be like this: in the bull phase, a long period (4-7 years) with few defaults and low loss severity followed by a bear phase, a shorter period (1-3 years) with high defaults and high loss severity. This is a phenomenon where history may not repeat exactly, but it will rhyme very well.

In the bull phase of the credit cycle there are a few defaults, but when you analyze the defaults, they occur for reasons unrelated to the economy as a whole. What do the failures look like? Fraud (think Enron), bad business plans from a megalomanic (think Reliance Insurance, ACH, Southmark, etc.) , a sudden shift in relative prices (think Energy Future Holdings), etc. Bad banking — think Continental Illinois in 1984.

In the bull phase, companies that fail would fail in any environment. But now let’s talk about the transition between the bull and bear phase — that is the “pop, Pop, POP.”

As the credit cycle shifts, a few companies fail that are closely related to the crisis that will come. They are your early warning. Think of the subprime lenders under stress in 2007, or the failure of Bear Stearns in early 2008. Think of LTCM in 1998, or the life insurers that came under stress for writing too many GICs [Guaranteed Investment Contracts] in the late 80s and invested the money in commercial mortgages.

As the cycle moves on defaults become more closely related to the financial economy as a whole. Fed policy is tight, and a bunch of things blow up that borrowed too much money short term. This is when the correlated failures happen.

Right now, Merkel believes that we are starting to see the first "pop" (emphasis added):

The present is always confusing. I get it right more often than most, but not by a large margin. We have companies threatening to fail in China and Portugal, but I don’t see much systemic lending risk in the US yet, aside from what is leftover from the last crisis.

It is worth noting that deleveraging has occurred more in word than in deed over the last five years. Yes, debt has traveled from public to private hands, but that only defers the problems, as governments will either have to inflate, tax more, or default to deal with the additional debts.

I am not trying to sound the alarm here. I am trying to tell you to be ready. During the intermediate phase between bull and bear, the weakest companies fail from unrecognized systemic risk. Personally, I think I have heard the first ‘pop.” It is coming from nations that did not delever, and that may suffer further if the bad debts overwhelm the banking systems.

His advice is to be careful, but it's too early to dive into the foxhole:

Are you ready for the bear phase of the credit cycle? Screen your portfolios, and look for weak names that will not survive a general panic where only the best names can get credit.

I would tend to agree. The kinds of excesses that we are seeing are starting to get worrisome, but they are a natural part of the expansion, where caution gives way to exuberance. I can recall that in the late 1990`s, one of the greatest value of Deutsche Telekom was its valuation and the ability of that company to use its stock for acquisitions. Those excesses did not mark the top of the cycle, but those signs of froth lasted for a couple of years before the market collapsed.


A mania is developing
All of these issues that have been raised - excessive valuation, companies using overvalued paper to fund acquisitions, the kinds of CYNK silliness that show up on occasion are part of a developing mania for risk (see this commentary from Matt Levine about what the more likely story on CYNK was). For this stock market to truly top out, you have to wait for excesses to really, really get out of hand. We are nowhere at that point of the market cycle yet.

One of signs of a top is the irrational exuberance exhibited by the retail investor. Public (retail) participation is still relatively low and individual investors remain cautious. This chart from Patrick O'Shaughnessy shows that the individual retail investor starting to tiptoe back into equity mutual funds after the devastating sell-off in the wake of the Lehman Crisis, but sentiment can hardly be described at extreme levels.

No doubt, I will get emails and comments about the elevated readings from Investors Intelligence, etc. I would note that II polls are opinion polls, which ask newsletter writers their opinions, while hard numbers like mutual fund flows show what people are actually doing with their money. The chart below shows the SPX on the top panel and the II Bull-Bear ratio on the bottom. The vertical lines show the instances where the bull-bear ratio has risen above 3, indicating a crowded long. As the chart shows, while this indicator has shown some value, it has also flashed too many false positives to be useful as an effective market timing tool.

Remember - opinions can change on a dime, but asset allocations generally do not. Actions speak louder than words when it comes to sentiment analysis.

Indeed, the AAII weekly sentiment poll paints a picture of a highly jittery public. While the bull and bear sentiment readings have been volatile, they have been relatively low compared to the level of neutral (read: unsure) opinions, which indicate a high level of uncertainty. This comment from Bespoke hit the mark on the issue of public sentiment (emphasis added):

While bullish sentiment only saw a small decline, bearish sentiment spiked to 28.65% from 22.39%. This was the largest one week increase since April 10th. This week's trend in bullish and bearish sentiment readings is a continuation of the trend that has been in place for much of this bull market. Individual investors are slow to embrace the bull, but at the first signs of trouble are quick to exit.

By contrast, the TD-Ameritrade IMX Index, which tracks what TD-Ameritrade customers are actually doing with their money, shows that even as the stock markets advanced to new highs, individual investors have stayed cautious and been slow to embrace the bull:

Funds flow positive
For now, my inner trader remain cautiously bullish. For some time, I have relied on a funds flow model based on this study of skew analysis. The funds flow model measures the skew of the relative returns of equities (SPY) compared to long Treasuries (TLT) and sees what the shape of the distribution looks like.

