Sunday, March 16, 2014

Stock market pothole or precipice?

Well that didn't take long! The stock market goes down for a week and the bears are coming out of hibernation. We are starting to see more posts like Hale Stewart's More signs of a US equity market top. For bulls and bears alike, it's time to take the weekend, relax, and review the upside and downside risks in the broad market averages. Here is what the US equity market seems to be worried about, in no particular order:
  • Ukraine/Crimea
  • Chinese slowdown and financial tail-risk
  • Falling corporate earnings
I will examine each of these issues one by one and conclude this post with a assessment of the technical picture for US equities. In essence, I am trying ask the question, "What could go wrong and how much of it is the market?"

Ukraine/Crimea: Market wildcard
Much has written about the Crimean situation and this represents the true market wildcard. The news that Crimeans voted to rejoin Russia was no surprise, the key question is what happens next. The most balanced and reasoned view that I have seen comes from Oleg Babinov of The Risk Advisory Group (via Moscow Times). Babinov wrote that much will depend on what kind of sanctions are imposed by the West:
If Russia does not rush in to incorporate Crimea as its "administrative unit" and the sanctions are limited to its dropping from Group of Eight and some limited visa sanctions and asset freezes for politicians and businessmen who are directly involved in separatist activities, Russia's response would be relatively small-scale. If this is the case, there will be little effect on investors, except those who may be involved in cooperation with Russian companies in the field of military technology — but this is possible only if the U.S. and the European Union do not decide to freeze cooperation with Russia in this field.

But if sanctions are applied to Russian state-owned companies and banks, Russia might want to retaliate by freezing foreign companies' accounts here. There was an announcement that the constitutional law committee of the Federation Council has invited legal experts to study whether such sanctions would be legal, but no draft law has been produced yet.
Babinov believes that Putin cares more about geopolitics than economic sanctions. We are seeing in effect an assertion of a Russian Monroe Doctrine (my interpretation, not his):
President Vladimir Putin is ready and willing to have a confrontation with the West of the scale that would not have been imaginable during the previous 14 years of his presidency.

He considers a pro-Western Ukraine to be a strategic challenge to Russia and a likely new member of NATO on Russia's border. Putin no longer trusts Western politicians and seems to have concluded that Russian interests will be taken into account only, if and when it has a strong negotiating position.

Putin sees a strong chance of winning in the political confrontation, and this is probably more important for him now than foreign investors.
In an interview with Der Spiegel, Fiona Hill of the Brookings Institute confirmed my Russian Monroe Doctrine thesis and believes that Putin views EU encroachment in the Ukraine as an existential threat:
Putin is not interested in an off-ramp right now. We are trying to offer him a face-saving gesture on the basis of our assumption that he wants to save face internationally. But that's wrong. Putin actually sees the ongoing developments in Ukraine as an existential threat. He has carefully calculated the costs and the risks of his steps. Now he is obviously going to wait and see how people react to the outcome of this referendum on Sunday.
Christopher Clark, professor of Modern European History at the University of Cambridge, wrote in Der Spiegel that the Europeans have begun to admit that they miscalculated when they got overly enthusiastic about the enthusiastic pro-EU popular uprising in Kiev, without giving weight to the geopolitical situation:
In a recent statement for a news program, German Foreign Minister Frank-Walter Steinmeier conceded that the EU foreign ministers (himself included) had been too quick during the early days of the crisis to engage with the Ukrainian opposition and too slow to take account of the larger geopolitical issues that are entangled with the crisis. This remark exhibited a level of self-critical reflection and a readiness to adjust to new developments that would have been completely alien to his early twentieth-century counterparts.
Today, Western Europe finds itself boxed in. While it remains supportive of the principles of self-determination, it is also cognizant of Russia's perceived needs of the security of its borders (the Russian Monroe Doctrine). The question then becomes one of how the West and Russia can each save face and achieve their respective objectives without appearing to back down?

