Wednesday, January 31, 2018

A glass half-full, or...

Mid-week market update: I turned cautious on equities last Wednesday (see Out of words for 'extreme' and 'unprecedented'). Since then, the market rallied, and fell for two straight days on Monday and Tuesday, ending the last five days slightly negative.



Is this the start of a downside break, or just a blip in a continuing market rally?

On one hand, investors have been buying the dip, indicating continuing confidence in the market. Eric Balchunas of Bloomberg pointed out that investors poured $8 billion into equity ETFs during the two day selloff.


On the other hand, this funds flow data poses a high degree of downside risk. Should the market continue to correct or consolidate, sentiment needs to wash out before a durable short-term bottom can be seen.

What's the real story?

The full post can be found at our new site here.

Monday, January 29, 2018

How to lose a trade war even before it begins

As we wait for Donald Trump's first State of the Union address, investors are left to wonder which Trump will show up before Congress on Tuesday. Will it be Teleprompter Trump, whose well-crafted speech will be interpreted favorably by the markets, or Twitter Trump, whose utterances will spook the markets?



Why tariffs won't work
Trump will undoubtedly make comments about trade policy, which was a centerpiece of his campaign (see Sleepwalking toward a possible trade war).

The full post can be found at our new site here.

Sunday, January 28, 2018

The pain trade signals from the bond market

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Bullish*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Important questions for the bond and stock markets
As the 10-year Treasury yield staged an upside breakout at 2.6%, and luminary investors such as Bill Gross, Jeff Gundlach, and Ray Dalio have declared the bond bull to be over, I have a number of key questions for the markets. First and foremost, "What's the pain trade?"


How these questions are resolved will also have important implications for the future direction of stock prices.

The full post can be found at our new site here.

Wednesday, January 24, 2018

Out of words for 'extreme' and 'unprecedented'

Mid-week market update: most of this rally (see Embrace the blow-off, but with a stop-loss discipline published last November), but the scale of the unrelenting grind-up has been breathtaking. I have run out of words to describe "extreme" and "unprecedented" conditions. In short, the market has been dominated by momentum.


Josh Brown recently highlighted analysis by Ari Wald outlining the positive price momentum gripping the stock market. The high level of monthly RSI readings is indicative of a "good overbought" condition that has led to further gains.



Positive momentum can also be seen from a fundamental viewpoint as well. Ned Davis Research observed that bottom-up aggregated FY2018 EPS has been displaying the unusual pattern of a surge in upward revisions. Historically, Street analysts have tended to be overly optimistic and publish overly high EPS estimates, and revise them downward as time passes. The upward revision was undoubtedly related to company guidance of the effects of the recently passed corporate tax cuts.


Despite the Fed's tightening bias, financial conditions have also been extremely easy, which is also supportive of the market's risk-on tone.


When will this all end? It may be soon, as some cracks are appearing in the foundation of this rally.

The full post can be found at our new site here.

Tuesday, January 23, 2018

Sleeping walking toward a possible trade war

Sometimes misunderstandings can lead to enormous adverse consequences. In 1941, Japan believed that war was inevitable with the United States. The Americans had slapped a trade embargo on Japan, and made it clear that Japanese occupation of China was unacceptable. The Japanese High Command saw that America was a big industrialized country with resources that it could not defeat in the long run. The only solution was a quick strike to destroy American combat capabilities. The logical solution was a sneak attack on Pearl Harbor as a way of crippling American naval power. The rest, as they say, is history.

Tokyo just had one fatal misinterpretation of the American position. Washington did not consider Manchuria, which was China's industrial heartland and the jewel of Japan's occupation of the Chinese mainland, to be part of China. Had Japan withdrawn its troops from the south and remained in Manchuria, American entry into the Second World War would have been delayed for several years. Under that scenario, Nazi Germany would not have been forced to fight a two front war. Britain and her Commonwealth Allies would have been too weak to land in Italy in 1943, and the D-Day landings would have been out of the question. There would have been no Manhattan Project, or it would have been delayed for several years. Hitler might have been able to develop the Bomb. History could have been dramatically changed,

A similar scenario is setting up in Sino-American relations. Both sides seem to be talking past each other. The result could be a trade war with catastrophic results (see Could a Trump trade war spark a bear market?).

The full post can be found at our new site here.