If the distribution is symmetric (top chart), then funds flows are normal. If it is skewed to the left or right, it would indicate either significant flows into either stocks (risk-on) or bonds (risk-off). Late last week, it flipped bullish indicating funds flow into risky assets. This model does not identify the source of the flows, whether it is retail, institutional or fast money (hedge funds), only that there are significant flows.

The chart below shows the funds flow model signals in the last three years. Buy signals are marked by blue arrows and sell signals are marked by red arrows. The circles indicate a return to a neutral condition, which would indicate a move to cash signal. Overall, it appears that buy signals have performed better than sell signals:

Funds Flow Model signal history

Key risk: EPS growth scare
In conclusion, the weight of the evidence suggests that intermediate path of least resistance for stock prices is still up. My inner investor is getting somewhat cautious, but he remains long the market. My inner trader believes that the party thrown by the Fed and ECB is just getting going and he is fully enjoying himself.

While these conditions suggest that a major bear market is nowhere close to starting, it does not mean that stock prices cannot correct. The one key risk and weak link to the current bull phase is the EPS growth outlook. Analysis from Ed Yardeni shows that Street consensus estimates are still rising, which indicates an equity friendly environment.

However, more recent data from Brian Gilmartin shows that forward EPS growth estimates slipped this week and this is the second week of decelerating growth (emphasis added):

The year-over-year growth rate on the SP 500 slipped to 8.51% from last week’s 8.66%. The y/y growth rate of the forward estimate is still at the higher end of its recent range, and the highest y/y growth rate since 2012.

Recently, I also outlined my concerns that the combination of falling profitability, which affects the numerator in EPS, and declining share buyback plans, which affect the denominator in EPS, are top-down warnings that EPS growth may stall out (see "Ending in tears" doesn't mean the market goes down right away). That's why I believe that the reports from this Earnings Season is so critical to the short-term equity market outlook as these series of earnings reports will serve as a bottom-up verification of that top-down analysis. That's why the earnings reports will bear watching very carefully.

For now, my inner trader is giving the bull case the benefit of the doubt, but he is keeping his stops tight in case we see a series of negative EPS disappointments and guidance.

The end of an era (and the start of a new one)

Last week, I was catching up and making my farewells to a number of my friends and former colleagues from Batterymarch. The announcement had come in May, as per this Bloomberg story:

Legg Mason Inc. (LM) is firing 62 Batterymarch Financial Management employees as it combines the affiliate with QS Investors, the global quantitative equity firm it’s purchasing this year.

The employees will depart beginning in July, and 12 will join QS Investors, spokeswoman Mary Athridge said in an e-mail. The Baltimore, Maryland-based money manager sent a letter to the state of Massachusetts providing notice under the Worker Adjustment and Retraining Notification Act, she said.

I had spent 10 years of my professional life at Batterymarch and I can say without reservation that it was an truly innovative and pioneering firm. This Pensions + Investments article summed up the history of the firm, co-founded by Dean LeBaron, best with this quote from Larry Speidell:

“Dean was always looking for the next idea. He was really obsessed with doing things differently,” Mr. Speidell said. “When index funds reached their general popularity, Dean abandoned them. When he felt that markets were more efficient, he developed an international strategy.”

Mr. LeBaron himself said: “I would prefer to be first than best.

“First was easier to select. We were always looking to fill that unfilled niche.”

“Batterymarch was a pioneering firm in the quant era,” said Michael J. Clowes, retired editor of P+I and now editor at large. “It's unfortunate that it'll be no more. It's a part of history.”

During the early 70's, when most equity investors were fundamental stock pickers, Batterymarch was a pioneer in indexing. In the late 70's, when the custodian banks moved into the investing business in a serious way, Batterymarch was an innovator into quantitative equity management, first in the US and later internationally. Back then, whoever dreamed of using quantitative techniques in strange places like *gasp* Japan??? In the mid-1980`s, Batterymarch was the first institutional investor in Latin America - and that effort branched out into other emerging markets.

I joined the Batterymarch organization in Toronto in 1990, as part of the effort to bring quantitative equity management to Canada. Later, I moved to Boston to be a PM as part of the international equity team, though I did work on both US and emerging market groups during my tenure. It was a heady time for a thirtysomething portfolio manager who was just learning the business. The experience was like stepping from the minors to the major league.

Batterymarch had a very flat organizational structure and therefore I was lucky to have had the opportunity to learn about many aspects of the investment business that many of my peers may not have been exposed to in a lifetime, from building quantitative stock selection models, to portfolio construction and optimization, to trading, to model and portfolio analysis and, last but not least, marketing and client service. The unfortunate fact for many young quants today is that they become overly specialized and become an expert in only one discipline, e.g. portfolio optimization, without knowing how the whole investment process worked together.

What`s more, I was surrounded by a group of innovative thinkers with different disciplines, fed by the academic thinking that came out of the Harvard-MIT axis in Boston. It was an exhilarating time of my life that I will never forget. It was there that I met the likes of Evan Schulman, trader extradinaire and serial entrepreneur, Larry Speidell, CIO at Frontier Market, Mary Ann Bartels, CIO of Portfolio Strategies at Merrill Lynch, Tom Linkas, Jarrod Wilcox, just to name a few. There have been many others and I apologize if I left out any names.

