Sunday, September 13, 2015

A V or W shaped bottom?

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bullish (upgrade)

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.

What kind of bottom?
The fundamental picture hasn't changed very much since the abrupt stock market decline in August. The US economy is still motoring along just fine, to the extend that the Fed is considering raising interest rates at its next FOMC meeting. For my inner investor, this is a time to be looking around for bargains (see Relax, have a glass of wine).

Downside risk on US equities is limited, the only question that remains is whether we are likely to see a V-shaped or W-shaped bottom in stock prices. By a W-shaped bottom, please don't take me too literally. What I mean is a market that chops around for several weeks before taking off again. It certainly does not mean a single re-test of the lows experienced in August 2015 or October 2014.

The case for V: China is "fixed"
Here is the (bull) case for a V-shaped bottom. If the proximate cause of the most recent market weakness was China, we are seeing China worries starting to recede. Callum Thomas highlighted the fact that Chinese real estate prices are starting to rise again - and most of the debt is concentrated in the Chinese property, not the stock market.

Thomas further pointed to analysis showing that China is making progress in re-balancing its economy towards the household sector:

In response to the recent weakness, Xinhua reported that Beijing has blinked (my words, not theirs) and they are considering another fiscal stimulus program:
China is considering more than 1 trillion yuan in fiscal stimulus over the next three years, according to a latest report from the China International Capital Corporation (CICC).

A total of 1.2 trillion yuan (188 billion U.S. dollars) to 1.5 trillion yuan may be taken from the government coffers to replenish the capital for investment projects, mainly those already approved by the authorities, the investment bank estimated.

The stimulus is likely to drive a total potential investment of 5 trillion yuan to 7 trillion yuan in the next three years, or 2.5 percent to 3.4 percent of the 2015 GDP each year, it said.
What about the side-effects of a China slowdown on the emerging market economies? Isn't the combination of slowing Chinese growth and Fed tightening supposed to be a lethal combination? There seems to be some good news on that front as well. The chart below shows the relative performance of US HY bond prices (bottom panel, black line) and EM USD bond prices (bottom panel, green line) relative to their duration-equivalent US Treasury proxies. The last couple of weeks has seen EM bonds outperform US HY, which is a definite vote of confidence by the credit markets in the EM outlook.

The case for V: A robust US economy
Notwithstanding any angst over softness in the EM growth outlook, the US economy appears to be well insulated from weakness abroad. New Deal democrat`s weekly summary of high frequency economic releases summed it up this way, namely that there is no US recession on the horizon:
This week like last week highlighted the difference between those portions of the US economy most exposed to global forces, which have all turned negative, and those most insulated from global problems, which are all positive, and even strengthening. I suspect that the globe, as a whole, is in recession. With good numbers in housing and vehicle sales, and especially with gas prices declining again, the US is still positive, and although I believe we are past the midpoint of this expansion, I still remain positive through the first half of next year.
Data from John Butters of Factset shows that forward EPS estimates continue to rise, which is bullish for equities (annotations are mine):

The case for V: Sentiment puts a floor on stock prices
In addition, sentiment models continue to show a crowded short, which is contrarian bullish. Jason Goepfert highlighted that small speculators are near a record short in US equity futures.

Schaeffers Research also pointed to a highly elevated put-call ratio, based on buy to open data, which is another bullish sign:

My own analysis, based on a combination of AAII sentiment surveys and Rydex data also tells the same story. The chart below shows the evolution of AAII sentiment (black line) and Rydex funds flows (pink lines) over the last 15 years. Whenever either of these metrics get into a crowded short reading (shaded areas), the stock market has historically bottomed in the past. (As an aside, it is interesting that these indicators appear to be better with its buy signals than sell signals.)

In the meantime, the latest update from Barron's shows that "smart money" insiders continue to buy:
Astute readers will note from reading many of the above charts is that sentiment models are often imprecise in market timing. Thus, a V-shaped bottom is not assured.

The case for W: Technical damage
From a chartist`s point of view, the technical damage done by the waterfall decline of August 2015 was too great. After such events, a sideways period of basing and consolidation is necessary before stock prices can revive to new highs.

The point and figure chart of the SPX tells the story. Take 2011 as an example, the market went through a choppy sideways period before rallying to new highs. A V-shaped bottom in 2015 therefore looks highly unlikely.

In other words, while the case for a V-shaped recovery may indicate that downside risk is limited from current levels, there will be lots of bumps along the way. Do not expect a straight line upwards for stock prices.

The case for W: EM anxiety
One reason is because anxiety over China and emerging markets remains elevated. As an example, Citigroup chief economist Willem Buiter is forecasting a 55% chance of a global recession from slowing Chinese growth (via Bloomberg):
In an analysis published late on Tuesday, the New York-based bank’s chief economist, Willem Buiter, said there is a 55 percent chance of some form of global recession in the next couple of years, most likely one of moderate depth and length.

Unlike the U.S.-driven international slumps of the past two decades, this one will be generated by sliding demand from emerging markets, especially China, which has surged in size to become the world’s No. 2 economy.

“The world appears to be at material and rising risk of entering a recession, led by EMs and in particular by China,” wrote Buiter, a former U.K. policy maker.

Among reasons for worry is his view that in reality China is already growing closer to 4 percent than the government’s goal of about 7 percent targeted for this year. A shallow recession would likely occur if expansion slowed to 2.5 percent in the middle of next year and stayed there, he said.

