Volatility breakout?

I've been seeing some odd and contradictory readings from the option market all week. One screams "fear" while the other screams "complacency".

On one hand, the equity put-call ratio, which I highlighted on Sunday night (see Watch for the sentimental rally), remains elevated and is suggestive of a high level of fear. Such a condition is contrarian bullish for equities. The chart below shows the 5 day exponential moving average of the equity only put-call ratio (in blue) and the 21 day moving average (in red). Both are at elevated levels relative to their own recent history.

By contrast, the VIX and its term structure are sending out a completely opposite message. The top panel of the chart below shows the VIX term structure measured as a ratio of VIX to VXV, or three-month expected volatility. When the ratio is above 1, it means that the term structure is downward sloping, the option market is showing a high level of fear. By contrast, if the ratio is low, indicating that the term structure is steeply upward sloping, it is an indication of complacency.

Here is the puzzle: When the equity put-call ratio is showing a high level of fear, why is the VIX structure in the complacency zone?

The bottom panel shows the VIX Index. If the markets are so fearful, then why is this so-called "fear index" so low?


A regime change?
I had written about a possible volatility regime change (see Interpreting a possible volatility regime change). In my previous blog post, I had featured this chart of the equity put-call ratio (top panel) and VIX (bottom panel). I showed how changes in the trend in equity put-call ratio may be a precursor to a higher volatility environment:

Might this dichotomy in put-call and VIX pricing be part of that process? In that case, an elevated put-call ratio relative to its own recent history could be a signal of rising volatility, rather than just rising fear.


Jittery sentiment
Indeed, the latest AAII sentiment readings (via Bespoke) could be a clue of a volatility regime change. Even though the major large cap averages made a new high, AAII bulls rose from 28.3% to 33.1% this week, but they remain low on an absolute basis, which would normally be interpreted as bullish.

However, the AAII survey readings from the previous week also show a very low level of bulls and bears alike.

I interpret these conditions as a highly jittery market. These are clues of a market ready to move to an environment of higher volatility.




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

China turns Japanese?

I haven't written much about China lately, but I continue to get questions. So I thought that it was time to summarize my big picture thoughts on China here.


Riding a motorcycle at 100mph without a helmet
There is much to cover so I will just go through the highlights. There is no question that the risks are rising in China. The best analogy is someone riding around on a motorcycle at 100mph without a helmet. It doesn't mean that anything bad happens to you. It just means that if you got into an accident, the results won't be pretty.

The problems of China are intertwined with each other. The biggest challenge has to do with the buildup of debt to finance unproductive assets. Data from the IMF suggests concern over the level of non-financial corporate debt in China:

While most of the debt remains denominated in RMB and therefore China is unlikely to experience a significant currency crisis in a debt crisis, the global financial system remains vulnerable as recent BIS data shows nearly USD 1 trillion in external foreign currency denominated debt. Note that the data only goes to March 2013 and the reading was USD 880 billion. At that rate of increase, it would not be a big leap to imagine that total external foreign currency debt has topped USD 1 trillion today.

The road gets bumpy
So far, we have a picture of someone riding around on a motorcycle at high speed with little protection. As long as the road is clear and the rider remains in control, everything should be all right. But then the road gets bumpy...

The economy is starting to slow (via Sober Look):

What's more, FT Alphaville reports that the Chinese property market is starting to soften (emphasis added):

They’re from Nomura’s latest on China property stress which, they say, is increasing at pace. Apparently every property market leading indicator at the national level turned down in Q1, and for most monthly indicators the rate of decline accelerated through the quarter. That, says Nomura, means the question is no longer “if” or “when”, but rather “how much” China’s structurally oversupplied property market will correct.

The most apparent problem is supply is outrunning demand:

What happens if property prices crash?

Property prices remain the linchpin of the Chinese financial system. Unlike lending in the West, which is based on the principle of whether the borrower has sufficient cash flow to service debt, Chinese lending is based on assets, or collateral value. That's because income statements can be somewhat *ahem* flexible and creative about the sources and levels of cash flow. If you can't trust cash flow and believe in asset values, then real estate is solid, right???