It is therefore with great sadness that many of my former colleagues and I marked the passing of Batterymarch Financial Management.


A New Era for me
I do have another announcement to make. Astute readers will also notice from changes on my blog that I am no longer a portfolio manager at Qwest Investment Fund Management. Qwest and I decided to part ways because we were going in different directions. I am working on a number of projects that I am not at liberty to discuss at this time yet.

However, I would like to tie up a few loose ends. First of all, I received some feedback to the termination of the weekly Qwest newsletter, Trend Indicator, where I discussed the model readings of my Trend Model (see An intriguing Trend Model interim report card). The real-time history of the Trend Model was promising, as changes in trend were correlated with changes in market direction. In addition, my blog post also highlighted the “demonstration account“ that I had been running (and will continue to run) based on the Trend Model and some short-term sentiment indicators was showing some promising results.

I will continue to update the Trend Model readings on a weekly basis through my vote on the TickerSense blogger sentiment poll.


Follow me on Twitter
While I was at Qwest, I was constrained from extensive use of social media because the Securities Commission required that every tweet and message be first reviewed by Compliance, which created a logistical nightmare for the firm. Now that I am free from those constraints, please follow me on Twitter at @HumbleStudent but clicking on the link on the right.

In that sense, this is the start of a new era for me.

Some ETF suggestions for bullish traders

Regular readers will know that I recently turned more positive short-term on US equities (see Ending in tears doesn't mean that the market goes down right away and Complacency? Don't worry, be happy!). Based on that assumption and my past research indicating that in a bull phase, traders should focus on high momentum stocks and sectors for their long positions (see Momentum + Bull market = Chocolate + Peanut butter), I offer the following sector and industry ETF suggestions for traders. These ETF suggestions are based on my sector and industry momentum screens and I would caution that some of the ETFs are correlated with each other, so it may not be appropriate to overly weight any two correlated sectors or industries.


Energy (XLE)
Here is the relative performance chart of XLE to SPY. As the chart shows, Energy stocks have moved to a leadership position in the last few months. The sector got a little over-extended and has pulled back on a relative basis. Current levels may provide a good entry point for long positions.

Canada (EWC)
One surprise that came out of my relative strength and leadership screen were Canadian stocks. As Canadian stocks are more heavily weighted in the resource sector and in energy in particular, EWC is somewhat correlated to XLE and therefore partly represents the energy overweight theme that I mentioned above. On the other hand, EWC is a more broadly diversified index with other sector exposures and it may represent a less risky way of taking an energy overweight position than a simple long position in XLE.

Semiconductors (SMH)
Recently I have questioned the lack of capital expenditures (see CapEx: Still waiting for Godot). Many capital goods producing companies have either lagged or only kept pace with the market, which made me question the strength and sustainability of the economic rebound. However, the cyclically and capital goods sensitive semiconductor industry has been a notable exception. While the group is a bit over-extended on a relative basis and could pull back at any time, semiconductors (SMH) represent a solid momentum pick for bullish traders.

Technology (XLK)
The semiconductor stocks are a subset of the Technology sector and their performances are correlated, but Tech stocks recently staged a relative upside breakout in the context of a relative uptrend.

Biotech (IBB)
The poster child for risk appetite is back! Biotechology stocks (IBB) got clobbered in March and early April, but they have gradually recovered. This is an indication that the animal spirits of risk appetite is returning. If you are a bullish trader, IBB could be your vehicle.

In conclusion, it looks like the bulls are running again. Despite some obvious fundamental risks (see This will end in tears, but when?), my inner trader has turned to the Dark Side and he is running with the bulls. Some of the sectors and industry ETFs that I mentioned are prime candidates for long positions for bullishly inclined traders.

The usual caveats about risk applies here. Keep your stops tight if you enter positions.

Complacency? Don't worry, be happy!

Recently, there has been a rising cacophony of voices warning about the low volatility environment spawning complacency and excessive risk taking. In early June, Jon "Fedwire" Hilsenrath penned a WSJ article describing how various Fed officials had raised concerns about the low volatility environment:

Federal Reserve officials are starting to wonder whether a tranquillity that has descended on financial markets is a sign that investors have become unafraid of the type of risk that could lead to bubbles and volatility.

One of the most prominent voices was Bill Dudley of the New York Fed, who is an Establishment figure in the Federal Reserve apparatus:

The Fed's growing worry—which could influence future interest rate decisions—is that if investors start taking undue risk it could lead to economic turbulence down the road.

"Volatility in the markets is unusually low," William Dudley, president of the Federal Reserve Bank of New York and a member of chairwoman Janet Yellen's inner circle, said after a speech last week. "I am a little bit nervous that people are taking too much comfort in this low-volatility period. As a consequence, they'll take more risk than really what's appropriate."