Other emerging markets such as Brazil, South Africa and Russia are already in trouble while developed economies are still lackluster. Commodity prices, trade and inflation remain sluggish and corporate earnings are slowing.
In conjunction with the Citigroup call, Standard and Poor's has downgraded its growth forecast for the Asian Tiger economies, which are China's major trading partners, citing "structural", rather than cyclical reasons (via Bloomberg):
Standard+Poor’s cut its growth forecasts for Asian economies, citing “abysmal” trade data and fears about China’s market stability, a day after Moody’s Investors Service made a similar reduction.

S+P now sees the region growing 5.4 percent in 2015 instead of 5.5 percent, dragged down by Indonesia, the Philippines, Singapore, Taiwan and Thailand. It also predicts that currencies will weaken.

“Although market fears that the sky is falling are almost certainly overblown, in our view, they have been enough to move the needle,” Paul Gruenwald, S+P’s Asia-Pacific chief economist, wrote in a report on Wednesday. The company sees “slower growth, higher volatility, and more risks” compared with its previous report published in July.
Indeed, a glance at Asian stock markets reveal that all of the markets of Chinese trading partners trading well below their 200 dma.

The damage done by the Chinese slowdown and anxiety over a Fed hike may not be over. Analysis from IIF shows that EM outflows have not reached levels seen either during the Taper Tantrum or 2008.

The case for W: A wobbly US economy
Another possible reason for near-term rising market angst comes from a possible wobble in the US economy, just as the Fed begins to tighten monetary policy. New Deal democrat`s weekly review showed numerous negative readings among the short-term leading indicators and coincidental indicators, which the market may interpret in the next few weeks as signs of a tanking economy:
Among short leading indicators, the interest rate spread between corporates and treasuries remains negative although a little less so than at its recent worst. The US$ also turned even more negative. Temporary staffing was negative for the 17th week in a row. Positives included jobless claims, oil and gas prices, and gas usage. Commodities are a big global negative, but bounced a little more off their bottom this week.

Among coincident indicators, rail carloads, shipping, and steel production are all negatives, as are the TED spread and LIBOR. Positives included tax withholding and consumer spending, with Gallup spending having a rare positive week, as less spending on gas apparently translated into bingeing on back to school purchases.
The Citigroup Economic Surprise Index (gold line below), which measures whether high frequency economic releases are beating or missing consensus estimates, is starting to roll over.

Some of the weakness has already been incorporated into expectations.  Analysis from John Butters showed that net margins are expected to decline in the next two reporting quarters (annotations are mine):

On top of that, the risk of a government shutdown is growing (via Marketwatch):
With only about three weeks to go before that date, Congress hasn’t passed a single spending bill for the fiscal year that begins Oct. 1. And with the House scheduled to be in session for just 10 days before Oct. 1, lawmakers are expected to vote on a so-called continuing resolution to keep the government open.

But even that may not head off a shutdown, analysts warn. In a piece on Tuesday in Forbes, budget-watcher Stan Collender raised his odds of a shutdown to 67% from 60%, given the amount of time lawmakers will take debating the Iran deal, and the likelihood of trying to block funding for it in the continuing resolution. President Barack Obama has the votes in the Senate to sustain the agreement, which lifts sanctions on Iran in exchange for curbs on its nuclear program.

“The continuing resolution will provide those senators and representatives against the deal with a second bite of the disapproval apple,” Collender wrote.

A vote on the Iran deal isn’t the only complicating factor. There’s also the issue of funding for Planned Parenthood, the provider of women’s reproductive health services. Some conservatives want to cut off its federal funds.
Bottom line: Expect more bumpiness ahead (and I haven't even mentioned the wildcard represented by the FOMC September decision).

More Ws ahead?
Looking to the week ahead, my inner trader flipped from bearish to bullish at the market close on Friday. The bearish call did not work as negative price momentum ebbed and the SPX neared the apex of a triangle wedge formation. However, there was a key "clue" as the downtrend in RSI(5) was broken, though the longer dated RSI(14) downtrend remained intact.

Notwithstanding the binary risk posed by the FOMC decision on Thursday, next week is option expiry week (OpEx). Chad Gassaway showed that September Opex has historically been bullish for stock pricese, though they tend to mean revert downwards the following week.

Putting it all together, I updated the chart of the price pattern past market "crashes" I showed last week (see Constructive on stocks, but waiting for the re-test). My best wild-eyed guess calls for a rally next week, to be followed by a decline the following week, possibly to test either the August 2015 or October 2014 lows.

Schaeffer`s Research recently showed that the number of days with 2% swings have spiked, which is typical of the volatility seen in a correction. The bottom line is, until the large daily moves die down (and ES futures goes at least a week without seeing a 1% move overnight), the market will remain choppy.

My base case remains a W, or multiple Ws, in this bottoming process.

Disclosure: Long SPXL

1 comment:

Unknown said...

Excellent analysis. Key issue: is the market action seeing some real pending doom that is yet to unfold or is it just another scare that never seems to be as real as we feared, Ebola, tapering, Europe, China, etc? From your work and others it appears this is a fleeting fear. But "fear" itself can be an issue if it motivates enough people to sell, under invest and embolden the causes of suppression and mistrust.