Sunday, June 1, 2014

Correction, interrupted

The analysis of financial markets has a low signal-to-noise ratio. Under those circumstances, good traders need to learn to admit when they were wrong and I am prepared to do that. Regular readers will know that I have been fairly cautious about the intermediate term outlook for US equities and I have been calling for a correction this summer. However, with the SPX pushing to new highs last week:

...and major European averages rallying to new highs in anticipation of another round of ECB stimulus:

It's time to throw in the towel on the correction scenario (as did Dennis Gartman and Ralph Acampora last week).

I have not moved to the bull camp, like BoAML which came out last week with a forecast of a market melt-up, following by a nasty correction. However, I do believe that stock prices will remain range-bound in a choppy fashion until new developments cause the market break up or down. That`s because a number of forces are combining to either be supportive of stock prices and to put a lid on rallies.

Let`s go through the bull and bear cases.

The bull case: Earnings outlook still positive
In a recent post (see Time for a growth scare?), I wrote that one of the critical drivers of stock prices is the earnings outlook. As Ed Yardeni pointed out, forward 12 month consensus EPS estimates continue to rise. In the current macro environment, rising EPS estimates are supportive of higher equity prices. Note how the red line in the chart below, which represents forward 12 month consensus EPS, is rising to new highs and past periods when the slope flattened out were associated with market corrections:

Bullish insiders
As optimism for earnings growth rise, insider activity has also flashed a big signal (via New Deal Democrat):

Hedge funds in a crowded short
As well, BoAML pointed out that large speculators (read: hedge funds) are in a crowded short in SPX, NASDAQ 100 and Russell 2000 futures:
According to [Bank of America Merrill Lynch] Hedge Fund Monitor speculators have recently sold SPX to a net short position; Russell 2000 shorts are the highest they have been in 2-years, while Nasdaq longs are at a 1-year low.
I was the original author of the Hedge Fund Monitor and therefore I am very familiar with the data. I would discount the comment about SPX futures as I found that it had relatively low predictive value. However, extreme readings in large speculator futures positions in the NDX and Russell were good contrarian indicators of market direction for the next few weeks.

Late cycle and defensive sectors are faltering
In addition, a main reason for my cautiousness has been based on the signals from sector rotation as late cycle resource sectors and defensive sectors had been turning up to assume the mantle of market leadership. These were signs to be cautious about stock prices (see The bearish verdict from market cycle analysis). Since then, late market cycle leadership has stalled.

The chart below of the relative performance of European Basic Materials against DJ Europe and Metals and Mining against the SPX both show a similar pattern of near-term relative weakness.

The chart below of the relative performance of the Energy sector against the SPX indicate that this late cycle sector rallied hard on a relative basis, but they got overbought and have started to roll over.

I also constructed an index of equally weighted defensive sectors of Consumer Staples (XLP), Telecom (IYT) and Utilities (XLU) and measured their performance against the market. I deliberated excluded Healthcare, which is thought to be a defensive sector, because of the performance of biotechs have muddied the waters. As the chart below shows, past corrective periods have been marked by a rally out of the relative downtrends shown by dotted lines, which are followed by relative upturns. The current episode was marked by the rally out of the relative downtrend, but the relative upturn by the defensive sectors is missing.

The bear case: Inflation ticks up = Rising short rates
While these factors are likely to put a floor on stock prices, there are a number of bearish factors that are likely to put a ceiling on any major advances by the stock market averages.

First of all, inflation is starting to tick up and that could cause an interest rate scare about the timing of tightening action at the Fed. This chart from Doug Short shows the Fed's favorite inflation metric, Personal Consumption Expenditure (PCE), is ticking up.

Any way you look at it, core PCE is rising. The Dallas Fed has an alternative measure, called Trimmed Mean PCE, which strips out the most volatile components of PCE instead of just food and energy. As the table shows, one-month core PCE inflation has been above the Fed's own target of 2% for two straight months. The one-month Trimmed Mean PCE inflation rate has doubled from 1.2% to 2.5% in the space of two months. As well, the various PCE inflation rates measured over longer six and twelve month time horizons are rising.

If the Fed were to mention rising inflationary pressures at the statement after the next FOMC meeting, it would be interpreted as a hawkish statement could therefore spook the markets.