,,,and Fisher at the Dallas Fed:

Richard Fisher, president of the Federal Reserve Bank of Dallas, added to the chorus of concern over complacency in an interview Tuesday. "Low volatility I don't think is healthy," he said. "This indicates to me a little bit too much complacency that [interest] rates are going to stay at abnormally low levels forever."

When volatility is low, it encourages too much risk-taking and asset bubbles, which prompted the likes of Gillian Tett of the FT warned of a potential Minsky Moment:

For while ultra-low volatility might sound like good news in some respects (say, if you are a company trying to plan for the future), there is a stumbling block: as the economist Hyman Minksy observed, when conditions are calm, investors become complacent, assume too much leverage and create asset-price bubbles that eventually burst. Market tranquillity tends to sow the seeds of its own demise and the longer the period of calm, the worse the eventual whiplash.

That pattern played out back in 2007. There are good reasons to suspect it will recur, if this pattern continues, particularly given the scale of bubbles now emerging in some asset classes. Unless you believe that western central banks will be able to bend the markets to their will indefinitely. And that would be a dangerous bet indeed.

 It also prompted John Mauldin to hit the panic button in a none too gentle fashion:

There is a bull market in complacency. As Dylan goes on to say, the illusion of central bank control is in full force. And one of the chief ironies is that a bull market can last longer than any of us can reasonably expect – and then end more abruptly than even the most cautious bulls suspect. The St. Louis Fed Financial Stress Index is at its lowest ebb since they began calculating the index. How much lower can it realistically go? The answer is that no one really knows.

I don’t know what the trigger for the next debt crisis will be, but whatever it is, it will result in an even deeper liquidity crisis than we saw in ’08. That is just the nature of the beast.

 Mauldin went on to ask some critical questions (emphasis added):

You need to look into your portfolios, deep into your portfolios, and see what your various investments did back in 2008-09. Then take a deep, long, serious look in the mirror. Ask yourself, “Can I withstand another shock like that?” Do you think you are smart enough to pull the trigger to get out in time? Do you have automatic triggers that will cause you to exit without having to be emotionally involved? Are there illiquid assets in your portfolio that you want to own right on through the next crisis? (Let me note that there are a lot of assets about which you might answer positively, with a full-throated yes, in that regard.) Would you rather be biased to cash today, when cash is in a true bear market and at its lowest value in years, if that cash will give you the buying power to purchase assets at prices that will once again look like 2009’s? Think about how you will feel in the wake of the next crisis, when cash will be king!

How risky is the environment?
My inner long-term investor is indeed concerned about signs of rising complacency and lower margin of safety (see This will end in tears, but when?). While recognizing that systemic risk is rising, the issue of timing the downturn is a non-trivial problem.

Ben Chabot of the Chicago Fed recently wrote an essay entitled "Is there a trade-off between low bond risk premiums and financial stability?" addressing this very issue. He concluded that just relying on low risk premium signals from the bond market to forecast potential spikes in volatility, i.e. Minsky Moments, generated too many "false positive" signals.

The hazard model results suggest that the current levels and past changes in risk premiums are poor predictors of the risk of future large increases in risk premiums. The level and change in the real fed funds rate and risk premiums are insignificant in most specifications. In the few cases where the variables do significantly shift the hazard, the sign is always the opposite of what one would expect if low risk premiums or accommodative monetary policy did indeed sow the seeds of future instability.

In fact, Chabot found a perverse effect that low risk premiums is likely to lead to more stability, not less:

The hazard model suggests large increases in risk premiums are less likely when risk premiums have been depressed or have declined over the past year.

It would therefore be wrong for policy makers to respond with more a aggressive monetary policy in order to try to prick potential financial bubbles precisely because low risk premiums, or complacency, have not always resulted in crashes (emphasis added):

Financial instability is costly. It has been suggested that low bond risk premiums may predict future financial instability and that policymakers should take this into account and respond to low risk premiums by adopting less accommodative monetary policy than would otherwise be justified by economic conditions. But before we conclude that the economic cost of a potentially sharp increase in bond risk premiums justifies less accommodative monetary policy, we should be certain that financial instability is in fact more likely to arise when bond risk premiums are low. This study casts doubt upon the hypothesis that low levels of bond risk premiums increase the likelihood of destabilizing sharp increases. To the contrary, the past 60 years of data suggest that large increases in bond risk premiums are independent of the recent level or change in risk premiums or the real federal funds rate.

Indeed, Goldman Sachs published a study of the history of volatility (via FT Alphaville) and showed that while the current vol environment is low, it is not at extreme levels.

As well, consider this chart from Tobias Levkovich of Citi (via FT Alphaville) of the relationship between the VIX and the next 12 month return of the SP 500. The R-Squared of the regression of the two variables turned out to be a minuscule 0.01:

It seems that the latest view from central bankers is to rely on macroprudent policies instead of monetary policy to guard against financial instability. Marc Chandler summarized the consensus view perfectly here (emphasis added):

We note that Draghi appeared to be singing from the same song book as Yellen regarding the use of monetary policy to address financial stability. Like the Fed Chair yesterday, Draghi indicated that macro-prudential measures and regulation is the first line of defense, not monetary policy (price and quantity of money). Monetary policy seems too blunt of an instrument and operates with unpredictable lags. Macro-prudential policy and regulatory efforts are more precise and can be implemented almost immediately. This is part of the new orthodoxy.