George Magnus recently outlined the stakes should property prices collapse:

The greater risk to China lies in the pervasive consequences of any property bust. Property investment has grown to account for about 13 per cent of gross domestic product, roughly double the US share at the height of the bubble in 2007. Add related sectors, such as steel, cement and other construction materials, and the figure is closer to 16 per cent. The broadly defined property sector accounts for about a third of fixed-asset investment, which Beijing is supposed to be subordinating to the target of economic rebalancing in favour of household consumption. It accounts for about a fifth of commercial bank loans but is used as collateral in at least two-fifths of total lending. The booming property market, moreover, has produced bounteous revenues from land sales, which fuel much local and provincial government infrastructure spending.

The reason things look different today is the realisation of chronic oversupply. As the property slowdown has kicked in, housing starts, completions and sales have turned markedly lower, especially outside the principal cities. Inventories of unsold homes in Beijing are reported to have risen from seven to 12 months’ supply in the year to April. But when it comes to homes under construction and total sales, the bulk is in “tier two” cities, where the overhang of unsold homes has risen to about 15 months; and in tier three and four cities, where it is about 24 months.

FT Alphaville reported that declining real estate values can set off a negative feedback loop (emphasis added):

More so, the bet is that the property market is just waaay too important and connected to be allowed to correct aggressively. As ASY says, as property transactions slow, more and more liquidity is trapped in the sector, and this inevitably leads to financial failures and knock-ons everywhere else — downstream industries, local government revenues, collateral for bank lending and via wealth effects on consumption to name a few specifics. As UBS note, given that property investment accounts for almost a quarter of fixed investment, construction value-added is 13 per cent of GDP, and there are extensive linkages between property and industrial sectors including steel, cement and construction machinery, the impact on the economy from a drop in construction volume is bigger than that from a worsening household balance sheet and consumption.

Nomura estimate that property investment (including residential, commercial and public housing) contributes to around 16 per cent of GDP, taking into account its direct contribution and that of related industries such as steel and cement. Not a sector to ignore, in other words, particularly as the property correction could snowball in the short run.

This is the kind of bumpiness in the road that the motorcycle rider will have to navigate.


Building the right kind of road
Instead of worrying about whether the rider will crash, Beijing has opted for a long-term solution of reforming the system to allow China to better deal with shocks - sort of building the right kind of road, so to speak. The leadership in Beijing recognizes the risks to China`s growth model. They have made commitments to reform the system. The latest Five Year Plan calls for re-balancing the source of growth from infrastructure driven growth to consumer driven growth, financial reform and greater mobility from the reform of the hukou system of residency.

These measures sound good, but will it be fast enough and robust enough to forestall a crash? Satyajit Das, who foresaw the global financial crisis but have become a permabear ever since (permabears and permabulls are useful because you always want to hear their side of the story - and they can be right), has warned, despite the rhetoric, that the “'talk-to-walk' ratio is disappointing”:

In effect, the internal contradictions of an economic model where investment drives growth rather than the reverse will become apparent. Wei Yao, an analyst at French bank Société Générale spoke for many when he termed the effort to balance growth and reform as “mission impossible.”

These tensions may drive a process of ‘skewed reform’. For example, the rapid growth of the shadow banking system constitutes de facto reform of the banking system as depositors can obtain higher returns than that available from banks. But this increases risk. The shadow banking system has led to systemic issues, such as a rapid increase in debt levels and complex links with the banking system. Limited regulation has led to poor governance and risk disclosure. It has increased moral hazard as investors unaware of the real risks rely on state owned banks or governments to ensure return of their capital.

Little is likely to change. At the March National People’s Congress, a meeting to rubber-stamp policies, Premier Li Keqiang conceded as much. While stressing the government was committed to structural reforms, he admitted investment remained “the key to maintaining stable economic growth,” targeted at 7.5%.

The main challenge to these initiatives is Party insiders have become filthy rich prospered under the old system and it would be difficult for them to make changes that hurt their own well being:

Policy implementation will remain challenging. Local governments are unlikely to acquiesce to reforms that undermine their power, which is rooted in rapid growth built around property development using cheap land, mispriced utilities and low taxes. The rebalancing in favor of consumption brings the central government into direct conflict with powerful vested interests that have benefitted from the credit-fueled, investment-based growth model. 

