Thursday, July 31, 2014

Still bearish, but watch for the dead-cat bounce

Despite my recent bearish call (see Global growth scare = Trend Model downgrade), I didn't expect that the US equity market would sell off so hard on little or no news Thursday after an upside surprise on 1Q GDP and a relatively unsurprising FOMC meeting. After the dust settled, the SPX was down about 2% on the day, which is highly unusual given the recent low volatility environment that the market has been experiencing.

What caught my eye was the sheer panic associated with Thursday's sell-off. The prices of none of the usual diversifying asset classes such as Treasuries (IEF, TLT) and gold held up well on the day. This is suggestive of a rush to cash - a seemingly margin clerk's market where market participants are forced to de-risk for institutional reasons. But that explanation doesn't really hold water, as the SPX is only about 3% from its all-time high at the close Thursday. I honestly have no idea why the markets went risk-off it did on Thursday, but the lack of an explanation suggests that the markets are due for a dead-cat bounce in the near future. Note that this is strictly a tactical short-term call with a 1-5 day time horizon.

VIX term structure inversion is bullish
As I watched stock prices crater throughout the day, a key characteristic about the sell-off was the spike in fear levels seen in the option market. The VIX/VXV ratio, which is a measure of the term structure of volatility, moved from a normal upward sloping curve to inversion in a single day. As the chart below shows, the majority of past VIX inversion, which are marked by dotted vertical lines, have historically been reasonably low-risk entry points on the long side of the market (also see my previous analysis Is the MH17 sell-off a gift to the bulls?).

Market oversold
As well, other signs are showing that the fear levels are getting a little overdone in the short-term. The middle panel of the chart blow shows that the VIX Index is at or near the top of an upward sloping channel indicating excessive panic. In addition, the bottom panel shows the ratio of the small cap Russell 2000 to the large cap SPX. Small caps have been very weak in the last few weeks, but the RUT/SPX ratio did not make a new low and confirm Thursday's weakness - a supportive sign for the dead-cat bounce case.

Despite the oversold readings, the technical picture for the SPX is mixed. The index sliced through the 50 day moving average, which typically acts as a support zone, as if the support level was non-existent. Such episodes of dramatic weakness are indications of severe technical breakdown. Short-term, the SPX is sitting just above a minor support zone at the 1925-1930 level which could serve to arrest any further near-term weakness.

I have no idea what NFP will show tomorrow morning, but US equities are oversold and due for a dead-cat bounce. Intermediate term, however, the crystal ball gets a little cloudy. I would like to look at how the market behaves at the obvious downside targets at the next two Fibonacci retracement levels of about 1900 and 1865 and how the fundamental backdrop is developing before making further calls on market direction.

My inner trader remains bearish intermediate term, but he closed out his shorts and he has taken a modest position on the long side.

Disclosure: Long TNA

Tuesday, July 29, 2014

Latent geopolitical risk rising in Asia

As we wait for the 2Q GDP and FOMC announcement, here is something different to ponder...

I had written previously about the intense animosity between the Chinese and Japanese (see China turns Japanese):

Now a Chinese mall is re-enacting World War II executions of Japanese soldiers (h/t Patrick Chovanec) in order to promote sales.

Oh, how the memories run deep! This is just an illustration of the institutional memories of attitudes arising from the Second World War and serves heightens geopolitical risk in the region.

Former Australian Foreign Minister Gareth Evans recently penned a Project Syndicate essay warning that Japanese Prime Minister's Abe's "makeover of Japanese foreign policy could undermine the fragile power balances that have so far kept the Sino-American rivalry in check", largely because "opposition to any perceived revival of Japanese militarism is hard-wired in Northeast Asia". Evans warned:
The dangers should not be exaggerated. But, with strategic competition between the US and China as delicately poised as it is, and with the economic interests of Australia, Japan, and many others in the region bound up just as intensely with China as their security interests are with the US, rocking the boat carries serious risks.
In the meantime, I am waiting for the WalMart 4th of July re-enactment of the Bataan death march, coming to you at a California mall.

Monday, July 28, 2014

A possible miss on 2Q GDP

In my last post, I wrote about signs of slowing non-US growth as a warning of impending stock market weakness (see Global growth scare = Trend Model downgrade). It seems that we will see a key report card of US growth on Wednesday morning - the 2Q GDP report.

The calendar from shows consensus expectations of 3.0% growth:

The Atlanta Fed provides a GDPNow indicator, which is their best estimate, or "nowcast", of GDP growth given the latest data:
The growth rate of real gross domestic product (GDP) is a key indicator of economic activity, but the official estimate is released with a delay. Our new GDPNow forecasting model provides a “nowcast” of the official estimate prior to its release.
The latest GDPNow reading is 2.7%, which is well below the consensus estimate of 3.0%:
The final GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2014 was 2.7 percent on July 25, unchanged from its July 17 reading.

In order to close the gap and meet expectations, the final growth figure would have to rise by 0.3% from the last GDPNow reading. With the Citigroup US Surprise Index looking a little wobbly, would you take the "over" or "under" bet on 2Q GDP consensus?

What is more important to the future path of asset prices are expectations. Gawyn Davies recently noted that:
Forecasts for US GDP growth this year have been slashed, but there is no change in optimism about GDP next year.

Regardless of whether 2Q GDP beats or misses the consensus estimate, the more important thing to watch is how future expectations for GDP growth for the rest of 2014 and 2015 . If 2Q were to miss and future growth get revised downwards, it could create a serious headwind for stock prices.

Sunday, July 27, 2014

Global growth scare = Trend Model downgrade

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Negative (Trading Downgrade)

(Please scroll to the bottom of this post to see how you can get a free subscription to Trend Model updates.)

A downgrade in Trend Model signal strength
Late Friday, CNBC reported that Goldman Sachs downgraded equities to "neutral" over fears of a possible sell-off in the bond market:
Goldman Sachs downgraded equities to "neutral" over the next three months on Friday afternoon, citing the risk of a temporary sell-off in stocks following a sell-off in bonds.

The firm said the near-term risk/reward profile for stocks was less attractive, even as it reiterated a "strong conviction" that stocks were the best-positioned class over the next year.
My Trend Model also detected a number of signals of global weakness, though the reasoning behind my downgrade were different from Goldman's. Even though the absolute level of the signal remains "risk-on", the weaknesses led to a directional change which amounted to a trading downgrade. As the chart below of real-time (not back-tested) past trading upgrades and downgrades show, they have had a reasonable track of signaling short-term stock market movements.