That view was confirmed by Janet Yellen's recent July 2, 2014 speech on the issue of Monetary Policy and Financial Stability (emphasis added):

In my remarks, I will argue that monetary policy faces significant limitations as a tool to promote financial stability: Its effects on financial vulnerabilities, such as excessive leverage and maturity transformation, are not well understood and are less direct than a regulatory or supervisory approach; in addition, efforts to promote financial stability through adjustments in interest rates would increase the volatility of inflation and employment. As a result, I believe a macroprudential approach to supervision and regulation needs to play the primary role. Such an approach should focus on "through the cycle" standards that increase the resilience of the financial system to adverse shocks and on efforts to ensure that the regulatory umbrella will cover previously uncovered systemically important institutions and activities. These efforts should be complemented by the use of countercyclical macroprudential tools, a few of which I will describe. But experience with such tools remains limited, and we have much to learn to use these measures effectively.

What about the pending Minsky Moment?
Even if we were to throw all of the regression analysis aside, ignore the Chicago Fed study and raise the alarm about how central bankers are encouraging excessive risk taking, how can investors avoid the instability of a Minsky Moment?

The answer is to look for possible triggers of instability. At the moment, there are few:

• The likelihood of a US recession is unlikely (via BCA Research). In fact, the weekly review of high frequency economic releases by New Deal Democrat came to the conclusion that "growth through the end of this year and into 2015 remains almost certain".
• Street consensus EPS growth continue to rise and are supportive of further market gains.
• Other triggers, such as geopolitical turmoil is unlikely to cause a major disruption to the markets (see "Ending in tears" doesn't mean that the market goes down right away).

My inner investor is enjoying these parties thrown by the Fed and ECB. He is getting a little uneasy and edging his way to the door, just in case the cops raid the place. On the other hand, my inner trader is staying with the bullish view and he is still dancing with the lampshade on his head. He refers the doomsters to the latest Josh Brown quote from Eric Peters (emphasis added):

“Should have known what to expect,” he said, laughing at his own idiocy. “When you move into a house filled with 19yr old derelict degenerates, there’s no going to sleep early.” But refusing to cut and run, he traded out of the position. “I figured if these morons were going to keep me up till 2am listening to Pearl Jam, they were going have to pay.” So he started a casino in the frat-house basement. That stank of stale beer and Skoal. But quickly overflowed with drunken gamblers, baseball caps turned backwards, drinking, dipping, crowded around blackjack tables. And indeed, they paid. Consistently. Reliably. He emerged from that basement stench to get his diploma. Tossed his cap. And headed to the ultimate casino. Wealthier. Wiser. “Built my entire business around buying carry, you’ll never meet someone who loves it more than me,” he said. I politely refused to take the other side. “So the fact that I can’t bring myself to buy this stuff anymore is very bad news for other guys.” But calling the end of a bull market is rather different from calling the beginning of a bear. The last great credit debacle in the US was the S+L crisis. Which was followed by an 8yr recovery. The 2008/09 crisis was far more severe and will be followed by a much longer, lackluster recovery. That’s how economies recover from financial crises – and we’re only 5yrs into this one. “We’re approaching an infection point, the past 5yrs have been fantastic for financial assets, for carry, but not great for the real economy, and that relationship is now in the process of reversing.” So he’s jumping on this credit cycle’s final trade. Buying every illiquid thing left, securitizing the crap, marking it up, creating new carry instruments. “To sell to some drunk idiots.”

In other words, the end may be getting close, but it's not here yet. There is one more leg up. So don't worry, be happy!

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

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 blog 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 I may hold or control long or short positions in the securities or instruments mentioned.

An intriguing Trend Model interim report card

Let me start this post with the disclaimer that I have nothing to sell anyone. Moreover, I am not in a position to manage anyone`s money based on the investment strategy that I am about to describe. (If nominated, I will not run. If elected, I will not serve.)

This is an interim report card on my Trend Model, which I haven`t written about for quite some time. 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).


Intriguing signal results
We have been writing a weekly report showing the signals of the Trend Model since 2010. To communicate the strength of the signal, We used a dial to graphically represent the Trend Model`s output. If the risk-on signal strengthens, the dial would move to the right and if it weakens, it would move to the left.

A funny thing happened as we ran this model in real-time. While the Trend Model was relatively effective at showing risk friendly and unfriendly environments, we noticed that the model was much better at turning points. The chart below shows the real-time (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 green 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.

A proof of concept
While the results from the above chart, which represents 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. 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 a preliminary report card of the 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.


