Sunday, October 13, 2013

The sun will come out tomorrow

The NFL had a great series of commercials on Superbowl Sunday (examples here and here) that featured players and coaches who didn't make it to the Big Game singing "Tomorrow" from Annie. It was hilarious to see big football players singing "The sun will come out tomorrow" off-key.

The sun will come out tomorrow! So can we get past the headline driven volatility and focus on stock market's technical and fundamental picture?

I have made it clear how I think the political stalemate in Washington will be resolved (see How does the Washington impasse end? Ask Italy! and conspiracy theorists can read The tinfoil hat scenario). It seems that the catastrophic tail-risk of a default is mostly off the table as the politicians will not allow it to happen (and the Administration and the Fed would step in to save the world if the stalemate were to continue). What is left is the growth risk posed by a government shutdown, but much of the negative economic growth would be reversed once the shutdown is over, notwithstanding permanent one-time seasonal effects like the one on the Alaskan crab fishery, which negatively affects not only Alaska, but Oregon and Washington State as well.

Bulls remain in control
When I consider the market's fundamental and technical picture, I see the bulls remaining in control of the tape. I see evidence of a cyclical upturn, which can be best summarized by the relative performance of the Morgan Stanley Cyclical Index against the market:

These conditions are suggestive of further upside, once the political standoff is resolved. High-beta small cap leadership remains intact:

...and the small cap Russell 2000 isn't even overbought, despite the rally seen last Thursday and Friday:

Not surprisingly, cyclically sensitive sectors like Industrials are in a relative uptrend:

The same goes for Consumer Discretionary stocks:

As part of the rising tide of cyclical stock leadership, I am seeing a bullish setup in the Exploration and Production stocks within the Energy sector, but I will be watching for the relative breakout before I get too bullish about this group:

Intermediate term, however, negative breadth divergences such as the faltering momentum from New highs - New lows remain a concern:

Bearish tripwires
Last week, I outlined a number of bearish tripwires that I am watching for (see Get set for the relief rally):
  • How are earnings behaving?
  • Is there any sign of a recession or slowdown?
  • How equity market friendly is are central bankers?
I will address those issues, but in a different order.

Easy money
First of all, let me address the global liquidity situation. Business Insider reports that Morgan Stanley believes that global central bankers are tilted towards being more accommodative in the near future [emphasis added]:
In his weekly "Sunday Start" note to clients, Morgan Stanley chief economist Joachim Fels says "the mood among the officials and investors mingling at the IMF/World Bank Annual Meetings in Washington, D.C. [this week] mirrored the grim weather."

Fels said discussions among those in attendance were dominated by three topics: (1) the battle in D.C. over the debt ceiling; (2) what a Janet Yellen Federal Reserve means for markets and the economy; and (3) the problems — both structural and cyclical — that have propelled emerging-market economies into the limelight as of late...

...Fels thinks the meetings left a strong impression on global policymakers "that the world remains a risky place," a sentiment that could trigger a new round of central bank easing in the coming weeks and months.
As for the outlook for the Fed's monetary policy, it is clear that the Fed would not even consider a taper until the December FOMC meeting at the earliest, especially in light of the fiscal uncertainties that overhang the financial markets. Tapering would most likely be pushed out until 2014, when Janet Yellen takes on the role of the Fed Chair.

Sam Ro at Business Insider pointed out that Yellen has historically focused on employment metrics as a key guide to monetary policy. Given the anemic recovery in employment since the Great Recession, a Yellen Fed is unlikely to normalize interest rates for a long, long time.

So mark the monetary policy tripwire as stock bullish.

Earnings are rising, sort of
What about Street earnings estimates, which are key indicators of market expectations? As per Ed Yardeni, forward 12 month earnings estimate (red line) continue to rise:

Though it's still very early in Earnings Season, Thomson-Reuters expects this reporting season to come in roughly in line with Street expectations [emphasis added]:
A total of 21 companies have already reported Q3 earnings. Of these, 62% exceeded their consensus analyst earnings estimates. This is slightly below the 63% that beat estimates in a typical full earnings season and the 67% that beat in a typical earnings “preseason”. Historically, when a higher-than-average percentage of companies beat their estimates in the preseason, more companies than average beat their estimates throughout the full earnings season 70% of the time, and vice versa. This suggests that third-quarter earnings results are unlikely to exceed expectations at an abnormally high rate. However, the fact that the preseason beat rate is very close to the average suggests that results will probably not be much worse than average either. 
Brian Gilmartin keeps a close eye on forward 12 month Street estimates and he reports a worrying seesaw up-down-up-down pattern:
Per ThomsonReuters, the “forward 4-quarter” estimate this week fell to $118.94, from last week’s $119.04, however the year-over-year growth rate rose to 6.34% this week from last week’s 6.04%.
In the latest week, forward 12 month estimates were down. Last week, they rose to all-time highs but they fell three weeks ago. Gilmartin did see a silver lining in that the 12 month growth rate rose in the latest week:
As was mentioned, the growth rate of the forward estimate rose to 6.34%. The highest recorded year-over-year growth rate since early 2012 was 7.30% in mid-September, 2013. We need to break over 7.30% for me to have high conviction that the SP 500 will continue to solidly advance once again. (We always have doubt, it is just the degree of doubt that varies…)
Byron Wien of Blackstone Group (via Business Insider) highlighted another source of concern for the earnings outlook. Even though EPS estimates have been rising, net incomes haven't. That's because EPS gains have been powered by share buybacks (a lower denominator in the Earnings Per Share calculation) rather than net income gains:

The negative divergence posed by the EPS vs. net income analysis is a concern, but these kinds of problems have a tendency of not mattering to the market until it matters. Overall, I would give the earnings metric a neutral score.

Any sign of recession or slowdown?
What about the global economic outlook? China seems to have dodged a bullet yet once more and a hard landing is off the table, for now. Europe continues to show signs of emerging growth, as exemplified by Irish Prime Minister Kenny's declaration that Ireland will exit the EU/IMF bailout program in December. Ed Yardeni also pointed out that Europe is showing signs of recovery, though the pace is anemic:

The OECD Leading Composite Index for Europe is confirming the region's recovery. It is up for the past 11 consecutive months to August’s 100.5, the highest reading since July 2011. Leading the way up have been some of the more distressed countries in the euro zone, particularly Spain. The UK is also looking very strong. Here is August’s ranking: Spain (102.0), Ireland (101.9), Greece (101.8), Portugal (101.4), UK (101.2), Italy (100.7), Europe (100.5), Germany (100.4), Belgium (100.2), Netherlands (100.0), and France (99.7).
What I worry most about is the American consumer, who has been a remarkable engine of growth in a slow-growth world. Gallup documented a collapse in consumer confidence, though the cliff-like nature of the drop suggests that the consumer confidence setback is and government shutdown/debt ceiling related and therefore temporary:

Similarly, the latest figures jobless claims jumped and badly missed expectations, though the negative news is partly data related (California) and government shutdown related (which is temporary):
Claims for U.S. jobless benefits jumped last week to the highest level in six months, providing the first statistical warning that the damage from the partial federal shutdown is starting to ripple through the economy.

While half the increase came from California as the state worked through a backlog following a switch in computer systems, another 15,000 reflected the furlough of non-federal workers from employers losing government business, a Labor Department spokesman said as the data was released to the press. Applications (INJCJC) for unemployment insurance benefits surged by 66,000 in the week ended Oct. 5 to 374,000, the most since late March, figures from the Labor Department showed today in Washington.

“The economic costs of a shutdown are going to increase the longer the shutdown occurs,” said Ryan Sweet, a senior economist at Moody’s Analytics Inc. in West Chester, Pennsylvania and the second-best claims forecaster over the past two years, according to data compiled by Bloomberg. “If this drags along for the next couple of weeks, the economic toll will be even more significant.”
New deal democrat also noted this week that consumer spending is showing signs of stalling:
This week, Gallup's 14 day average of consumer spending was the second poorest this year (it was worse last week). This was also the poorest week for absolute spending this year (although we need to be careful with that, since mid-autumn typically is weak). Last year the ICSC varied between +1.5% and +4.5% YoY in, while Johnson Redbook was generally below +3%. The ICSC is once again weak compared YoY and the rest of 2013. Johnson Redbook, however, remains near the high end of its range.
Indeed, the relative performance of Retailing stocks to the market has been faltering as they switched from a relative uptrend to a sideways consolidation pattern. Note that the relative performance of these stocks began to roll over several months ago and their flat relative strength cannot be attribable to the current political impasse.

From a tactical viewpoint, I would not be inclined to turn bearish until the retailers break relative support. There is a lot of market noise surrounding the government shutdown and debt ceiling impasse. So I would rate the economic growth outlook as being neutral to slightly positive.

Sell the relief rally?
For traders, what does mean at a tactical level?

My inner trader tells me that the bulls, and especially high-beta and cyclical leadership remains in control of the tape. He is wary, however, that the bears are plotting a comeback so he is watching the aforementioned bearish tripwires carefully. His inclination is to take some profits as the relief rally materializes in the wake of a debt-ceiling deal but stay long but play things by ear as time progresses.

On a technical basis, he is watching relative charts for breakouts and breakdowns. As per the above charts, an upside breakout in the XOP/SPY ratio (Exploration and Production stocks) would indicate the continued dominance of cyclical stocks, which would be bullish. However, the violation of relative support by XRT/SPY ratio (Retailers) would be interpreted bearishly.

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.

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