I have expressed my own opinion on this issue before (see How I learned to stop worrying and love the Russian invasion). Why not let Russia have Crimea because it has been a net drain on the Ukrainian economy and identity? Russia scholar Mark Galoetti wrote:
Strictly from a coldly logical position (and I am not advocating this, I should add), in many ways it is in Kyiv’s interests for Moscow to steal Crimea, and turn it into some pseudo-state or new part of the Russian Federation. Ukraine loses a sunny peninsula, but also a distinct drain on the state’s coffers (the Crimean economy is not great, and the region receives net subsidies from the centre). It sheds the most troublesome and Russophile of its regions, one which has been a turbulent locus of trouble for Kyiv for most of post-Soviet Ukraine’s history. It also gets concrete proof of the threat it faces from Russian bullying and probably accelerated and solicitous assistance from the US, EU, NATO, etc. It also validates every Ukrainian fear about Russia.
A Washington Post article confirmed the analysis that absorbing the Crimea will be costly for Russia:
Ever since Ukraine became a sovereign nation in 1991, Crimea has received more subsidies from the central government than it pays in taxes, and that would probably continue on Moscow’s tab. Russian levels of social spending are higher than Ukraine’s, and economists predict that Moscow may have to pay about $3 billion a year to support the region. On Friday, Russia committed to at least $1 billion for the upcoming year, even without annexation.

Crimea receives nearly all its electricity and drinking water from Ukraine, and Russia will need to build new infrastructure — including a long-planned bridge — to link Crimea directly to the Russian mainland. Until that is complete, it will have to pay Ukraine for the utilities.

An analysis done by Russia’s Moskovsky Komsomolets newspaper suggested that absorbing Crimea might cost Russia $20 billion during the next three years.
Indeed, Canada's Globe and Mail featured an interview with a member of Crimea's intelligensia, or creative class, explaining the losers of a pro-Russia referendum win would be the creative class, while the winners would be those supported by the state:
“We have a joke here: Who wins if Crimea becomes part of Russia? The pensioners, the civil servants and the military. Who loses? The creative class, the middle class,” Mr. Kostinsky sighs.
Bulls and bears alike should decide for themselves what has already been priced by the market. They should also heed Oleg Babinov's advice to see the extent of Western sanctions and Moscow's response in the days and weeks to come.

China: A Beijing Put?
The second major worry for investors has been the rising prospect for an economic slowdown in China. Slowing growth would expose the Chinese financial system to rising levels of tail-risk. The press has been full of stories about a Chinese slowdown and I won't go through all of them. This Financial Post is story entitled 11 ugly signs confirming China's dramatic slowdown is an excellent example.

Despite the signs of falling growth, I reiterate my warning to China bears that, when push comes to shove, Beijing has shown a pattern of relenting with stimulus programs when faced with the prospect of instability (see Time to short China?). Premier Li Keqiang confirmed the bias for stability when he stated that government placed greater emphasis on employment and quality of life issues over numerical GDP growth targets [emphasis added]:
Speaking at a news conference in Beijing on Thursday, Premier Li Keqiang said that job growth and quality-of-life issues like the battle to reduce air pollution took precedence over the headline growth figure. China needs to create 10 million jobs, he added. He also said that further bond defaults were inevitable, as China remakes its financial system and rules. But he added that the government would do its best to ensure that bad debt did not roil the broader system. 
In some ways, the current market turmoil over potential defaults represents a health adjustment as China is moving towards market signals to properly price risk. Bloomberg reported that Chinese default risk has risen beyond Ireland's. Indeed, the pricing of my so-called Chinese canaries, or Chinese banks listed in HK, has seen a bifurcated path. While the an index of smaller banks have fallen to a critical support zone, which indicate some degree of caution is required, the index of the Big Four state owned banks remain relatively healthy compared to their own history.

When I put it all together, it appears that Beijing is trying to reform policies so that market forces become more dominant, but not so dominant that it would allow a disorderly market unwind. It has therefore implicitly signaled that a "Beijing Put" is in place for the markets.

Corporate earnings
Lastly, falling Street EPS estimates in the past few weeks have been a headwind for stock prices. The recent weakness in macro-economic indicators have fed through to falling Street estimates. Fortunately for the bulls, the bout of weakness in high-frequency economic releases may have been overdone. The chart below of the Citigroup Economic Surprise Index (in orange) has retreated to levels where it has rebounded in the past. If you are taking a bearish view on equities, then you are not just betting that the economic acceleration embraced as the market consensus in late 2013 was a false dawn, but that economic growth is actually starting to decelerate below 2%.