As Das puts it, Party insiders will have to gore their own ox in order to implement reforms:

As the process left households and ordinary workers with a relatively small share of GDP, economic rebalancing will require transferring an increasing share to this group at the expense of state-owned enterprises, banks and the economic elite.

In effect, reform requires an implicit redistribution of wealth, encoded in the language of reform — financial market liberalization, reform of state-owned enterprises, and labor mobility. This means that any reform agenda will, in all likelihood, face significant opposition from vested interests in the state sector and local government.

As an example of the difficulties of reforming the state sector, FT Alphaville highlighted analysis from Societe Generale indicating that while the private sector was deleveraging and adjusting to new market realities, the state owned sector continues to add debt:

That chart from SocGen shows that even as the state sector continues to leverage up — among industrial enterprises, the liability-to-asset ratio of SOEs jumped from 57 per cent to 61 per cent between 2008 and 2010, and continued to crawl up afterwards — non-state entities saw the ratio falling all the way from 59 per cent to 56 per cent.

Combine that with a low inflation environment — April inflation data came in notably below expectations and a low inflation environment has persisted for about two years — and a very large negative output gap, you get an argument for a debt-deflation scenario, at least in some sections of the economy.

What about the motorcycle?
I was digressing. All this talk about a building better road is all fine and good, but what about our story of the rider on the motorcycle riding at 100 mph without a helmet?

The most likely scenario is that should the motorcycle rider crash, he will be revived - but as a zombie.

There is a must-read article at Quartz about the outlook for China. It begins with an interview with Patrick Chovanec where he compares China to Japan of the 1980`s. He stated that China is likely to go down the Japanese road. Consider the similarities of Japan then and China now:

Even comparing headline data, the Japan of the 1980s and China of today are strikingly similar:

• Second-largest economy. In 1968, Japan unseated West Germany (paywall) as the second-biggest economy on the planet. China seized that title in 2010, with its nominal GDP of $5.9 trillion nudging past Japan’s $5.5 trillion.
• One-tenth of global GDP. By the early 1990s, Japan’s economy accounted for 10% of global GDP (in purchasing-power parity terms, via the IMF), a milestone China hit in 2007.
• One-tenth of global trade. In 1986, Japan accounted for 10% of global trade, a level China reached in 2010.
• The world’s biggest banks. By the late 1980s, the world’s five biggest commercial banks, by total assets, were Japanese. Here’s how China stacks up now:

The Japanese and Chinese property bubbles are eerily similar:

Banks issue loans off inflated property values

Japanese banks had traditionally loaned against the value of assets, not the income those assets generated; a property deed was considered the most reliable collateral, explains Wood. That policy came in handy as Japan’s capital markets took off. With big companies relying more on the stock market for funding, banks had to find new customers: smaller companies. Less familiar with these new firms, banks used property as collateral for credit. Soaring property values invited bigger and bigger loans. But because property prices had gone up every year since the end of World War II, banks thought their loans were safe.

In China’s case, banks have been issuing loans off not only inflated, but often falsified property values. For real-estate developers and underground bankers, offering real estate as collateral for new loans is a regular practice, says Victor Shih, professor at University of California, San Diego, and an expert on China’s political economy. But “the method of evaluating the collateral is highly convoluted in China so that collaterals are often valued much higher than market-clearing prices,” Shih told Quartz. “As long as banks and other lenders accept such fictional collateral value, they will continue to lend to distressed borrowers.”

If the motorcycle were to crash, the market-oriented policy is to allow the rider to die. The Chinese leadership has been unwilling to embrace that idea and history has shown that whenever the economy slows or shows signs of stress, Beijing capitulates and comes to the rescue and take steps to socialize losses, which would be counterproductive to their goal of reform, because it would be household sector that would ultimately pay the price (see Will Beijing blink yet one more time?). In our motorcycle analogy, it is the equivalent of reviving the corpse and making him into a zombie by lending to and propping up failed enterprises as the Japanese banking system did throughout their Lost Decades.