Sunday, January 21, 2018

Bubbleology 102: What could derail this momentum rally?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Bullish*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Looking for the bearish trigger
Last week, I wrote about how the price momentum factor is dominating equity returns (see Bubbleology 101: How to spot the top in a market melt-up). Most intermediate term tops, even with a parabolic market, saw double tops that are marked by negative technical divergences at the second top. As stock prices continue to rise, we have not even seen the first retreat yet.



What is likely to spark the first pullback? Recently, a number of extreme overbought readings have appeared, indicating risk levels last seen before the major market crashes in 1929 and 1987. Callum Thomas highlighted analysis by Sven Henrich, otherwise known as Northman Trader. Henrich found that you would have to go back to pre-crash 1929, before the RSI indicator was invented, to see weekly RSI as high as they are today.


Callum Thomas also highlighted this chart from Ed Yardeni which indicated that the II bull/bear ratio has not seen these heights since pre-crash 1987.


Are the appearance of these ominous signs warnings of an imminent market crash?

The full post can be found at our new site here.

Thursday, January 18, 2018

Trump's one-year report card

As we approach the one-year anniversary of Donald Trump's first year in office, I am seeing numerous commentaries assessing his first year in office (see FiveThirtyEight, The Economist and BBC) . About a year ago, I laid out my criteria for his success (see Forget politics! Here are the 5 key macro indicators of Trump's political fortunes) using the criteria that Newt Gingrich specified in a New York Times interview:
“Ultimately this is about governing,” said former House Speaker Newt Gingrich, who has advised Mr. Trump. “There are two things he’s got to do between now and 2020: He has to keep America safe and create a lot of jobs. That’s what he promised in his speech. If he does those two things, everything else is noise.”

“The average American isn’t paying attention to this stuff,” he added. “They are going to look around in late 2019 and early 2020 and ask themselves if they are doing better. If the answer’s yes, they are going to say, ‘Cool, give me some more.’”
As Trump has "kept America safe", because, like it or not, mass shootings such as the one in Las Vegas doesn't politically count as a terrorist incident. From a strictly economics viewpoint to judge whether he "created a lot of jobs", I used the Bloomberg Intelligence economic criteria to judge Trump on his economic record.

Despite all of the outrage of the anti-Trumpers, Trump`s economic record has been quite good in the past year.

The full post can be found at our new site here.

Wednesday, January 17, 2018

How far can this momentum rally run?

Mid-week market update: How far can this momentum rally run? Already, the momentum frenzy is exceeding the pace set during the height of the Tech Bubble.


The WSJ recently published an article about the dominance of price momentum: "The Momentum Game Has Returned to the Stock Market".
Forget fundamentals: Momentum is back in the stock market. For the first time since the 2008 financial crisis a simple strategy of buying the stocks that had already gone up the most delivered a remarkable outperformance last year. Is it a sign of excess or the start of a new bull run?

Momentum is a formal way to capture two old Wall Street dictums: The trend is your friend until the end, and let your winners run. It can be measured over any period from microseconds to years, but investment strategies typically look for three-, six- or 12-month trends.
The article went on to lay out the bull and bear cases for momentum, and, by implication, the latest bull run:
There are two prevalent explanations for momentum, and today the choice will make you more or less worried about the power of the trend.

The bearish explanation is that investors put far too much weight on the past, and buy what has gone up without properly assessing whether that is likely to continue. Momentum is created by this blind buying, and pulls prices further and further away from where they should be, until they snap back and crush those chasing gains.

The bullish explanation is that it takes time for investors to price in a new environment.

On this view prices rose as investors slowly woke up to the unexpected global economic strength and slowly came to believe in higher profits. Perhaps company analysts still haven’t included U.S. corporate tax cuts in their profit forecasts due to their complexity, which could mean still more good news to come as the earnings season brings tax guidance from CFOs.
Certainly, a number of sentiment indicators are looking stretched. Bloomberg reported that the prices of call options are extremely expensive relative to the price of put option protection.



Strategist Jim Paulsen, who had been very bullish, sounded a word of caution in a recent CNBC interview:
The stock market has incredible price momentum and broad participation but the challenges are "truly increasing," widely followed strategist Jim Paulsen told CNBC on Tuesday.

In fact, he called the optimism of late "really overwhelming."