Trend Model Trading Upgrades and Downgrades

As the frequency of the signals in the above chart clearly shows, this is a trading signal. The intermediate term outlook remains risk-on. This is most likely an indicator of minor stock market weakness. Long-term investors who are not hyper-focused on every little squiggle in market prices should not panic and sell everything. The long-term outlook remains bullish and there is no bear market in sight (see The "good" stock market mania).

A global growth scare?
The Trend Model is a composite model based on trend-following principles as applied to global equity and commodity prices. The picture that I am seeing is that markets are starting to price in a possible global growth slowdown, which is starting to raise concerns.

I view commodity prices as a key real-time indicator of the Chinese economy. Despite the better PMI releases coming out of China last week, commodity prices are weakening. The chart below of the CRB Index shows that commodity prices violated its 50 day moving average (dma) in early July and they are showing a general topping pattern. Longer term, however, the trend remains positive as the CRB Index is holding up above its 200 dma.

As another confirmation of incipient weakness in China, the price of Chinese iron ore, another key industrial commodity, is slipping:

Another area of concern are European stocks. The chart below of the Euro STOXX 50 shows a similar pattern of violating its 50 dma. While this eurozone zone index remains above its 200 dma, the geopolticial good news that pro-Russian rebels handed over the MH17 black boxes to investigative authorities failed to propel the rally above the key 50 dma line.

The UK`s FTSE 100 fared better than the Euro STOXX 50. It is disappointing, however, that the FTSE 100 did the zigzag around the 50 dma but closed the week just below that key trend indicator.

Indeed, analysis from Jens Nordvig of Nomura indicates that money is coming out of European equities, which would account for their recent weakness.

US stocks have been one of the strongest of the major global equity markets. However, as SPX moved to new all-time highs last week, it is experiencing a minor divergence against the SP 1500 Advance-Decline line:

Taken in isolation, each of these warnings are not very important. When compiled into a mosaic picture, however, all these little warnings are raising concerns about flagging global growth. Indeed, the IMF downgraded the global growth outlook last week on the basis of slowing US and Chinese growth.

Despite the relatively robust results from the US 2Q earnings season so far, results from key capital goods companies like Caterpillar are worrisome (also see CapEx: Still waiting for Godot) as signs of a CapEx rebound are still MIA. CAT reported better than expected EPS but missed on the key revenue metric and went on to guide revenue expectations lower. As well, Gerald Minack recently showed that corporate debt loads are rising, but the extra debt is primarily dividend payouts and share buybacks instead of capital expenditures.

A possible credit induced sell-off?
In addition, I pointed to the negative divergence in US junk bonds last week (see Returning to high school, investment style). Analysts have raised concerns that a  sell-off in low liquidity vehicles such as the corporate bond market could spark a stampede out the exit in what amounts to a crowded theatre.

However, Peter Tchir of Brean Capital recently postulated that credit markets are bubbly and nearing the end of the fear-greed cycle, but greed could have a bit more to run:

When I put it all together, risks are rising and a Trend Model downgrade is warranted. Nevertheless, the intermediate term trend for US stocks is still up so it's not time to panic. If recent history is any guide, any pullback is likely to be less than 5%.

My inner investor therefore remains overweight US equities. He is not taking any action but he is keeping an eye on how the situation is developing as he doesn't want to react to every little twist and turn of the market. My inner trader, on the other hand, has sold out of his long equity position and he has taken short positions in stocks.

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Disclosure: Long SPXU, TZA.

Friday, July 25, 2014

Four trade suggestions from the BoAML Fund Manager Survey

I have been meaning to write about this, but other more important things seemed to get in the way. The latest BoAML Fund Manager Survey shows managers to be well overweight risk and equities (via The Telegraph):
Bank of America’s monthly survey of world fund-managers shows that investors have their second highest allocation to stock markets in thirteen years at 61pc. It is lead by shares in technology, energy, and even banks, and is stretched to a net 35pc overweight in Europe. “The summer 'melt-up' is likely to be followed by an autumn correction,” it said.

Four contrarian trades
Further, the report suggested four contrarian trades that appeared somewhat intriguing:
Bank of America recommends four contrarian trades (for the brave only of course, nor for Welsh widows) based on herding effects. Go long bonds, and short equities; long the US dollar/ short sterling; long telecoms (the most reviled equity group), and short energy; and long emerging markets/short Eurozone.
When I consider contrarian "value" trades, I prefer to look for entry points where there is not only "value", but a positive catalyst that propels the trade in the right direction. When I evaluate the four from a technical perspective, I find one to be in that category, two that appear to be nearing a trade setup and one in a wait-and-see mode.

The first chart shows the long EM and short eurozone equity pair trade. Note how EM equities have bottomed out and begun a relative rally against eurozone equities - that is the positive catalyst that I like to see.

The second and third are intriguing trade setups, but I am not quite ready to pull the trigger yet. Here is the long bond-short US equity pair chart below. Long Treasuries have broken out of a relative downtrend against US equities and they appear to be undergoing a sideways relative consolidation period. This is somewhat intriguing given the sentiment background, but I would wait until a relative breakout by bonds before making a significant commitment to this position.

Similarly, the long Telecom-short Energy pair shows a similar pattern of rallying through a relative downtrend. While there may be some tactical short-term upside, these pairs typically undergoing a sideways consolidation period before staging a relative upside breakout.

The last is the long USD-short GBP pair. Here is the chart of Sterling. GBP is still in an uptrend. At the very least, wait for the break through the trend-line before shorting Sterling.

In conclusion, sentiment analysis can uncover intriguing trades based on crowded long or short positions. Combining sentiment analysis with inter-market technical analysis is another way to see the progression of how the trade may be setting up and can be useful in timing entry and exit points.

Wednesday, July 23, 2014

Another complementary factor model

In the past, I had written about how combining factors can lead to more performance stability (see Momentum + Bull market = Chocolate + Peanut butter?). My past research showed that while price momentum did exhibit positive alpha over the course of a market cycle, returns were highly volatile.

Instead, the Cass Business School paper entitled The Trend is Our Friend: Risk Parity, Momentum and Trend Following in Global Asset Allocation indicated that momentum worked much better when conditioned on bull and bear market cycles. The paper showed that returns to price momentum was especially positive during bull phases at a stock level. My research showed that this effect was extended to the sector and industry level. I identified bull (uptrend), bear (downtrend) and neutral market phases using a 50-200 day crossing moving average trend following system.

Quality and Value
Now comes some interesting research results from Research Affiliates showing conditioning value investing with certain quality factors potentially adds alpha as well (emphasis added):
We used three measures to capture the pertinent information: return on equity (ROE) to reflect growth and profitability; the debt coverage ratio to represent the likelihood of default; and the accruals-to-average-total-assets measure defined by Sloan (1996) to quantify possible accounting red flags.12 To arrive at company-specific quality measures, we used the simple arithmetic average of each stock’s percentile rank for these three variables.