New Deal Democrat's review of last week's economic releases concluded that no economic downturn is imminent [emphasis added]:
This week is a continuation of the last few week's trends. Last year's weakness in the long leading indicators has fed through into the short leading and coincident indicators, although there was improvement in many this week. Because the recent weak consumer spending leads jobs, I expect that job reports in the next several months may be weak. At the same time, the long leading indicators did not roll over and have recently rebounded somewhat and suggest this will not lead to actual contraction.
There was more good news for the bulls on the earnings front. Brian Gilmartin, who keeps a diligent watch on the progress of EPS estimates, reported that they ticked up last week [emphasis added]:
Per Thomson Reuters, the “forward 4-quarter” earnings estimate for the SP 500 actually rose $0.02 last week from $118.87 to $118.89...

More importantly, the year-over-year growth rate of the 4-quarter estimate rose to 6.19%, from 6.11% last week and 6.05% two weeks ago. In my opinion it needs to move over 8% to start to think we can see 10% growth in 2014.
So far, so good, on the EPS growth outlook.

However, no discussion of the corporate earnings outlook without a highlight of Mark Hulbert's most recent warning on insider selling:
Corporate insiders are more bearish than they have been in almost 25 years. That isn’t good news for the stock market, since these insiders — corporate officers and directors— know more about their companies’ prospects than the rest of us.
The high level of insider selling is a concern and something to keep on your radar, but insider buying has historically been a more powerful signal than insider selling. Indeed, the last time Hulbert sounded the alarm on insider selling was in December 2012, just before the stock market continue to rally to further recovery highs.

Technical market review
To finish my review, I conclude with a technical market assessment of the US equity market. The SPX has fallen, but it has descended to a level where there is ample technical support, such as the 50 day moving average at about 1128 level.

The advance-decline line remains in an uptrend, though it did violate a support level.

Other breadth measures remain constructive. I constructed an equal weighted composite of the relative performance of the Russell 2000, the SP 600 and the equal weighted SP 500 against the SP 500 as a broad measure of the small cap vs. large cap breadth. Small cap stocks remain in a relative uptrend against large caps that began in mid-2012. Moreover, they recently staged an upside relative breakout and that breakout has held up.

As well, the map of market leadership remains in the bulls' favor. The chart below shows the relative performance of the defensive sectors (in black), which consist of consumer staples, utilities and telecom (health care was not included as sector performance has been skewed by the biotechs, which have been on a tear) against the SP 500. The SP 500 performance is shown for reference in purple. Note how past market tops have been preceded or coincidental with the outperformance of defensive stocks. Today, while defensive stocks have ticked up a bit, they remain in a relative downtrend.

In the short-term, the market is oversold and the risk is tilted to the upside. This depiction of the equity-only put-call ratio (blue=5 day moving average, red=21 dma) is a contrarian indicator. It shows that short-term option trader sentiment is at or near a crowded short reading and medium term sentiment to be roughly neutral.

Positive short-term seasonal and cyclical patterns
Of secondary consideration is a number of positive seasonal and cyclical patterns for stock prices. I wrote a somewhat speculative post last week about the 20-week cycle which suggested a cyclical low see Cycles in the eye of the beholder and Cycle model update). Ryan Detrick of Schaeffer's Research highlighted the typical March seasonal pattern. Note how we are about to enter into a positive seasonal period for stocks:

In a separate post, Detrick also pointed to the fact that the upcoming week is option expiry week. Though returns have been volatile, stock prices have had a bullish bias:

What bet are you making?
To summarize, bulls and bears have to understand the nature of the bet that they are making if they take a directional bias in the current market environment.

Equity markets have taken a hit mainly on worries over Ukraine/Crimea and China. The fear level is a tad on the high side, which doesn't mean that they can't get even higher on negative developments. I believe that China fears are overblown for the reasons that I already cited, but the geopolitical situation with the Crimea is a wildcard. Longer term, the outlook for equities appear benign as positive breadth and rising EPS expectations are supportive of higher stock prices.

Bearish traders have to know that if they get short or remain short here, they are betting mainly on geopolitical tensions getting out of control. In effect, they are betting that the world is on the edge of a precipice and it's ready to go over. In addition, they are betting on a neutral or hawkish statement from an FOMC meeting on March 19 from a Fed headed by a new chair with a dovish reputation.

By contrast, bulls are betting that someone in Moscow, Washington, Berlin, etc. doesn't miscalculate and deepen the crisis. The bulls' underlying view is that the stock market just hit a pothole, but it's not going to slide over a cliff.

Traders have to decide, in effect, on what kind of bear they encountered last week.

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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