Cyclical stocks still weak
I would also reiterate my concern that the CapEx cycle has yet to kick in for this recovery. At this point of the expansion, companies should be hiring and buying capital equipment. Ed Yardeni, along with many other analysts, have been expecting a CapEx rebound:
The profits outlook remains bright according to the S+P 500 forward earnings. This series has been highly correlated with capital spending in real GDP and with nondefense capital goods orders.

Comparing capital spending in real GDP during the current expansion to the previous six shows that it has also been growing at a subpar pace. Spending on structures, on information processing equipment, and on intellectual property products (including software and R+D) have been especially weak. On the strong side have been industrial and transportation equipment.
Yet CapEx is nowhere to be seen. While the last headline Durable Goods report beat expectations, core Durable Goods growth was only 0.1%, which missed expectations, and Durable Goods ex-defense and volatile aircraft orders growth came in at an abysmal -1.2%.

As a measure of the market expectations of the CapEx cycle and expectations of economic growth acceleration, the relative performance of the Morgan Stanley Cyclical Index against the SPX has been rolling over. Could a growth scare be around the corner?

What is comforting to the bull case is the expectation of a rebounding US economy, which is becoming the consensus view. In his latest weekly report on high frequency economic releases, New Deal Democrat reported:
We remain on track for a strong rebound in economic activity and the GDP in the second quarter, and the rest of 2014 remains intact as well. We did get a small decline in the long leading indicator of corporate profits adjusted by unit labor costs for the first quarter, but on top of the fact that it can easily be reversed this quarter, it isn't of significance until next year, if the negative trend were to continue.
A glance at the Citigroup US Economic Surprise Index, which measures high frequency economic releases to see whether they are beating or missing consensus, is rising and now roughly at zero indicating a rough balance between beats and misses after the spate of negative reports because of the bad winter. It may be that, with a rebounding growth outlook, we may need to see the Surprise Index rise to the grey target zone where there is an excess of positive surprises before the growth outlook and stock prices correct.

In the meantime, Consumer Discretionary stocks continue to be weak and could be the source of another negative growth surprise. Thomson-Reuters reports that forward guidance for the Consumer Discretionary sector and specifically retailers continues to be disappointing:
As the first-quarter earnings season wraps up, retailers in the consumer discretionary sector have been some of the last companies to report results. Throughout earnings season, consumer discretionary has been one of the stronger areas, with its 8.6% earnings growth rate outpacing the 5.5% growth of the S+P as a whole. But when it comes to looking ahead, the story has been less positive. Earnings growth for the second quarter is now estimated at 6.9%, just shy of the 7.1% growth anticipated for the index overall. The current 6.9% estimate is down from the 10.3% that was forecast on April 1. This 3.4 percentage point downward revision is the second steepest fall of any sector outside of materials over this time period.

Inter-market analysis still signaling caution
Despite the near-term failure of my market analysis (see The bearish verdict from market cycle analysis), I continue to believe that inter-market analysis is still signaling caution for the stock market. To underline this point, my former Merrill colleague Walter Murphy wrote the following last week (emphasis added):
We have regularly pointed out that there has historically been an inter-market relationship between the S+P, yields, the euro, and select commodities. With that in mind, it seems important to note that 10-year yields, the euro, and gold have all recently broken down through important support trend lines. These breakdowns, along with price counts and weak momentum, suggest that lower lows are likely for these assets.

Nonetheless, and despite these inter-market pressures, the S+P has continued higher to all-time highs.

So the question is: Who missed the message? Was it the “500” or the other three asset classes? Given the equity market’s overbought momentum and sentiment indicators, as well as fragile seasonal considerations, it would seem that the S+P it the one listening to the wrong message.

Low volatility = Rising complacency
In addition, the fall in market volatility is fueling activity that might not be classified as "prudent". For example, the FT reports that investors have been reaching for yield by using the carry trade (borrow short-lend long) to enhance returns. These kinds of comments are signs of a maturing bull (emphasis added):
“The credit market is fully or fairly valued at the moment when we look at low default rates, strong company balance sheets and ease of debt financing,” says Edward Marrinan, head of credit strategy at RBS Securities.

