Sunday, August 30, 2015

2015 = 1998?

Trend Model signal summary
Trend Model signal: Neutral
Trading model: Bullish

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.

Trend Model signal history

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent.

Surveying the technical damage
Wow! The great big smoking crater in the stock charts is the financial equivalent of surveying the damage from the Tianjin explosion. To say that much technical damage has been done is an understatement. For the sake of consistency, I will be showing the weekly point and figure charts of different market indices, all with a 0.5% box and a 3 box reversal. This is a chart of the broadest US market index, the Wiltshire 5000, but the picture for all of the US indices look more or less the same. The uptrend has been decisively broken.

Across the Atlantic, here is the UK`s FTSE 100. The pattern looks ugly.

On the Continent, here is the Euro STOXX 50.

In Asia, here is Hong Kong Hang Seng Index.

South Korea`s cyclically sensitive KOSPI Index.

Here is Taiwan.

I could go on, but you get the idea. These are weekly charts going back several years - and the obvious technical conclusion that can be drawn is that the bull run of the last few years is over.

On an intermediate term basis, all of my technical training tells me that there are really only two ways forward from here. Either the market bottoms here or this is the start of a bear market.

The stock market was obviously very oversold right now and it is bouncing. Once the reflex rally peters out, either the SPX consolidates sideways and bases, which does not rule out a re-test of the lows, or this is the start of a bear market. In that case, the market weakens to new lows after the bounce.

Under the bear market scenario, the key question then becomes whether the market is re-tracing its upward move from the bottom formed in 2011 or in 2009. While initial support exists at the 1820-1860 area, Key Fibonacci downside targets for a 2011 retracement would be at about the 1730 and 1600. By contrast, the initial downside targets of a 2009 retracement are 1570 and 1400. Any way you look at it, those targets are a long way down from here.

What's the bearish trigger?
On the other hand, the macro and fundamental strategist in me rebels against the idea of a bear market. In order for stock prices to go down, the slow (but big) institutional money has to have a fundamental reason to sell. Frankly, I can't find any at the moment.

Bear markets, though not corrections, have three causes:
  • Recession: Such as what we saw in 2008, 2000, 1990, 1982 and so on. Chart via Business Insider:

  • Overly aggressive Fed tightening: The Fed tightened twice in a week in September 1987, just ahead of the October Crash.
  • War and insurrection: Imagine your country has been taken over by either an unfriendly power. They're rounding up people and executing them at the local football stadium. You are faced with the permanent loss on the value of your assets and maybe your life. Under those circumstances, the value of your stock portfolio is probably the least of your worries.
    None of those conditions are in place right now. Consider the first criteria of pending recession. The latest Q2 US GDP report last week came in at 3.7%, a full 0.5% ahead of expectations. The economy is robust enough that the Fed is contemplating raising interest rates. Recession? You've got to be kidding me.

    In addition, monetary conditions are far from being tight. The chart below of YoY MZM growth shows that money growth was decelerating into the Crash of 1987 and the Lehman Crisis. Today, growth in the monetary base remains benign.

    Across the Atlantic, monetary conditions are also highly accommodative. Ambrose Evans-Pritchard pointed out that eurozone money growth is accelerating as the ECB is flooding the system with liquidity. Nope, no sign of overly aggressive central bank tightening here.

    Eurozone money growth

    As well, Variant Perception pointed out that global liquidity is on the rise. Such conditions have been highly equity friendly in the past.

    What about valuation? In 2000, the reversion in the valuation of the high flying Tech, Media and Telecom stocks pushed the economy into recession. Analysis from Morningstar shows that the median stock is moved from overvalued to 7% undervalued.

    Another a bullish signal of the equity friendly environment is the behavior of the  "smart money" corporate insiders. Insiders have been buying this market weakness since mid-July and increased their buying last week, according to Barron's.

    What about China?
    The key macro risk for global market is the deflationary forces coming from China, which has already leaked into emerging market countries and resource-based economies. Already, there are reports of hot money fleeing Latin America. Can Chinese risk be contained?

    In a Project Syndicate essay, Stephen Roach has conceded that China has a "complexity problem". Simply put, Beijing has its hands full:
    While progress on economic rebalancing is encouraging, China has put far more on its plate: simultaneous plans to modernize the financial system, reform the currency, and address excesses in equity, debt, and property markets. Meanwhile, the authorities are also pursuing an aggressive anti-corruption campaign, a more muscular foreign policy, and a nationalistic revival couched in terms of the “China Dream.”
    Is it any wonder that stresses are showing up in the system?