"It's so striking because we haven't had it in the entire recovery. The wall of worry was probably the cornerstone of this bull market. … That is gone," the chief investment officer at the Lethold Group said in an interview with "Power Lunch."

"That opens you up to the bear's bite," he added.
Is the combination of a pause in stock prices Tuesday and the carnage in crytpocurrencies* represent a warning that the momentum run is nearing an end? If so, does that mean the stock market is destined to suffer a near-term correction?

* Sorry, the cryptos aren't tanking, that's just a dead-cat bounce in the value of the fiat paper currencies.


The full post can be found at our new site here.

Sunday, January 14, 2018

Bubbleology 101: How to spot the top in a market melt-up

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Bullish*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Come over to the Dark Side
I have a confession to make. I've gone over to the Dark Side. Valuation doesn't matter. Excessively bullish sentiment doesn't matter. Overbought readings don't matter. The only thing matters is the Melt-Up (see Embrace the blow-off, but with a stop-loss discipline and Jeremy Grantham's call for a market melt-up).


If the market is indeed undergoing a blow-off rally, then investors should be mindful of Bob Farrell's Rule #4: "Parabolic markets go up further than you think, but they don't correct by going sideways."

Nevertheless, there are a number of simple techniques of spotting the top in a parabolic move.

The full post can be found at our new site here.

Wednesday, January 10, 2018

Can the melt-up continue?

Mid-week market update: The week began on a bullish note this week as the melt-up theme dominated early in the week (see Jeremy Grantham`s call for a possible melt-up, and my own views published last November: Embrace the blow-off, but with a stop loss discipline). On Monday, the market rose for a fifth consecutive day, which flashed a First Five Day (FFD) buy signal. Ryan Detrick at LPL Financial detailed the historical evidence of this momentum effect for the remainder of the year.


In addition, analysis from Jeff Hirsch of Almanac Trader showing a shorter positive momentum effects of the FFD for the remainder of January, shown as JB in the table below (January Barometer). Since 1950, whenever the first five days was positive, the rest of January went on to be positive 86% of the time, with an average return of 2.6% and median return of 2.1% for the remainder of the month (N=29).


The market celebrated with another win on Tuesday, making its winning streak an astounding six consecutive days. The risk-on rally came to a screeching halt when China reported was considering slowing down or halting its purchases of Treasury paper. The initial reaction saw the yield on 10-year Treasury note spiked and a steepening of the yield curve, though both ended the day roughly unchanged. At the same time, the stock market took a risk-off tone. Here is the Bloomberg report:
Senior government officials in Beijing reviewing the nation’s foreign-exchange holdings have recommended slowing or halting purchases of U.S. Treasuries, according to people familiar with the matter. The news comes as global debt markets were already selling off amid signs that central banks are starting to step back after years of bond-buying stimulus. Yields on 10-year Treasuries rose for a fifth day, touching the highest since March.
Arguably, the response from Beijing was a warning shot to the Trump administration over the prospect of a trade war (see Could a Trump trade war spark a bear market?).
China holds the world’s largest foreign-exchange reserves, at $3.1 trillion, and regularly assesses its strategy for investing them. It isn’t clear whether the officials’ recommendations have been adopted. The market for U.S. government bonds is becoming less attractive relative to other assets, and trade tensions with the U.S. may provide a reason to slow or stop buying American debt, the thinking of these officials goes, according to the people, who asked not to be named as they aren’t allowed to discuss the matter publicly.
Is this the end of the momentum rally?

The full post can be found at our new site here.

Monday, January 8, 2018

Things you don't see at market bottoms: Retail stampede edition

It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time. My experience has shown that overly bullish sentiment should be viewed as a condition indicator, and not a market timing tool.

I have stated that while I don't believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Five steps, where's the stumble?). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of "things you don't see at market bottoms". Past editions of this series include:
I reiterate my belief that this is not the top of the market, but investors should be aware of the risks where sentiment is getting increasingly frothy. Jeremy Grantham of GMO recently penned an essay calling for a market melt-up. Investors should also remember Bob Farrell’s Rule #4: “When markets go parabolic, they rise further than you think, but they don’t correct by going sideways."

As a result, I am publishing another edition of "things you don't see at market bottoms", as exemplified by the mood captured by this recent magazine ad.


The full post can be found at our new site here.