The first line of Table 2 shows the performance of a simple long–short strategy based on this quality measure. On average the strategy produces a small negative return. It has some alpha after we control for factor exposure and negative exposure to the value factor.
When we use quality in conjunction with value, the results are much better. The second line of Table 2 shows the results of a portfolio where we go long value stocks with high quality and short growth stocks with low quality. This long–short strategy has annual alpha of 11.2% per annum. A substantial portion of this statistically significant alpha comes from conditioning on quality information. The annualized alpha, controlling for the Fama–French–Asness–Carhart four factor model, is 9.3% per annum.
On a long-only basis, the value-high quality combination exhibited higher returns with lower volatility when compared to the value-low quality combination.

The authors concluded (emphasis added):
The high quality value portfolio has fewer distressed, slow growing, unprofitable companies with potentially questionable accounting practices. As a result, the high-quality value portfolio has a better risk-adjusted return. Quality is not, in itself, a factor that generates a premium; but value investing conditioned on a properly specified concept of quality is a powerful investment strategy.
This is another example of how combining factors can add value. In fact, the use of both of these disciplines, namely price momentum-trend following and quality-value, can be highly complementary strategies in a quantitative equity portfolio.

Tuesday, July 22, 2014

Returning to high school, investment style

Investment manager Jane Hwangbo wrote a terrific first post about what it's like to become an accomplished investment manager (emphasis added):
One of the strongest behavioral tendencies we possess as human beings, no matter what line of work we choose for ourselves, is that we never really want to leave high school. Let me explain: We would rather not go through the emotional pain again of being a freshman in a senior-dominated world. We like the feeling, once we have made it, of being one of the cool kids, and will actively promote it and behave in such a way that reassures that we never “start over”. In the world that I live in, managing people’s money and investing it in assets, there are many sets of cool kids – the bond managers, the equity managers, the currency kings, and so on. I have a strong professional history in equities (stocks), while others have a strong background in bonds (fixed income), currencies (e.g. US dollars vs. Japanese yen), or commodities (bets on future price swings of things like oil, natural gas, or corn).

As a general onlooker, you would think that as a particular fund manager grows more and more accomplished in a major field of the markets, say equities in my case, one would also become an expert on all things markets-related, like bonds and currencies and commodities as they are all connected to each other. However, the opposite really happens, because most of us never want to feel like a freshman again. It’s painful to start at ground zero, knowing nothing, how things move, and why they move the way they do. One must ask dumb-sounding questions to get going in accumulating a fresh knowledge base, and when you’re a highly respected specialist in the field you have mastered, this is a huge psychological barrier to becoming fluent in other asset classes. The equity managers I know have a very shallow understanding of how bonds trade, and most bond managers do not pay more attention to equities than noting the performance of the SP 500. These managers are very smart people, by any measure. This condition goes beyond asset managers – I have rarely met “in real life” an accomplished economist who can invest with great success. There are very few. The opposite applies to managers in markets – they are typically terrible economists.
Like Ms Hwangbo, my specialty is equities. However, as the saying goes, I know enough of other languages (bonds, derivatives) to get my face slapped.

A risk appetite warning gone wrong
So it has been with some disappointment that I have recently seen analysis by accomplished equity specialists making erroneous conclusions about risk appetite and making conclusions about the stock market. One of many examples is to compare the relative performance of the junk bond ETF (HYG) to the long Treasury ETF (TLT). As the chart below shows, the HYG-TLT ratio (in purple) started to roll over in January, while the stock market (in black) continued to advance. This analysis suggests a negative divergence that represents a warning of declining risk appetite.

Nothing could be further from the truth. The HYG-TLT ratio is a relative price performance chart. As good bond investors know, price performance of a bond portfolio comes from principally two factors:

  1. Interest rate sensitivity (duration)
  2. Changes in credit spreads
I will show that the HYG-TLT ratio rollover is more a function of the first factor than the second. As the bottom panel shows, the yield of the long Treasury bond has been declining since January and coincides with the underperformance of HYG against TLT. 

A bond math primer
First, here is a little bond math. The interest rate sensitivity of the price of a bond is a function of its duration. Here is the formula for Macaulay duration, but the math-phobic need not worry too much about what the Greek letters lounging on their sides mean.

Here are the important properties of duration that you need to know:
  • The longer the duration, the more sensitive the price is to changes in interest rates
  • For bonds with equal coupons, a longer maturity bond will have a longer duration
  • For bonds with equal maturities, a lower coupon bond will have a longer duration
Putting this concept into practice, I went to iShares and looked up the duration of TLT, which came to 16.9 years.

iShares also showed the duration of HYG to be 4.0 years. These two ETFs have a serious duration mismatch. It was that duration mismatch that mainly accounted for the differential in performance when interest rates started to fall in January.

A better Treasury comparison for HYG would be IEI, the 3-7 year Treasury ETF, with a duration of 4.5 years:

Better measures of risk appetite in bonds
With that analysis in mind, here is the HYG-IEI ratio as a better measure of risk appetite as duration risk between the two ETFs have been minimized. The relative uptrend of HYG to IEI was broken and turned down only this month, not in January as the HYG-TLT ratio showed. This broken relative uptrend represents an early warning of declining risk appetite that needs to be watched and confirmed by other indicators. The downturn in the HYG-TLT ratio was a false alarm.

On the other hand, the relative performance chart of the Emerging Market bond ETF (EMB), with a duration of 7.1 years, against the 7-10 year Treasury ETF (IEF), with a duration of 7.6 years, shows that the EMB-IEF ratio staged a relative upside breakout and is now consolidating just about the breakout zone. While the EMB-IEF ratio readings have been far more volatile, its behavior has not confirmed the risk appetite rollover in the HYG-IEI ratio.

In conclusion, I staged this exercise as an illustration of what Jane Hwangbo wrote. Even if you are one of the "cool kids", you need to continually "ask dumb-sounding questions to...accumulate a fresh knowledge base". That's why I remain a "humble" student of the markets.

Monday, July 21, 2014

Dissecting the bull case for China

Regular readers will know that I have been relatively cautious on the outlook for China. But despite recent dire headlines such as China debt surges to 251% of GDP, China has not crashed. What`s more, I have seen a number of bullish calls on Chinese and Asian equities. Here is one example (via CNBC):
"We have been cautious on China for most of the past three years," Guy Stear, head of research for Asia at Societe Generale, told CNBC.