With China’s stock market already mired in its epic slump, the thing most likely to trigger a Japan-style crisis is a real estate market collapse. However, China already exhibits more than a few symptoms of a zombie infection. Even without the catalyst of a market crash, it in many ways already seems more like Japan in the late 1990s than the Japan of 1989.

Though lending continues to surge, it’s getting harder and harder for China to grow. In 2013, credit rose 10% annually (paywall), much higher than the 7.5% expansion of official GDP. That trend is worsening: China must invest twice what it did in 2008 to generate the same amount of GDP growth, according to Wei Yao, an economist at Société Générale. By her tally, China now owes the equivalent of 38.6% of its GDP in principal and interest each year. 

Policy makers appear reluctant to embrace the idea of creative destruction. Rather, they would rather live with the zombification of the economy as evidenced by Societe Generale's above analysis showing that SOEs continued to pile on debt while non-state enterprises were deleveraging (emphasis added):

But growth won’t revive until credit starts supporting the right businesses or industries. Even though state-owned enterprises (SOEs) tend to be much less profitable than private firms, the big banks are also state-owned. And because China’s credit system is still based on political, and not market, risk, the big state-owned banks still loan to SOEs over smaller companies.

That system, says Hoshi, looks awfully familiar. “In a similar way that the Japanese [lending practices] discouraged new entrants… Chinese SOEs are doing the same thing,” he says. “They’re protected, they’re not that profitable, but they can stay in the market because they’re owned by the state, which reduces the possible profit of new entrants.”

Societe Generale (via FT Alphaville) outlined the similarities between SOE zombification and the pushing on a string effects of QE (emphasis added):

If we treat the debt of SOEs and local government guaranteed corporates just as government debt, China’s situation is, to some degree, similar to the post-Lehman US: rising public debt, declining private sector leverage. Particularly, the state sector as a whole generates sub-par economic return. Loss-making industrial SOEs account for more than a quarter of total industrial SOEs, double the ratio among non-state industrial enterprises. Granting credit to profitless corporates is not too much different from having quantitative-easing liquidity trapped in the commercial banks’ vault.

Indeed, Beijing may be in the process of blinking in the face of weakness, despite statements about they will not engage in large scale stimulus programs. Here is Ambrose Evans-Pritchard's article entitled "China reverts to credit as property slump threatens to drag down economy" (emphasis added):

China's authorities are becoming increasingly nervous as the country’s property market flirts with full-blown bust, threatening to set off a sharp economic slowdown and a worrying erosion of tax revenues.

New housing starts fell by 15pc in April from a year earlier, with effects rippling through the steel and cement industries. The growth of industrial production slipped yet again to 8.7pc and has been almost flat in recent months. Land sales fell by 20pc, eating into government income. The Chinese state depends on land sales and property taxes to fund 39pc of total revenues.

“We really think this year is a tipping point for the industry,” Wang Yan, from Hong Kong brokers CLSA, told Caixin magazine. “From 2013 to 2020, we expect the sales volume of the country’s property market to shrink by 36pc. They can keep on building but no one will buy.”

The Chinese central bank has ordered 15 commercial banks to boost loans to first-time buyers and “expedite the approval and disbursement of mortgage loans”, the latest sign that it is backing away from monetary tightening.

Longer term, the Quartz article outlined the challenges facing China:

Japan’s experience explains why the challenges facing the Chinese economy are actually much greater even than avoiding a housing market crash or a financial crisis. China’s leaders may well be able to steer the country clear of either. But pulling off yet another miracle of administrative legerdemain will be perilous if it means China’s leaders further postpone financial reforms—things like lifting the deposit-rate cap, allowing SOE failures, or permitting foreign banks to compete. One thing Japan’s history makes painfully vivid is that the longer China waits, the larger its zombie horde grows.

China becomes Japanese
With the Chinese leadership implicitly signaling to the market the existence of a Beijing Put for the Chinese economy, China is unlikely to see a crash landing. The price for such a policy is a prolonged period of slow growth.

In other words, China is likely to turn Japanese. Just don't tell either the Chinese or Japanese that, they hate each other.

J J J J J

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

It`s the risk appetite, stupid!