    For the moment, the risks that China derails global growth is low. The Economist put China's troubles into context this way. Don't pay attention to their stock market, the Chinese property market is far more important and prices are stabilizing:
    So is this the hour of China’s crisis? Highly unlikely. Though the economy faces grave problems, the financial tumult is misleading. China’s stockmarket has long been derided as a casino, and for good reason. The bourse is small relative to the economy, with a tradable value of a third of GDP, compared with more than 100% in developed economies. Stocks and economic fundamentals have little in common. When share prices nearly tripled in the year to June, they no more reflected a stunning improvement in China’s growth prospects than their collapse since then has foreshadowed a sudden deterioration.

    Less than a fifth of China’s household wealth is invested in shares; their boom did little to boost consumption and their crash will do little to slow it. Punters borrowed lots of money to buy stocks in good times, to be sure, and some of that debt will default. But it amounts to just 1% of total banking assets, a potential hit that, although unpleasant, is hardly systemic.

    The property market matters far more for China’s economy than equities do. Housing and land account for the vast majority of collateral in the financial system and play a much bigger role in spurring on growth. Yet the barrage of bearish headlines about share prices has obscured news of a property rebound. House prices have perked up nationwide for three straight months. Two months after the stockmarket first crashed, this upturn continues.
    Goldman Sachs went even further and believes that China is likely to see a near-term positive growth surprise (via Business Insider):
    Despite the recent weakening of growth momentum, policy flexibility for policymakers continues to buoy expectations for a rebound in growth, in Goldman's view.

    On the monetary front, the bank suggests the People's Bank of China will follow up on Tuesday's interest and reserve ratio requirement (RRR) cuts, predicting another rate cut of 25 basis points along with two additional 50-basis-point reductions in the RRR.

    Fiscally, Goldman expects local-government debt swaps — allowing entities to swap shorter-dated, higher-yielding debt into longer-dated, lower-yielding debt — to continue while public-private partnerships are enhanced. It also expects the PBOC to increase direct lending to policy banks, something it thinks "should further improve investment demand, in addition to higher political pressure from the Central government on local officials to invest."

    On reforms that could potentially boost growth, the bank suggests they will be rolled out in the areas of demographic policy, social safety nets, and environmental protection, along with reform of state-owned enterprises.

    With all those factors, particularly on the fiscal front, potentially on the way, Goldman expects fourth-quarter growth of 8.0% (quarter-over-quarter annualized), up from 7.5% expected in the third quarter.
    In times of crisis, don't forget that monetary authorities can ride to the rescue. Ray Dalio, who is one of the most astute global macro thinkers around, turned bearish on China about a month ago (see Is China getting hit with THE BIG ONE?). Despite his bearishness, Dalio believes that the next major move by the Federal Reserve is to loosen, not tighten, monetary conditions, which would be equity bullish (emphasis added):
    While we don't know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces. These long-term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars and holding a huge amount of dollar assets—at the same time as the world is holding large leveraged long positions.

    While, in our opinion, the Fed has over-emphasized the importance of the "cyclical" (i.e., the short-term debt/business cycle) and underweighted the importance of the "secular" (i.e., the long-term debt/supercycle), they will react to what happens. Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required.

    To be clear, we are not saying that we don't believe that there will be a tightening before there is an easing. We are saying that we believe that there will be a big easing before a big tightening. We don't consider a 25-50 basis point tightening to be a big tightening. Rather, it would be tied with the smallest tightening ever. 
    As for issue of emerging market contagion risk, Greg Ip at the WSJ wrote that EM economies are far more insulated from a foreign currency crisis than they were in 1997.

    Even Zero Hedge conceded that (based another Goldman research note) that the risks of a foreign currency crisis is overblown:
    Broadly, Asian FX reserves can be judged to be adequate, with the exception of Malaysia, where FX reserves now barely cover short-term debt.

    In comparison to their status prior to the Asian Financial Crisis, Asia’s fundamentals are (broadly) in better shape. Consequently, we are unlikely to see explosive FX weakness. But other factors are at play, including large debt overhangs in some countries, the sharp decline in commodity prices and political uncertainty in some countries. On the other side of the FX equation, we expect US Dollar strength to continue on the back of solid US growth and the prospect of Fed tightening in coming months. We therefore expect Asian currencies to continue to depreciate.
    If ZH can`t make a bear case, then what reason is there to be bearish?

    Putting it all together, the most likely scenario is therefore the more benign one, where stock prices have seen the lows for this panic. There will be no bear market. Another research note by Goldman projects a SPX 2100 target for year-end and uses the 1998 Russia Crisis as a template for the stock market (via Marketwatch):
    “We expect the U.S. economy will avoid contagion and continue to expand. [The] S+P 500 will rise by 11% to reach 2,100 at year-end. Such a rebound would echo the trading pattern exhibited in 1998, when U.S. equities rallied and largely ignored the Asian financial crisis,” says Kostin. History shows that stock markets tend to recover within three to four months following the end of a correction, he notes.