Sunday, January 7, 2018

Could a Trump trade war spark a bear market?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Bullish*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Staying ahead of the curve
It is gratifying to be ahead of the curve and anticipate the changes in the market narrative. The two themes du jour are Jeremy Grantham's call for a market melt-up (see Embrace the blow-off, but with a stop-loss discipline), and concerns about rising inflation, which I have been writing about endlessly (as an example, see Five steps, where's the stumble?).

What's next?

How about the risk of rising protectionism? The news site Axios reported that 2018 will bring “full Trump”, with a dramatic change in policy tone after the legislative tax cut victory:
Trump keeps asking for tariffs — on steel and aluminum, in particular. He wants a trade war, and has for many years. His economic and diplomatic advisers persuaded him to delay trade actions in 2017.
  • Those advisers recognize that the day of reckoning will come in 2018, regardless of whether economic adviser Gary Cohn and Secretary of State Rex Tillerson — who advocated restraint — stay or go.
  • Cohn and Treasury Secretary Steve Mnuchin successfully persuaded Trump not to do anything rash while tax reform was being negotiated.
  • Trump also saw the advantage of trying to use that as leverage with China to get help on North Korea. He said yesterday in an interview with the N.Y Times: "China's hurting us very badly on trade, but I have been soft on China because the only thing more important to me than trade is war. O.K.?"
  • And he tweeted yesterday, in response to Chinese ships secretly delivering oil to North Korea: "Caught RED HANDED - very disappointed that China is allowing oil to go into North Korea. There will never be a friendly solution to the North Korea problem if this continues to happen!"

The Washington Post also reported that the Trump Administration is close to imposing trade sanctions on China in January:
The Trump administration is setting the stage to unveil tough new trade penalties against China early next year, moving closer to an oft-promised crackdown that some U.S. business executives fear will ignite a costly battle.

Several corporate officials and analysts closely tracking trade policy said that President Trump is expected to take concrete actions on a range of disputes involving China within weeks.

Trump is due by the end of January to render his first decision in response to petitions from U.S. companies seeking tariffs or import quotas on Chinese solar panels and washing machines manufactured in China and its neighbors.
The Trump Administration’s newly unveiled National Security Strategy reframes the China relationship in an adversarial fashion. As a result, the latest anticipated pivot on trade policy is therefore not an unexpected development, though the scale of the reaction is likely to surprise the market:
White House action is due on a separate Commerce Department probe triggered by worries about the national security impact of rising imports of Chinese steel and aluminum.

“Their intent is to bring shock and awe,” said Scott Kennedy, an expert on Chinese trade at the Center for Strategic and International Studies. “They’re not kidding around.”
My base-case scenario calls for an equity market melt-up, supported by a combination of fundamental growth momentum and technical price momentum. It would end with aggressive Federal Reserve action to cool an overheated economy. In other words, an equity bear market would begin with a classic Fed-induced slowdown.

What if the economic slowdown is not caused by monetary policy but by trade policy? What would happen if the growth outlook slowed because of a trade war? What would be the damage, both to the economy and stock prices?

While I am not forecasting a trade war-induced bear market, good investors engage in scenario modeling in order to be prepared for different possibilities. I explore the ramifications of a trade war as an exercise in investor preparation.

The full post can be found at our new site here.

Wednesday, January 3, 2018

A frothy rally, but...

Mid-week market update: The stock market began the year by roaring out of the gate. This was not a big surprise. Rob Hanna at Quantifiable Edges tweeted on New Year's Eve that the market has rallied strongly when it closed at a 10-day low at the end of the year.


Though the sample size is small (N=4), past episodes has been stock prices advance for a minimum of four consecutive days before pausing.


Hanna followed that tweet with a post which observed that positive momentum on the first day of the year usually leads to follow through for the next two days (which would be tomorrow, or Thursday).



Another bullish seasonal sign come from Jeff Hirsch of Trader`s Almanac.
The first indicator to register a reading in January is the Santa Claus Rally. The seven-trading day period begins on the open on December 22 and ends with the close of trading on January 3. Normally, the SP 500 posts an average gain of 1.3%. The failure of stocks to rally during this time tends to precede bear markets or times when stocks could be purchased at lower prices later in the year.
The SPX returned 1.1% during the seven-day period, which is positive but below average. This is a preliminary sign which should be enough to get traders and investors excited about 2018.

What happens now? Can equities continue to rise after these seasonal tailwinds?

The full post can be found at our new site here.