There has been much written lately about market divergences. Jeff Miller, who I depend on for a level-headed view of macro and fundamental insights, this week rhetorically asked the following question:

Here is a simple test:

When these more speculative stocks were surging last year, did analysts now warning about "divergences" celebrate the "confirmation" of the strength of the market? Or did they warn that the market was in a "bubble?"

If the latter, isn't it healthy to restore more normal valuations?

Brett Steenbarger at TraderFeed looked back past instances of negative breadth divergencess when the broad market averages were making new highs. What he found surprised him:

Specifically, I went back to the start of 1990 and looked at all occasions in which the SP 500 Index closed within 2% of its 200-day high under the following conditions: a) VIX less than 15; b) new 52-week highs under 100; and c) new 52-week lows over 50...

Indeed, looking across the 38 occasions, the next 20 trading sessions averaged a gain of 1.9% and the next 50 sessions averaged a gain of 3.51%, with only a handful of losing instances in each case.

He concluded:

Now, my conclusion is not to jump in with both hands and buy this market. Rather, the data exercise has accomplished two things: 1) tempered my bearish leaning; and 2) illuminated the kind of market we are in.

I find this to be true of data exercises in general. They offer a kind of perspective that checks assumptions and biases and can trigger new ideas as well. The historical perspective is not always the correct perspective, but it often is a fresh one--and there is value in examining one's assumptions critically.

A risk-off environment
I would agree with Steenbarger. My own view of breadth indicators is that while they can provide warnings of negative environments for stocks, they are not precise timing indicators. I showed that the corrections of 2011 and 2012 were not accompanied by breadth deterioration in the Advance-Decline Line (see Should you sell in May?).

My cautiousness about the stock market is related to broad based indications of the loss of risk appetite across the board (see The bearish verdict from market cycle analysis). However, I do agree with the evidence based approach used by Steenbarger to test his conjectures about markets.

In that spirit, I have constructed a Risk Appetite Index, consisting of an equal weighted long position in the high-beta segments of the market, namely the Russell 2000 (IWM) and NASDAQ 100 (QQQ), coupled with an equal weighted short position in defensive sectors of Consumer Staples (XLP), Utilities (XLU) and Telecom (IYZ). The chart below shows the Risk Appetite Index (in black) and SP 500 (in red).

There were four past instances of trend breaks in the Risk Appetite Index, where the breaks were marked by the dotted purple lines. In three of those instances (2008, 2011 and 2012), stock prices either entered a bear market (2008) or corrected (2011 and 2012). On one occasion (2010), stocks failed to decline, but that can be partly explained by the fact that they had already corrected.

Now we have a trend break in the Risk Appetite Index, not just in US equities, but marked by the underperformance of European small caps against large caps and a loss of appetite in credit markets. Despite the new highs achieved by the major US large cap equity averages today, which I believe was a short-term sentiment-driven rally (see my previous post Watch for the sentimental rally), I continue to find it difficult to get overly bullish on US equities over the summer months.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Watch for the sentimental rally

Regular readers will know that I have been fairly cautious on the stock market for the past several weeks (see A case of risk exhaustion?, Interpreting a possible volatility regime change,  Should you sell in May? and The bearish verdict from market cycle analysis). However, investor sentiment have moved to an overly bearish reading indicating a crowded short. While I remain convinced that the intermediate term path of least resistance is down for equities, we are likely to see a rally that takes the major large cap stock averages to marginal new highs in the next week or so.


Hulbert: Too much bearishness
The signs of excessive bearishness are emerging. Mark Hulbert wrote last week that his NASDAQ newletter writer sentiment index was at a bearish extreme:

Even though the market is more or less at the same level today than it was a month ago, if not slightly higher, the average market timer is more bearish today than then. That’s positive from a contrarian perspective, since it means that the wall of worry is that much stronger.

Notice also from the accompanying chart that, at the NASDAQ Composite’s mid-April low, the HNNSI dipped to minus 20% — meaning that the average NASDAQ-oriented timer was allocating 20% of his equity portfolio to going short. That is a significantly bearish posture to take. It’s the greatest amount of bearishness, in fact, in well more than a year.