But this year, he's been "very impressed" by the government's reform measures.

"That's made us a little more comfortable that the valuations are worth it," he said, adding that Societe Generale has turned bullish. "The valuations are quite cheap," Stear said.

Comparing valuations between U.S. and China shares on a price-to-book and medium-term economic growth basis, "you're probably talking about a valuation difference of four to one," he said.
A Morningstar interview with Oppenheimer manager Justin Leverenz indicates that he is bullish on the China growth theme:
I think the most interesting theme at the moment is everything associated with the great concern about China. And those have many different facets.

What we've seen, of course, is that China has been this unbelievable growth story for the last decade, but equities have been probably the worst major bourse in the world. And selectively, we're now starting to see some opportunities emerge alongside this because the pessimism is far too great, and there are some really extraordinary companies, which is really what we're focused on.

The second issue in terms of China is opportunities for extraordinary global businesses that have a large part of their franchise in China. As you know, I typically have about 10% of my fund in developed-markets companies that domiciled in developed markets, but have their principal growth engines or principal assets and earnings and cash flow associated with the developing world, largely China in many cases.

Companies like Pernod or Prada have some really extraordinary prices associated with, again, concerns about the Chinese durability of the economy. Actually there are more recent concerns about anti-austerity measures which have taken away part of the gifting market in that segment. But these are incredibly durable businesses with relatively low penetration. And I think one of the great themes in the world is not the emerging-markets middle class, but the Chinese middle class, and part of that's associated with tourism and increased leisure and spending.

So, I think all things related to pessimism about China really is maybe the most interesting near-term theme we're looking at, or subtheme.
From a technical viewpoint, Peter Brandt wrote that Asia — The Tigers are Ready to Roar. Here is the key conclusion:
Asian equity markets are on the verge of explosive advances. Investors and traders need to find ways suitable to their investment strategy to have significant long exposure in Asian equities.
The Short Side of Long recently pointed to the rising bearishness over China but the resilience of the Shanghai Composite as an indication to turn cautiously bullish:
The truth is, Chinese mainland stock market is incredibly oversold. After peaking in 2007 at around 6000 points, the index finds itself 66% lower 7 long years later. Furthermore, since 2009, Shanghai Composite has failed to staged a multi-quarter rally. Constantly bombard by bad news and a sideways trending market, investors have surely forgotten that Chinese stocks can actually go up, too.
While I remain somewhat cautious on China, every good investor should always examine the other side of his views and this post is an attempt to review the bull case for the Middle Kingdom.

China's policy dilemma
I have outlined Beijing's policy dilemma before (see China, beyond the hard/soft landing debate). Here are the basics:
The roots of China's growth
The China miracle was fueled mainly by two factors:
  1. Access to a cheap source of labor and the willingness to use it as a source of competitive advantage to grow the economy; and
  2. The CNYUSD currency peg.
While the currency peg allowed Chinese labor to be highly competitive, it also created all sorts of nasty side effects. First and foremost, China was stuck with America's monetary policy, which was inappropriate for China. As the Chinese economy heated up and inflation rose, Chinese interest rates could not rise with inflation and inflationary expectations because of the currency peg. Thus, real interest rates went negative.

Negative real interest rates created winners and losers. The winners were the companies with easy access to capital, which were mostly the SOEs at the expense of private businesses, which are often referred to as Small and Medium Enterprises (SMEs). An academic paper called A Model of China’s State Capitalism (h/t Michael Pettis) that shows that the dominance of SOEs and their superior growth is largely attributable to their monopolistic or semi-monopolistic positions in the Chinese economy, e.g. telecom, oil refining. etc. John Hempton called this arrangement a kleptocracy because Party insiders have become enormously wealthy at the expense of the ordinary citizen.

Negative interest rates also meant very low or negative cost of capital. As Japanese companies found out in the late 1980's, it's easy to make money when your cost of capital is that low. You borrow as much as you can and invest in something, anything with a positive real return. If you are positioned properly, you can make obscene profits - and they did.

Currency peg = Financial repression
The biggest loser in China, on a relative basis, was the household sector. The ordinary Chinese who worked hard and managed to squirrel away savings had few places to put their money other than the banking system. The Chinese bond market is not sufficiently large. The stock market is very small and undeveloped compared to major industrialized countries and is regarded mostly as a casino. The household sector was forced to put money into the banking system at negative interest rates. Carmen Reinhart calls that financial repression. Here is the definition from Wikipedia:
Reinhart and Sbrancia characterise financial repression as consisting of the following key elements:
1.Explicit or indirect capping of, or control over, interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
2.Government ownership or control of domestic banks and financial institutions with simultaneous placing of barriers before other institutions seeking to enter the market.
3.Creation or maintenance of a captive domestic market for government debt, achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
4.Government restrictions on the transfer of assets abroad through the imposition of capital controls.
John Hempton at Bronte Capital outlined the dilemma of the Chinese household well:
The Chinese lower income and middle class people have extremely limited savings options. There are capital controls and they cannot take their money out of the country. So they can't invest in any foreign assets.

Their local share market is unbelievably corrupt. I have looked at many Chinese stocks listed in Shanghai and corruption levels are similar to Chinese stocks listed in New York. Expect fraud.

What Chinese are left with is bank deposits, life insurance accounts and (maybe) apartments.
For those ordinary Chinese citizens who could afford it, the only logical place for savings is in real estate. Real estate became a form of money and savings poured into it. In effect, the CNYUSD peg was indirectly responsible for China's property boom.

Where we are today
Fast forward to today. China's growth has hit a slow patch. One of the objectives in the Party's latest five-year plan calls for a re-balancing of growth away from heavy infrastructure spending, which has benefited SOEs, to the consumer (read: household sector). Andy Xie described the slowdown and how the authorities have managed to contain the worst effects of the downturn:
There are no widespread bankruptcies. The main reason for this is government-owned banks not foreclosing on delinquent businesses. Of course, banks may have more bad assets down the road, which is the cost for achieving a soft landing.
SOEs, the vehicle of wealthy Party insiders, have been hit hard:
State-owned enterprises (SOEs) reported 4.6% net profit margin on sales and 7.4% return on net asset in 2011. Both are very low by international standards. In the first five months of 2012, SOEs reported a 10.4% decline in profits but 11.3% increase in sales.
SOE performance indicators are low and declining. This is despite the fact that SOEs have such favorable access to financing and monopolistic market positions.
Xie also echoed Hempton's kleptocracy claims, though in a less dramatic fashion:
Closer observation gives clues as to why SOEs are so inefficient. Their fixed investment often costs 20% to 30% more than that for private companies and take about 50% longer to complete. The leakage through overpriced procurement and outsourcing and underpriced sales is enormous. SOE leakage can explain much of the anomalies in China.
In addition to the problems presented by slowing growth, the financial system is teetering because of an over-expansion of the shadow banking system (see my previous comment Ominous signs from China). Left unchecked, it could have the potential for a crash landing, i.e. negative GDP growth, which is not in anybody's spreadsheet model.