He adds that an increase in the use of leverage, which is generally hard to measure, would definitely be a step towards pushing valuations in credit to an unsustainable level that would ultimately prompt a major correction.

Anecdotally, for instance, some investors are beginning to employ leverage to pump up returns on the senior slices of CLOs that currently offer the lowest yields.

The carry demand is not just purely based on a reach for yield, it’s also based on low volatility,” says Marc Ostwald at Monument Securities. “The people who have been selling volatility have to get more and more aggressive about it. If they get more aggressive that means they have to get more leverage.
FT editor Gillian Tett openly fretted about how this kinds of complacency might resolve itself:
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 tranquility 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.
So did Josh Brown:
Volatility is nowhere to be found – not in currencies, in fixed income or in equities. Complacency rules the day as investors and institutions gradually add more risk, using leverage and increasingly exotic vehicles to reach for diminishing returns in an aging bull market. This as economic growth – led by housing and consumer spending – stalls out and the Fed removes stimulus that never really worked in the first place.

And once again, the media is oblivious for the most part, fixated as it is on a French economist and the valuations of text messaging startups.

None of this has to mean disaster is imminent.

But man I wish it didn’t feel quite so much like de ja vu.
By deja vu, Brown was referred to two important blog posts about the dangers of complacency and the parallels with 2007. At this point, raising the ghosts of 2007 is a bit of exaggeration as there is no recession on the horizon:
Charlie Bilello takes a time machine back to May of 2007 – the charts are all you need to see. (PensionPartners)

“The most notable thing in the financial markets today is the absence of anything notable: volatility has collapsed to near-historic lows.” (Economist)
In of itself, low realized market volatility is not a concern. What is a concern is that it encourages undue risk taking and excessive leverage. Just as rising margin debt, by itself, is not a concern. However, if margin debt does get excessive and it starts rolling over, as it is doing now, that does become a cautionary signal.

Limited near-term upside
Though they warn of rising risk levels, none of the bearish factors that I mentioned are suggestive of an imminent crash in stock prices. In the near-term, however, the upside in stock prices are likely to be limited. Bespoke reports that 8 of 10 sectors in the SPX are overbought:

The SPX just kissed the top of its weekly Bollinger Band, and analysis from Springheel Jack shows that such occurrences have historically served to cap market rallies. He also indicated that punches over the weekly Bollinger Band have historically signaled a downdraft in prices.

Ryan Detrick recently featured this chart of AAII neutral sentiment, which shows neutral sentiment at 11 year highs. I interpret these readings to mean a jittery market, which could break hard and fast either way, depending on news flow:

When I put this all together, it is suggestive that stock prices are likely to move sideways in a choppy pattern for the next few weeks. While I continue to lean slightly bearishly, I am prepared to listen to the market and change my opinion should developments point to a bullish outcome.

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.


Anonymous said...

This low volume climb is bothering the heck out of me. I keep coming back to zerohedge's conspiracy that a large sponsored trader is suppressing VIX through selling puts. The sponsor being the fed.

Recent comments by fed governors makes it seem not entirely implausible. Lacker, Williams, last week stated that the fed will not bother curbing bubbles. What? We've gone through 2 massive booms and busts. What can they be thibking? And based on what I've seen in last 5 years, they seem very reluctant to stand by and let any significant correction happen on their watch. I think the answer lies with how massive the Fed balance sheet is. They have to whittle it down. The best way is through negative real rates - keeping rates low while inflation is encouraged. That plan will not work if deflation/recession scenario ever comes about. This may be the reason why they must do everything possible. QE cannot be sustained indefinitely. But they must nonetheless produce inflation through wealth effect somehow. How better to do that than through outright stock market levitation. It is likely more efficient than QE too.

I think this may explain why every bearish technicals breakdown. That is why the the potential forming Russell head and shoulder will falter too.

Under no circumstances can they let deflation ever happen. Any meaningful correction increases that possibility. Therefore they must stop it at any cost.

I have a feeling we may not see a correction in a decade more. I know this sounds crazy but recent market behavior is too suspect. Going fulltard long.

Anonymous said...

Based on Nasdaq movement, I would not be surprised if margin debt rollover has interrupted too. What with ECB move and Tepper's reversal, last week saw some major panic buying from traders.