    In conclusion, China's problems aren't over. Their growth is slowing and it will negatively affect emerging market and resource-based economies. However, contagion risk is fairly limited and, should stress levels rise, the combination of intervention by Beijing and global monetary authorities are likely to kick the can down the road yet one more time.

    Waiting for the next shoe to drop
    As I write these words, stock prices have rebounded strongly from last Tuesday's lows. However, a read of the message boards and my Twitter feed shows that the technical consensus is bearish and calls for a short rebound, followed by a decline to new lows, or at least test the previous lows.

    In short, we have a lot of fast money itching to short into this rally. The bearish consensus may actually be contrarian bullish. According to Mark Hulbert, who found that NASDAQ timers' equity exposure is at a five year low (and did not budge despite the rally late in the week).

    Standard technical analysis calls for a major SPX resistance level at 2040, which was old support turned resistance, further resistance at about 2075, which is the site of both the 50 and 200 dma, followed by 2100, which has acted as a barrier for much of 2015.

    Breadth indicators, such as this one of the net 20 day highs-lows from IndexIndicators, show that the market has swung from an extreme oversold reading to neutral. The momentum of the move suggests that there may be a couple of days left in the rally as the indicator is not overbought yet.

    My base case scenario is an approximate repeat of the 1998 market, with the caveat that history doesn't repeat, but rhymes. I will be waiting for the other shoe to drop in the days and weeks to come. How will the technical internals develop? How will sentiment metrics change should the strength continue? More importantly, what are the positive and negative surprises lurking around the corner?

    A possible bullish surprise could come from policy action. Supposing, that after all of the central bankers confer at Jackson Hole this weekend, they become concerned enough about emerging market contagion risk (such as the move by Turkey to prepare for rising short-term US rates) that they announce coordinated central bank intervention. The Federal Reserve, BoE, ECB, BoJ, SNB, BoC, etc. all announce that they have established very large or unlimited swap lines to a large list of EM central banks, including the PBoC. For the uninitiated, swap lines are the way that central banks borrow at the equivalent of the Fed window. Imagine that a Chinese financial gets into trouble over its USD loans. It cannot go to the Fed window to borrow because it is not under Fed supervision. A swap line allows it to borrow USD from the PBoC, where the PBoC obtains the funds by swap line facility at Fed window rates. In this way, it is the PBoC that is on the hook for the USD facility from the Fed. Such an announcement amounts to a statement by global central bankers standing ready to flood the global financial system with liquidity should it become necessary. Should such a scenario unfold, bearish traders would have to think twice about trying to shoot against the liquidity flood unleashed by central bankers.

    If, on the other hand, there is no policy response. The consensus technical analysis projection would be for the market to weaken and test its lows. Not so fast! Even if we were to use 1998 as a template for today's market, recall that the first leg down was attributable the Russian default, while the second leg to test the lows was sparked by the failure of Long Term Capital Management. What could be lurking in the financial system that could cause that kind of crisis in 2015? One possibility is the FOMC decides that the markets have stabilized enough that it can raise interest rates at its September meeting.

    My inner investor is inclined to accumulate stocks on weakness. He remains neutrally positioned as the rally in bond prices largely offset the fall in stock prices (see The difference between "investors" and "traders").

    My inner trader was battered by the downdraft, but he didn't sell. He will likely reduce some of his long positions should prices approach key resistance levels. He is nevertheless watching key technical support and resistance levels, as well as the possibility of both positive and negative macro shocks. Should the SPX reach some of these resistance levels, he will likely be scaling out of his long positions. We are likely to see some highly volatile markets in the weeks ahead. Under these conditions, it pays to reduce position sizes for risk control purposes, as the swings can be treacherous.

    Disclosure: Long SPXL


    Anonymous said...

    Very insightful. Great to read. Thank you.

    Ghart23 said...

    It's useful to draw a distinction between real trouble (May 2010 first signs of Greece, Aug 2011 debt ceiling mess) and hysterical panic attacks (Oct 2014 Ebola, Aug 2014 The Sky is falling in China) where frantic selling produces severe overshoots to downside. The recovery rate from those two "correction" categories is very different. Practically no one is paying attention to that difference treating all corrections as the same. In a world where Donald Trump and Kanye West can run for President a certain flakiness is in the air.

    Anonymous said...

    It's useful to draw a clear distinction between corrections based on some kind of rational market concerns (May 2010 surfacing of Greece problems, Aug 2011 US debt ceiling impasse) vs. total panic attacks where the market dives in frantic selling prompted by hysteria (Oct 2014 Ebola fears, Aug 2015 The Sky is falling in China). The rate of recovery from these two very different kinds of "corrections" is markedly different. Reality based damage takes months, panic attacks take weeks. The media is treating all corrections as similar.