How do you end financial repression?
The key to re-balancing growth is to end, or at least, ease the effects of financial repression on the household sector. But ending financial repression would directly hit the wallets of Party cadres. Consider, as an example, this Bloomberg story of how people try to bribe their way into the People's Liberation Army, or PLA:
“It’s impossible to weed out corruption at the basic level, because it’s embedded in the culture,” said retired Major General Xu Guangyu, a senior researcher at Beijing-based research group the China Arms Control and Disarmament Association. “The central leadership knows corruption is the number one enemy the army faces, and if strong-handed measures aren’t taken, it would weaken the army’s capabilities to fight a modern war.”
That's because the incentives for corruption is ever present (emphasis added):
While entering the military provides a stable income, the incentive for corruption after joining remains. New recruits get a yearly package of around 25,000 yuan ($4,031) in Beijing and 15,600 yuan in rural areas such as Haiyan county in Zhejiang province, according to state media. Inspectors in April in two major military regions -- Beijing and Jinan -- said they found “irregularities” in the handling of promotions, construction and allocation of military buildings, and misuse of assets, especially land, the official Xinhua News Agency reported.
Notwithstanding what happens in the PLA, the temptation and opportunities for Party officials to line their own pockets is even bigger in SOEs. Sara Hsu, writing in The Diplomat, outlined the problem of Chinese SOEs:
The tight interconnection between state apparatus and economically critical firms has had other repercussions besides low efficiency. The National Audit Office recently uncovered fraud in 11 SOEs, finding that some managers spent company funds on luxury goods and entertainment. This is in addition to 35 cases of bribery and embezzlement uncovered earlier this year. Corruption associated with SOEs and, more broadly, state assets owned by the “princelings” and other cronies has recently been exposed in a comprehensive state crackdown on corruption.

"Reform" starts with an anti-corruption drive
Many western analysts misunderstand the term "reform" when it comes to China. They think in terms of westernized institutions, such as transparency, property rights, democracy, etc. For Beijing and President Xi Jinping in particular, reforms starts with a consolidation of power through an anti-corruption drive. Otherwise, no financial reforms are possible because Beijing would issue edicts and the bureaucracy would resist.

In a recent WSJ article, Anne Stevenson-Yang and Ken DeWoskin explained these concepts:
China analysts have missed the story by peering at the landscape of reform and trying to find step-by-step progress toward economic liberalization. The disjunction between foreign and domestic understanding of what constitutes "reform," in fact, illuminates a fundamental misunderstanding of foreign commercial involvement. In today's post Third Plenum China, "reform" means to sideline and squash institutionalized bureaucracy and inject personal power into a sclerotic system. It means cutting through the layers of paperwork that invite bribery.
But what China has never had and never meant by its use of the word "reform" is the codification in law and practice of rules to govern transparently and at scale a growing economy. Rules are seen as stultifying, an impediment to the ability of the core ruling class to impose its will. The color of China's huge library of new laws, rules, and regulations is gray, leaving broad license for administrators to enforce them. The consequence is a large measure of chaos in the actual regulation of industry and commerce.
The true "reform" came from the concentration of power in the hands of Xi Jinping:
Yet the true and dramatic reforms are already laid out in plain sight; observers were simply looking for the wrong thing. The most sweeping of changes was a major restructuring of power, the formation of two new super-ministerial committees, one for foreign and domestic security and one for economic reforms, which, in actuality, were designed to override the machinery of government. After a period of lively speculation about who would head these committees, it was announced that Xi Jinping would head them both.

The hopeful bull case for China
That`s where the hopeful bull case for China begins. In the past, the leadership has launched "show" anti-corruption campaigns. This time, it seems to be real and the aim is to consolidate power at the top so that Xi can launch the real "reform" campaign of economic liberalization to re-balance economic growth.

Consider these stories that have come across my desk in the past few weeks. From Foreign Policy:
In late June, the Chinese Communist Party expelled Xu Caihou, who before his retirement in 2012 was one of the highest ranking members of China's military the People’s Liberation Army (PLA). Xu had been accused of taking bribes, and "gravely violating party discipline." A former vice-chairman of the Central Military Commission, the body that oversees the PLA, Xu is the highest ranking military official to be publically accused of corruption in at least 35 years. Simply put, this is a big deal.

Xu’s ouster comes on the heels of a host of dismissals and investigations of other occupants of top political offices since Xi Jinping became China’s leader a year and a half ago. A top Chinese investigative magazine Caixin recently published a graphic list of these key targets in Xi’s anti-corruption campaign; Chinafile has adapted it, adding its own research, to create this interactive timeline.
From Bloomberg:
China filed graft charges against the former deputy director of the economic planning ministry, saying he illegally received money and goods in bribes.

Liu Tienan, 59, former deputy head of the National Development and Reform Commission, was accused of seeking gain for others, a statement on the Supreme People’s Procuratorate said yesterday. The case was filed with the People’s Intermediate Court in Langfang city in central China’s Hebei province, it said. The procuratorate described the bribes as “extremely large.”
From the South China Morning Post:
An ancient Chinese aphorism says a wily hare has three burrows. Gong Aiai , a former bank executive in Shaanxi's Shenmu county, went one better, using four identities to build up a Beijing property portfolio worth more than one billion yuan (HK$1.24 billion).

At first, internet users revealed that the 49-year-old former deputy chief of Shenmu Rural Commercial Bank had used two names, two identity cards and two hukou (registered household addresses) to buy 20 properties in the capital.

Gong, once reputed to be the coal mining county's richest woman, said she thought it was auspicious to have two names and she had just been silly and ignorant. She said the properties were bought with her family, using money from coal mining.

Shenmu police said it was a registration error and the extra hukou was revoked.

People found this hard to swallow and they were proved right when further tip-offs led the media to report that Gong actually had four ID cards and four hukou, three in Shenmu county and one in Beijing.
Another tale of corruption of Party officials from the South China Morning Post:
China's ruling Communist Party said today it had expelled two more former senior officials for corruption, laying the way for their prosecution, as the government continues a high-profile campaign against deep-rooted graft.