Promising preliminary results
I offer the following observations based on nine months of actual performance:

• Returns were roughly in line with what I expected given the history of the signals. A nine-month return of 13.8% for an absolute return vehicle is promising, but the jury is still out on this trading system. While the return pattern was a little choppy, a quick-and-dirty risk-adjusted return ratio of return (13.8%) divided by maximum draw-down (6.7%) came to 2.1 and that is quite acceptable by most hedge fund standards.
• The low correlation shown by this trading strategy to the returns of major asset classes was also promising. The correlation of the account returns for the nine-month test period to equities (SPY) was 0.13 and -0.10 to bonds (AGG). These results suggest that the addition of such a strategy, in measured doses, can raise the risk-adjusted return of a well-diversified portfolio.
• The weakness of all trend following models is the risk of whipsaw when the market is not trending. When markets are choppy, trend following models will experience sub-par returns. That seems to be what happened in 1Q 2014.
• The real test for this trading strategy has yet to come as stock prices have largely gone in a single direction. Stock prices have been more or less in an uptrend all of the test period that began  in September 2014. The acid test of this trading strategy will occur when the market corrects. I will be watching carefully how it behaves before, during and after the correction.

This is a high frequency trading model that is not suitable for everyone. So far, the observed monthly turnover was approximately 175% per month, or over 2000% per year - definitely not for the faint of heart.

Nevertheless, the results are promising so far. I plan on reporting on the results later in the year when it has a one-year track record. Hopefully, the stock market will have hit an air pocket by then and we can observe the behavior of this model during a corrective period.

If there is sufficient interest in the future, we will contemplate offering an investment offering based on the Trend Model, but not without the proper offering documents and risk disclosures, etc. In the meantime, Canadians who are interested in subscribing to the weekly Trend Model commentary can do so by clicking here. Just selected "Trend Indicator" as the report you want to receive.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

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 blog 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 I may hold or control long or short positions in the securities or instruments mentioned.

"Ending in tears" doesn't mean the market goes down right away

This is the second part of a two-part post. In part 1, I outlined the risks to the equity market (see This will end in tears, but when?). The markets are getting frothy. The combination of too much complacency, which leads to excessive risk appetite, and diminishing margins of safety will magnify the downside effect of any negative catalysts. However, the existence of such a high risk environment doesn't mean that stock prices go down right away.

In part two, I examine the likely bearish triggers for risky assets such as stocks. In summary, there are four broad categories of risks to the US equity market:

• Geopolitics
• US politics
• Inflation scare
• Earnings growth scare

Stripped to the basics, stock prices respond to either changes in earnings multiples (P/E ratio) or changes in earnings growth expectations (the E in the P/E ratio). The metric for each of these risks is whether there are any possible developments that could be equity unfriendly, i.e. will the development either affect P/E or E?

Geopolitical risks: Well contained

There are three main sources of geopolitical risks that the market is focused on right now:

• Middle East
• Russia/Ukraine
• South China Sea

I have written about the market risks from the Middle East and Ukraine before (see Apocalypse Later and Are you a good capitalist?). As for the developments in Iraq, it is highly unfortunate that ISIS has become so prominent in the region. The news that ISIS has declared a caliphate and called itself Islamic State is highly contrary to western interests. The "bleedout" risk of foreign fighters who have flocked to the ISIS banner returning to their homeland to engage in terrorism is acute and growing.

Despite this geopolitical risk, investors have to ask themselves, what does any of this have to do with the market? Will it affect oil production in the region? No - ISIS has shown itself to be disciplined and interested in cash flow to fund itself so investors can count on little or no interruption in oil production. While the market may engage in minor sell-offs from developments in the Middle East, I can`t envision much that would have a substantial effect on either the P/E ratio or E of the stock market.

As for Russia/Ukraine situation, the news of the EU association agreements with Ukraine, Georgia and Moldova was probably an unfortunate geopolitical miscalculation on the part of the European Union. While thumbing your nose at the Russians is not a good idea, we have seen lots of behind the scenes lobbying from western companies to blunt the effects of American sanctions on Russia. My best guess is that the worst of the crisis is over and the geopolitical risks to the markets from this region is minimal.

The last major source of geopolitical risk comes from a possible outbreak of hostilities in the South China Sea. China has been engaged in simmering conflicts with many of its neighbors, Japan, the Philippines and Vietnam, just to name a few. Notable exceptions have been the Koreas and Taiwan, which has enjoyed warmer relations with the Mainland in the last few years.

In order to soothe any potential panic over possible Chinese military flare-ups with her neighbors, Bloomberg reported that President Obama recent stated that he would prefer to see the peaceful rise of Chinese influence in the region (emphasis added):

“We welcome China’s peaceful rise,” Obama said in a recent NPR interview. “In many ways, it would be a bigger national security problem for us if China started falling apart at the seams.”

There are worse alternatives, much worse:

The U.S. has a great deal riding on the outcome. China is the single largest holder of U.S. debt with $1.3 trillion in Treasury securities, and Sino-U.S. trade last year topped $562 billion, up 38 percent from five years earlier. In an extreme scenario, major turmoil could spark massive refugee flows or even endanger control of China’s estimated 250 nuclear warheads, said Lieberthal, a senior fellow at the Brookings Institution.

“That’s not a future you want to contemplate,” he said.

Here is my take on the geopolitical risk in the region. The Chinese are playing the long game and they recognize that they are not in a position to actively push back against an American ally (Japan, Philippines) just yet. Vietnam, on the other hand, is a different story as it has no strong allies. Watch for more developments in the simmering China-Vietnam dispute in the near future.