Notice also that, even though the average timer is not as bearish today as he was in mid-April, he is still just as bearish as he was at the market’s lows last June. That is particularly noteworthy, since the NASDAQ Composite today is 24% higher today than then. Because the usual pattern is for bullishness to rise and fall more or less in lockstep with the market itself, it’s remarkable that there is not a lot more bullishness.

All of this suggests that there is a strong wall of worry out there for the market to climb. That doesn’t guarantee that the market will rise, of course. But it does mean that, if it does, it will have the sentiment winds blowing in its sails.

More AAII bears than bulls
In addition, Bespoke reported that the latest AAII survey showed more bears than bulls.

My own interpretation of this chart is that the low level of bulls and bears indicate a lack of conviction and a highly jittery market, where sentiment survey readings will be volatile and be subject to wild swings. (Remember that sentiment surveys ask people about their opinions, not what they have done.)


Put-call ratio indicate a crowded short
The chart below shows the equity only put-call ratio, with a 5 day exponential moving average (in blue) and a 21 day moving average (in red). A rising put-call ratio indicates a heightened levels of fear as investors buy more put options for downside protection.

With the equity only put-call ratio at an elevated level relative to recent history, I would watch for the SPX to rally and test and perhaps overcome the resistance zone (top panel, shown in grey) and possibly a test of the 12 support level on the VIX Index (bottom panel) in the upcoming week.


A small cap rally?
One of the likely beneficiaries of any stock market rally would be the beleaguered small cap sector. The chart of the Russell 2000 below (top panel) shows that the RUT has descended to test an important support zone. As well, the RUT to SPX ratio (bottom panel) shows that the small cap to large cap ratio is also testing an important zone of relative support.

With sentiment overly bearish, one likely rally candidate would be the RUT. I would watch for either a test of the pictured downtrend lines, shown on the top panel, or the relative downtrend line, shown on the bottom channel. If I am correct about the sentiment-based rally, then the ability of the bulls to overcome either downtrend would be an important test of the intermediate term outlook.

My inner investor remains cautious and he is taking this bout of strength to raise some cash. My inner trader has abandoned his bearish stance and cautiously taken on a small long position in stocks.





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

A funds-flow reason for equity market weakness

Regular readers will know that I have been relatively cautious on the US equity market. The reasoning has been mainly technical (see The bearish verdict from market cycle analysis) and I have struggled to find a fundamental trigger for a market correction (see A market correction trigger?).

I recently came upon an argument for equity market weakness based on institutional asset allocation flows from this unknown analyst:

Public corporate pension funds thanks to the over 30% gain in SP500 last year and the rise in rates which lowered the net present value of the liabilities many are 100% to 110% funded. At the end of the first quarter a number of large pension funds were up 8% on the year because of there holdings in the MOMO stocks

( Amozon , Facebook, Netflix ect ) and with the Net present value of their liabilities lower it became attractive to reduce growth assets and increase hedge assets. I think this explains the decline in Momentum stocks in April and the strong bid for long dated fixed income.

In other words, the defined benefit pension funds that became fully funded because of last year's stock market gains are selling to lock in their profits. They do this by selling the risky asset, stocks, and buying the risk-less asset relative to their liabilities, which are long duration bonds. The writer believes that this asset allocation shift has a long way to go because of the scarcity of long-dated Treasuries (emphasis added):

The question is this asset reallocation over. The answer is no! Big picture there are 16T in Private pension fund assets and 12T in US treasuries so this story will continue to play out as our population ages and preference for fixed income increases. 

I don't know how valid the analysis is because I have not looked at the scale of the effect. What is the number of defined benefit plans that have moved into actuarial surplus because of stock market gains? If anyone has any data that bears light on this issue, please speak up!

The funds flow and asset allocation thesis is consistent with the BoAML report that I highlighted (see A warning from the retail investor?) indicating that institutions were large sellers of equities while the individual investor had been piling in and hedge funds had turned from sellers to mild buyers:

If the funds flow is correct, then we could well be seeing stock prices deflate and long-dated Treasury prices rally while the world scratches their heads. In that case, there may not be a fundamental or valuation driven reason for equity weakness in the days and weeks ahead.