The party's anti-corruption watchdog said in brief statements that Mao Xiaobing, former party boss of the western city of Xining, and Zhang Tianxin, former party chief of the southwestern city of Kunming, had “serious discipline problems”.

“The investigation found that Mao Xiaobing took advantage of his post to seek profits for others, demanded and took a huge amount of bribes and committed adultery,” the watchdog said in a statement.

Party members, especially senior officials, are supposed to be morally upstanding and adulterous affairs are considered a serious breach of party discipline.

Mao, whose investigation was announced in April, will be handed over to judicial authorities for prosecution, the watchdog said. He has also been sacked.

The former Kunming official, Zhang, also abused his official position, with his dereliction of duty causing “a loss of state assets”, the party said.

It did not say if he had been handed over to the prosecutors, but that is the most likely next step.
The anti-corruption campaign appears to be in full swing. The Washington Post reported Xi has relied on a special anti-corruption group to pursue wrongdoers:
The institution has an obscure name — the Central Commission for Discipline Inspection. But in the year and a half since Xi Jinping became China’s leader, it has become his main weapon in an anti-corruption campaign that has gone further than any other in the country’s modern history.

The campaign is meant to clean up the party’s image — so soiled by graft that some leaders fear public contempt could threaten their grip on power. It also appears aimed at consolidating Xi’s power. He has used the commission to weaken rival factions and, more broadly, to warn off anyone who might challenge his agenda.
The commission has extraordinary powers, much in the way the Holy Inquisition *ahem* Congregation of the Doctrine of the Faith had powers:
The Chinese commission has far more latitude than those U.S. agencies and is much more politicized. It operates entirely outside the legal system, as a Communist Party justice mechanism. Its investigators need no warrants to seize evidence. And it has the power to imprison and interrogate any party official.

Although the worst official punishment the commission can mete out is booting cadres from the party, its investigations are often transferred after the fact to the judicial branch, where the expelled officials usually receive heavy sentences.

The commission now appears poised to take down its biggest target yet: Zhou Yongkang, once a member of the top standing committee headed by Xi.
The takedown of Zhou Yongkang is unprecedented in modern Chinese history. One analyst likened it to the Obama Administration taking down the circle of Dick Cheney with criminal, tax and other investigations, starting with his friends, his associates, his family (e.g., Liz Cheney) and finally the former vice-president himself.

The next step is easing financial repression
The anti-corruption drive is a necessary first step to end, or at least ease, the effects of financial repression for the household sector in China. Since the state-owned sector has reaped the lion's share of the benefits from past growth, it appears that Xi needs to curtail their power before the real task of financial liberalization can begin.

This Bloomberg story entitled China’s Repression of Savers Eases shows that the process is already underway:
The extra interest Yin Xuelan earned last year by socking her savings into wealth management products instead of bank deposits paid for a tour of Taiwan and a microwave oven.

“I didn’t need to go to Taiwan and I didn’t need to buy a microwave oven, but with this extra money, why not?” said retired schoolteacher Yin, 60, as she put receipts into her pink purse at an Industrial + Commercial Bank of China Ltd. branch in central Beijing. “It’s like free money.”

Yin is a beneficiary of an easing in China’s financial repression, a term that describes the way savers have suffered artificially low returns on deposits in order to provide cheap loans for investment. Measures used for the size of the toll -- such as inflation-adjusted deposit rates, the gap between rates on loans and the pace of economic growth -- have shifted in favor of savers in the past four years.

The burden has dropped to the equivalent of about 1 percent of gross domestic product annually from 5 percent to 8 percent as recently as three to four years ago, estimates Michael Pettis, a finance professor at Peking University. (618) That’s a shift of as much as 2.6 trillion yuan ($420 billion) to households from borrowers from 2010 to 2013.
The effects of financial repression are easing and SOEs are bearing a greater burden:
Financial repression, a concept detailed in 1973 by Stanford University economists Ronald McKinnon and Edward Shaw, refers to policies that force savers to accept returns below the rate of inflation and that enable banks to provide cheap loans to companies and governments, reducing the burden of their debt repayments.

A sustained easing would channel more of China’s wealth to the average person while squeezing bank margins and the debt-fueled investment that’s evoked comparisons with the excesses that generated Japan’s lost decades and the Asian financial crisis. On the flip side, slimmer bank profits may add to risks for an industry grappling with the fallout from record lending in the aftermath of the global financial crisis.

“Many local governments and state enterprises have made low-return investments based on the low-cost funding,” said David Dollar, a former U.S. Treasury Department official in China who is now a senior fellow at the Brookings Institution in Washington. “As the cost of capital rises, some of them no doubt will have difficulty servicing their debts and may even be pushed into bankruptcy.”
One of the goals is to move the economy towards a more market based economy:
Chinese authorities are transitioning from a system of state-directed credit to one where markets play what Communist Party leaders term a “decisive” role in pricing capital. A floor was removed from lending rates in July 2013 and People’s Bank of China Governor Zhou Xiaochuan said in March that deposit rates will be liberalized in one to two years.

China's short-term challenges
In short, what I have outlined are the hopeful bullish signs for China's growth outlook. The anti-corruption drive throws the bureaucracy off-balance and enables the Beijing leadership to effect market-based reforms and to re-balance the source of growth from the same-old-same-old credit driven infrastructure driven growth to consumer-driven growth. To do that, Xi needs a re-distribution of wealth from the state-owned sector and Party insiders to the household sector. It will be a challenging task.

As if that is not enough, China has to deal with a credit-driven overhang of excessive investment in property and infrastructure. Bloomberg reported that a record number of cities (55 of 70) saw property prices fall.

This chart from George Magnus illustrates the magnitude of the supply and demand problem in real estate:

These problems are not totally intractable, but there are no easy answers. The trillions in foreign exchange reserves held by the PBoC cannot solve the problem without unwanted consequences (see my previous post China's new paper tiger?). Just because the central government has a deep pocket, it cannot assume the loss for those non-productive assets built during the boom without some form of blow-back. Michael Pettis explained in a recent post:
To the extent that China has significant hidden losses embedded in the balance sheets of the banks and the shadow banks, over the next several years Beijing must decide how to assign the losses. If it assigns them to the household sector, it will put significant downward pressure both on household income growth (which will be less than GDP growth) and, consequently, on consumption growth. Rebalancing means effectively that consumption growth (and household income growth) must exceed GDP growth, which means that even if GDP growth slows to 3-4%, as I expect, household income can continue growing at 5-6%. This explains why, contrary to the consensus, a more slowly growing, rebalancing China will not lead to social unrest.
Who eats the loss? If it's the household sector, then it means a return to financial repression and the end of re-balancing:
If the losses are assigned to the household sector, China cannot rebalance and it will be more than ever dependent on investment to drive growth. This is why I reject absolutely the argument that because China resolved the last banking crisis “painlessly”, it can do so again.
If the SME, or private, sector takes the loss, then the government is seriously penalizing a key engine of economic growth:
Beijing can also assign the losses to SMEs. In effect this is what it started to do in 2010-11 when wages rose sharply (SMEs tend to be labor intensive). It is widely recognized that SMEs are the most efficient part of the Chinese economy, however, and that assigning the losses to them will undermine the engine of China’s future productivity growth.
They can get the SOEs to pay, but that is politically difficult:
Finally Beijing can assign the losses to the state sector, by reforming the houkou system, land reform, interest rate and currency reform, financial sector governance reform, privatization, etc. Most of the Third Plenum reforms are simply ways of assigning the cost of rebalancing, which includes the recognition of earlier losses, to the state sector. This is likely however to be politically difficult. China’s elite generally benefits tremendously from control of state sector assets, and they are likely to resist strongly any attempt to assign to them the losses.
It appears that Xi Jinping is trying to effect the last alternative and starting the process with an anti-corruption drive. If it works, it will be positive for China in the long-term, but the near-term outlook remains uncertain.

The Pettis "best case" scenario
Michael Pettis laid out the policy dilemma facing Beijing and outlined a best case scenario for China this way:
I have always thought that the soft landing/hard landing debate wholly misses the point when it comes to China’s economic prospects. It confuses the kinds of market-based adjustments we are likely to see in the US or Europe with the much more controlled process we see in China. Instead of a hard landing or a soft landing, the Chinese economy faces two very different options, and these will be largely determined by the policies Beijing chooses over the next two years.

Beijing can manage a rapidly declining pace of credit creation, which must inevitably result in much slower although healthier GDP growth. Or Beijing can allow enough credit growth to prevent a further slowdown but, once the perpetual rolling-over of bad loans absorbs most of the country’s loan creation capacity, it will lose control of growth altogether and growth will collapse.

The choice, in other words, is not between hard landing and soft landing. China will either choose a “long landing”, in which growth rates drop sharply but in a controlled way such that unemployment remains reasonable even as GDP growth drops to 3% or less, or it will choose what analysts will at first hail as a soft landing – a few years of continued growth of 6-7% – followed by a collapse in growth and soaring unemployment.
In other words, the best case is a “long landing” where growth slows gradually to 3-4% and re-balances wealth distribution in favor of the household sector:
The amount of the direct or indirect wealth transfer from the state sector to ordinary households is, I think, the most important variable in understanding China’s adjustment. The pace of growth will be driven largely by the pace of household income growth, which will itself be driven largely by the pace of direct or indirect wealth transfers to ordinary Chinese households. If we could guess this right, much else would almost automatically follow.
Unfortunately, the latest GDP figures suggest that the "long landing" may not be the base case outcome for China. In the short term, Ed Yardeni commented that China is still relying too much on credit driven growth, which is more likely to the Pettis "loss of control" and "collapse" scenario in the not too distant future:
The Chinese government is no longer providing massive economic stimulus to prop up China’s growth rate. Instead, the government is targeting spending in a more rifle-shot approach. That’s the official mini-stimulus story. It just doesn’t jibe with the latest “social financing” data, which show that China’s economy continues to be flooded with credit. It worked in the past, and it should work now. But one day, it won’t work, and the economy could sink rather than float on the sea of credit. Let’s review the latest data:

(1) Social financing rose $320 billion during June. That’s not an annualized number. It is the amount of borrowing by all sectors just during that one month. On a ytd basis, it totals a staggering $1.7 trillion compared to $1.6 trillion over the same period last year.

(2) The totals above include bank loans, which increased $175 billion during June and $934 billion ytd. Chinese bank loans totaled a record $12.6 trillion during June, 64% more than the loans held by US commercial banks.

The market's verdict
Despite some of these somewhat hopeful signs of an anti-corruption campaign, my long-term technical call for China remains an "underperform" ranking. The chart below of an equal-weighted portfolio Greater China ETFs (FXI for China, EWH for Hong Kong, EWT for Taiwan and EWY for South Korea) shows that Greater China (in red) remains in a long-term relative downtrend compared to MSCI All-Country World Index (ACWI). In addition, the Chinese sensitive resource markets (EWA for Australia, EWC for Canada and EZA for South Africa) are also in a relative downtrend.

However, if Xi Jiping were to succeed in his initiatives and achieve the Pettis "long landing", the primary beneficiary would be the Chinese household sector, as represented by consumer-sensitive PGJ ETF, and not the old state sector, as represented by FXI. The chart of PGJ compared to FXI shows that Chinese consumer stocks remains in a volatile uptrend compared to the financial sector heavy FXI (also see my previous post A New China vs. Old China pair trade):

If any China bulls were to make a bet on China, then PGJ is probably the better vehicle as it is more exposed to the consumer sector (though I would add the caveat that it is very technology and internet heavy and therefore exposes the investor to a high degree of sector concentration risk).

Sunday, July 20, 2014

The leadership surprise in this bull cycle

Weekly Trend Model signal
Trend Model signal: Risk-on
Direction of last change: Positive (for an explanation, see An intriguing Trend Model interim report card).

Looking for leadership in the current bull cycle
It is a truism among technical analysts that each bull market is characterized but different kinds of market leaders. After the bull peaks, the old market leaders fade and new leaders take the baton.

As examples, the bull phase of the late 1970`s was marked by hard-asset, inflation-hedge leadership such as Energy and Materials. As a reminder of how difficult it is for former leaders to recover, the poster child of inflation-hedge vehicles, gold, peaked out at $850 in early 1980 and went into a long bear phase that did not bottom out until 2001.

The next bull cycle was characterized by consumer stocks, first the Consumer Staples and the enthusiasm spread into Consumer Discretionary companies. The shares of these companies was driven by the LBO-boom, fueled by junk bond offerings. (Recall Robert Campeau and his junk-bond fueled takeovers of Federated and Allied Department Stores and how it all came crashing down on him.)

The bull market of the 1990`s was the TMT era - Tech, Media and Telecom. The Four Horsemen (Intel, Cisco, Sun Microsystems and Oracle) boomed and it all ended with the NASDAQ peak in March 2000.