In terms of market impact, what would be global growth implications of rising tensions between China and Vietnam? Would the P/E or E effect on US or global equities be any different than if Botswana and Zimbabwe went to war?


US political risk rising

The US midterm elections are coming up and we have seen little political impact from the pre-election rhetoric. The only discernible effect so far has been the surprising loss by Republican Eric Cantor to his Tea Party backed opponent Dave Brat. There are two likely fallouts from this development:

1. The risks to the renewal of the Export-Import Bank charter, which the new Republican House Majority Leader Kevin McCarthy has stated he will not support.
2. Further risks of a government shutdown should Tea Party activists gain the upper hand.

The demise of the Export-Import Bank would be negative for capital goods companies such as GE, Caterpillar and Boeing, but the downside from such a development would be limited to companies in the sector. It would be difficult to see more than a 3-5% hiccup in the major market averages to the elimination of the Ex-Im Bank.

Market bulls should be consoled by the fact that gains by Tea Party activists were halted in Mississippi as the Establishment GOP candidate Thad Cochrane defeated Tea Party challenger Chris McDaniel. Nevertheless, political analyst Greg Valliere believes that the Cantor defeat spells the death of immigration reform and a tough fight on the debt ceiling next spring.

Next spring? That's a problem for after the election and next year! The immediate market impact is likely to minimal.

Unless we see more unexpected US political developments, I see no signs of a major bearish trigger from this quarter.

Rising inflation = Rising interest rates

The third market risk comes from upward pressure on interest rates from rising inflation. If interest rates were to rise, P/E multiples are likely to contract and, everything else being equal, therefore put downward pressure on stock prices.

In short, rising inflation and inflationary expectations are a definite threat to stock prices. There is no doubt that measures of inflation are starting to rise. The question is, "How long before the Fed starts to react to rising inflationary pressures?"

Cardiff Garcia of FT Alphaville put the issue into perspective: With the Fed`s target of a 2% core PCE inflation rate, Garcia highlighted the following comment from the Dallas Fed:

The Dallas Fed writes that its “rule-of-thumb forecast for headline PCE inflation over the coming 12 months is just the current 12-month trimmed mean rate. We thus expect headline PCE inflation to average 1.7 percent over the next 12 months, little different from its current 12-month rate”.

In other words, don`t expect policy makers to get overly excited about getting near the 2% target. What about the dangers of overshooting the inflation target? More here from Garcia:

Greenspan averaged 2.5 per cent PCE inflation and 3.1 per cent CPI inflation throughout his entire tenure. And that’s on the low side of post-war Fed chairs. Volcker allowed it to fluctuate between 2 and 4 per cent even after he had famously pounded it into submission from the terrifying levels of the 1970s and early 1980s.

More recently, both core and headline PCE have been below 2 per cent since the middle of 2012.

In other words, don`t worry so much about rising interest rates.

Jeff Miller of A Dash of Insight recently had some very sensible words about the Fed and inflation (emphasis added):

I have been extremely accurate in my Fed forecasts, but I am not claiming any prizes. It has not been difficult. I simply read information carefully and understand that it is a committee at work. Here are the key takeaways. You will disagree. You will hate them all. Keep reminding yourself that even if you are right and Yellen is wrong, you will lose on your investments. The Fed has the power. Figure out how to use the knowledge to your advantage.

1. The Fed is attempting to increase inflation. They seek 2% on the PCE index. This runs about 0.5% cooler than the CPI.
2. The Fed does not measure inflation through commodity prices.
3. The Fed believes that 2% is price stability. They think that traditional measures overstate inflation. They do not subscribe to ShadowStats (and neither do any of the people they respect). They also see a touch of inflation as easier to fix than deflation. They bias is toward stimulus.
4. The Fed will tolerate as much as 2.5% inflation (on the PCE index) for a time.
5. The Fed has a dual mandate – inflation and employment. It does not protect savers or emerging markets. Learn to live with it and ignore pundits who think this is important.
6. The Fed sees food and energy as noisy components of inflation – wild movements that do not relate to the dual mandate. If food prices are up because of a drought or disease in hog herds, how could this be controlled by raising interest rates? Middle East geopolitics and oil? Same question. These price changes are certainly real, but they are volatile and not relevant for policy. 
7. The Fed does not shift policy based upon small monthly changes in data. Longer trends are demanded.

The conclusion is that Fed policy is on a relatively stable course, but data dependent. The market does not like this, since the preference is for certainty.

Some time in the future, inflationary pressures will rise to a level where the Fed will feel compelled to act. That day is not likely to be in the near future. The immediate risks of P/E ratio contraction are low.


Earnings growth scare
I believe that the most serious risk to the bullish scenario comes from a possible growth scare. Mark Hulbert recently highlighted a decline in corporate profitability that could foreshadow slowing EPS growth, which would be highly negative to US stock prices:

Here’s the sobering data: According to the latest calculations of the U.S. Department of Commerce, corporate profits in the first quarter of this year represented 8.8% of gross domestic product. That’s the lowest level in nearly four years, and represents a big drop from the 10%-plus profitability that prevailed in the last quarter of 2013.