The lesson for investors is, "Once a bull market ends, don't cling to the leadership over the previous bull cycle. Look for new leadership." As an illustration of this principle, consider this 15-year chart of the relative performance of Technology stocks relative to the SPX. The sector peaked out with the NASDAQ in early 2000, tanked and has been in a sideways relative consolidation phase for over a decade. While the relative uptrend (shown by the blue arrowed trend line) shows some promise, this sector is unlikely to be the next market leaders for some time. Telecom stocks (not shown) also display a similar pattern of rise, fall and sideways relative consolidation.

Previous leaders falter
So what are the leaders in this bull cycle? I would not look for them among the last bull cycle's leaders. Here is the relative performance chart (all 15-year time frames) of Financials against the market. The relative performance pattern of this sector looks like the Tech sector, but pulled forward by a few years. Financials appear to be undergoing a sideways relative consolidation pattern.

The bull market of the early 2000s was marked by the revival of hard-asset plays. Here is the relative performance chart of the Energy sector. While Energy did not crash as the Financials did in the aftermath of the Lehman Crisis, this sector is either making a broad relative top by rolling over or, more charitably characterized as undergoing a sideways relative consolidation. No leadership here.

The relative performance of the other hard-asset sector, Materials, show a similar pattern of either relative rollver or sideways consolidation.

What about gold and gold stocks, the bellwether inflation hedge vehicles? When I look at the relative performance chart of HUI against SPX, the most likely conclusion is that the best days for this group are in the past and not in the immediate future.

These last three charts suggest that the bull phase of the Commodity Supercycle is largely over.

Looking for the new leaders
Once we have ruled out past leaders, we then look for the new leadership among other candidates. The cyclically sensitive Industrial stocks don`t appear to be the new leaders, as they remain in a broad sideways relative range against the SPX.

A case could be made for the Consumer Discretionary sector, but the knock against these stocks are 1) relative outperformance in the past couple of episodes appear to be cyclical and not secular in nature; and 2) these stocks are starting to falter as they recently breached a relative uptrend. If we accept the premise that Consumer Discretionary stocks constituted this cycle`s secular leadership, then the conclusion is this bull market is over. Kaput!

The healthcare surprise
There are only 10 GICS sectors and the sectors that are left are thought to be defensive in nature: Utilities, Consumer Staples and Healthcare. Relative performance charts of the first two, Utilities and Consumer Staples, do not reveal them to be the market leaders. This bull market`s leadership appears to be (surprise) healthcare.

While healthcare stocks are generally thought to be relatively stable and defensive, there is one growth industry within the sector: Biotechnology (sorry, Janet Yellen). In the past decade, we have seen an amazing number of life extension technologies being announced and worked on in the Biotech industry. As a consequence, the Biotech and Healthcare space are good candidates to be the market leaders for this bull cycle.

From a technical point of view, the Biotech stocks appear to be just getting started. The relative performance chart of IBB against SPY shows that IBB only staged a relative breakout out of a long base lasting over a decade. That`s a formula for much more relative gains.

Despite Janet Yellen's recent comments about stretched valuations in Biotech stocks, CNBC reported that Mark Schoenbaum, who was the top ranked biotech analyst for the past nine years according to Institutional Investor, pushed back on Yellen's comments in a recent published report:
"Dr. Yellen — Thank you for sharing your thoughts recently on the biotech sector. … You stated that biotechnology valuations are 'stretched, with ratios of prices to forward earnings remaining high relative to historical norms.'"

As evidence, Schoenbaum included Russell 1000 data from biotech stocks dating back to 1978, "and my data show that the current ratio is roughly in line with the historical median and is approximately 40% below the peak.

"Please tell me what I'm missing, Dr. Yellen," he wrote.

Schoenbaum added that he had a "great deal of respect" for Yellen.

"However, we have a different view, perhaps, of the data on price-to-earnings ratios," he said.

Schoenbaum called biotech is "a large, large sector" with hundreds of companies, "most of which have no profits and no earnings. They're basically options vehicles based on a drug that will report data out in a few months. And certainly, in 2012 and 2013, it was an unprecedented bull run in biotech. For some of those stocks, there's probably too much optimism baked in.

"But of course, in the giant universe of biotech stocks, you're going to find stocks that are overvalued and you're going to find some that are undervalued."

More room for this bull to run
Since market leadership generally changes when a bull market ends, then the longevity of the run in Healthcare and Biotech is a function of the health of the current bull run. Despite my concerns about valuation (see More evidence of a low return equity environment), I believe that this bull market is long from over. Even Jeremy Grantham, who has been known as a value investor, is postulating a M+A driven market bubble for the stock market:
These are my reasons. First, when compared to other deal frenzies, the real cost of debt this cycle is lower. Second, profit margins are, despite the first quarter, still at very high levels and are widely expected to stay there. Not a bad combination for a deal maker, but it is the third reason that influences my thinking most: the economy, despite its being in year six of an economic recovery, still looks in many ways like quite a young economy. There are massive reserves of labor in the official unemployment plus room for perhaps a 2% increase in labor participation rates as discouraged workers potentially get drawn into the workforce by steady growth in the economy. There is also lots of room for a pick-up in capital spending that has been uniquely low in this recovery, and I use the word “uniquely” in its old-fashioned sense, for such a slow recovery in capital spending has never, ever occurred before. The very disappointment in the rate of recovery thus becomes a virtue for deal making.

Previous upswings in deals tended to occur at market peaks, like 2000 and 2007, which in complete contrast to today were old economic cycles already showing their wrinkles. Worse than being in full swing, they were usually way over capacity. Thus, 2000 was helped along by the bubble in growth stocks to over 60 times earnings, allowing companies like Cisco, possibly correctly, to believe they were dealing with a near-zero cost of capital in making deal after deal for their massively overpriced stock.
Bull markets end in one of two ways, recession or a correction from excess valuation (1987, 2000 for NASDAQ). There are few signs of a US recession in the near future. Grantham wrote that the US economy "looks in many ways like quite a young economy" with more expansion potential in the future. As well, the latest review of high-frequency economic indicator from New Deal Democrat is also pointing to continued strength.

While valuations appear somewhat stretched, any market downturn needs a trigger. I have expressed some concerns about the possibility of an EPS growth scare. However, the early indications from Bespoke show that EPS and revenue beat rates this earnings seasons are at or above historical norms.

If Healthcare and Biotech are indeed the new leaders of this market cycle, then we need more excesses to build before this bull run is over. One sign is the sector weighting of Healthcare. Bespoke reports that Healthcare only represents the third highest weight in the SP 500. Before the bubble pops, we need to see this sector to get to at least the second largest weighting, or perhaps the top weighted sector in the SP 500.

Given the technical picture of the relative upside breakout of Biotech stocks and the sector weighting position of Healthcare, these stocks may have a lot further to run.