Those who focus on corporate profitability have worried for some time that such a decline was imminent. That’s because, in the past, profit margins have exhibited a strong tendency to “revert to the mean,” according to James Montier, a member of the asset allocation team at Boston-based GMO. In other words, margins in the past have eventually declined whenever they rose significantly above their long-term average, and vice versa.

There has been much debated over the issue of sky high net margins. I have highlighted analysis from BoAML (via Business Insider) that high net margins are mainly the result of low tax rates and low interest costs.

There has also been insightful analysis from Philosophical Economics that the profitability measure used by Hulbert, corporate after-tax profits to GDP, doesn't matter. What investors should focus on is ROE, or at least ROCE.

As you can see, the two terms have risen to record highs together. Relative to the historical average, the Profit/GNP term is elevated by around 383 bps. But of that amount, 252 bps is already accounted for in a higher Dividend/GNP term. To achieve an equilibrium at current Profit/GNP levels, then, all that is needed is an additional net 131 bps of reduced Saving/GNP from the other sectors of the economy. That’s a relatively modest amount–a small increase in the government deficit relative to the average could easily provide for it, and almost certainly will provide for it as baby boomers age over the next few decades.

So there really isn’t any problem here. Corporations will earn whatever amount of profit they earn. If they can’t find useful targets for reinvestment, they will distribute the profit as dividends (or buybacks–which get ignored here because of the way NIPA calculates “saving”), in which case the balance of payments condition set forth in the Kalecki-Levy equation will be satisfied.

In other words, corporate profitability shouldn't matter. If they can't find useful investments, they just re-distribute the profits either as dividends or buybacks.

Here's what should worry the bulls. Both profitability (red line) and distributions (blue line) have ticked down. For the time being, Street consensus EPS growth continues to march upwards. Brian Gilmartin's latest weekly forward EPS analysis shows "year-over-year growth rate of the forward estimate rose to 8.69% this past week, versus 8.60% last week". Consensus YoY EPS growth rate is continuing to rise, which is bullish.

EPS can continue to grow even if corporate profitability falls as long as the number of shares outstanding declines from share repurchases. Indeed, share buybacks have been growing steadily from 2009 and has reached new highs. Nevertheless, this may not be a problem as Ed Yardeni observed that there are definite incentives for companies to buy back their own shares in the current environment (emphasis added):

As I have often observed in the past, corporations have an incentive to borrow in the bond market and use the proceeds to buy back shares when their earnings yield exceeds the corporate bond yield. That’s been the case since 2004 thanks to the Fed’s easy monetary policies under both Alan Greenspan and Ben Bernanke, and now Janet Yellen.

Buybacks are a form of financial engineering since they boost earnings per share whether a company’s fundamentals are improving or not. They’ve certainly contributed to the bull market’s great run in an economic environment that has been widely described as “subpar.”

When the next recession hits, corporate cash flow will decline and investors are likely to be less willing to buy corporate bonds. As a result, buybacks will dry up as they did during 2008, exacerbating the eventual bear market in stocks.

Here is the problem. Bloomberg reports that buyback announcements have start to decline. If profitability is falling and so are buybacks, what will drive EPS growth?

Bullish or bearish? It depends on your time horizon
So where does that leave me? My inner long-term investor, whose time horizon is 5-10 years and a single tick is one quarter, is very cognizant of the high risk environment for stock prices. He is more concerned today about the return of capital than return on capital.

By contrast, my inner investor (6-24 month time horizon) and inner trader (1 week-1 month time horizon) are a nervous bulls. They recognize that investors are taking on excessive risk and it will not end well one day (see This will end in tears, but when?). In addition, Macro Man highlighted the degree of frothiness in the high yield bond market with the following factoid:

Did you know that the one year Sharpe ratio of the Iboxx US$ high yield index is roughly 8? As the chart below illustrates, the rolling 1 year Sharpe of the HY index has approached that level 3 previous times since the crisis (never having been anywhere close to it before the crisis, mind you.) On each occasion, the risk adjusted return moved swiftly lower.

On the other hand, most of the immediate risks are well contained for the time being. The greatest latent risk comes from a growth scare from the combination of declining profitability and falling share buybacks - a double whammy that could serve to blindside US equity investors. While we may be seeing early top-down sides of an EPS growth slowdown, we need to see some bottom-up evidence before taking action. I am therefore carefully watching the corporate guidance coming out of Earnings Season.

For now, the Fed and the ECB are throwing parties and there is no reason to enjoy them. Risk appetite continues to trend upwards. This chart of the high yield bond ETF compared to 3-7 year Treasuries (which I believe is a much better comparison because of the similarities in duration) shows that the relative uptrend, or risk appetite, to be intact:

My vote in the TickerSense Blogger Sentiment Poll is bullish, but I am a nervous bull. I am maintaining my bullish view but be watching carefully for signs of EPS growth hiccup and diminishing global risk appetite.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

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 blog 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 I may hold or control long or short positions in the securities or instruments mentioned.