Addendum: An astute reader wrote that institutions generally do not have a large weighting in momentum stocks and therefore I am exaggerating the momentum stock sell-off effect. I would tend to agree. However, I was quoting the analyst in his entirety. The re-balancing thesis from stocks to long duration bonds remains valid and would put downward pressure on equity prices and upward pressure on long Treasury bond prices.



Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

A market correction trigger?

In a recent post, I wrote that I was watching the relative performance of cyclical stocks against the market for rising expectations that economic growth was about to accelerate (see The bearish verdict from market cycle analysis). I stated that cyclical stocks looked a little wobbly but the relative uptrend was (sort of) still intact. Under those circumstances, the reasonable thing to do is to give the bull case the benefit of the doubt.

After the close on Tuesday, I reviewed the chart of the relative performance of the Morgan Stanley Cyclical Index (CYC) against the SPX and found that CYC had broken down out of its relative uptrend that stretches back almost two years (solid line). Any way you look at it, it had also broken down out of a short-term relative uptrend (dotted line).

Recently, Business Insider highlighted analysis from Citi credit analyst Matt King showing the negative divergence between stock prices and estimate revisions, or the momentum of changes in fundamentals.

Sometimes these kinds of disconnects have a way of not mattering to the market until it matters. Could the technical relative breakdown in cyclical stocks that it's starting to matter? If so, could such a change in market psychology be one of the triggers for a market correction?





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

Financial engineering as a CapEx substitute?

In my last post (see The bearish verdict from market cycle analysis), I pointed out that the relative performance of capital equipment sensitive sectors like Technology and Industrials were not behaving well. I further lamented the lack of sales growth visibility of capital equipment companies during the latest Earnings Season  (see What the equity bulls need for the next phase and CapEx: Still waiting for Godot).

As per Business Insider points out, loan standards are being relaxed and loan demand is rising, so these conditions "should" be conducive to higher business investment. But higher capex has yet to appear.

Zero Hedge confirmed the long awaited capital expenditure acceleration has yet to arrive, though I always read their analysis with a grain of salt:

One explanation for the lack of capital expenditures this cycle came from Drew Matus and Julian Emanuel of UBS. Matus and Emanuel postulated that companies are engaged in so-called "corporate QE" (via Bloomberg).

Companies that engage in corporate QE are characterized by a reasonable dividend yield, a history of dividend growth and share buybacks. The UBS analysts went on to explain that companies feel pressured to engage in this form of financial engineering in the current low return environment (emphasis added):

The strategy is understandable in an environment where gross domestic product is expanding at an anemic rate of 0.1 percent. Companies hard-pressed to grow their businesses organically are paying dividends and reducing share count in order to maintain 5 percent to 7 percent cash-on-cash returns for investors.

The concern, as Mssrs. Matus and Emanuel indicate, is the substitution effect where companies "give away" money rather than reinvest in the form of capital expenditures. Ultimately, top-line growth will justify investment and companies will generate higher returns. Until then, investors must acknowledge the slow-growth reality of PIMCO's "new normal" and take growth where they can find it... even if that means settling for corporate QE.

Is this what happened in this cycle? Are ROIs so low that companies turning to financial engineering instead of investing the money back in their own businesses?





Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

The bearish verdict from market cycle analysis

I received a ton of feedback from my post last week (see Should you sell in May?) and a lot of readers seemed to have misunderstood my views. Yes, I was calling for a 10-20% correction this summer, but, no, the reasons are not just based on midterm election year seasonality. It appeared that many people had read the headline and concluded that I was tilting bearishly because of the so-called Sell-in-May seasonality. Not true. While seasonality arguments created a tailwind for my call, my cautious stance was based on other factors, such as the change in market leadership and volatility regime (see Interpreting a possible volatility regime change and A case of risk exhaustion).


The market cycle analytical framework
Let me start again, but in the context of a market cycle framework to analyze the stock market. One key advantage of market cycle analysis over economic analysis is that market cycle analysis uses real-time data, which is more forward looking than economic statistics, which is by definition backward looking. In effect, market cycle analysis gives us a continuous real-time read of what Mr. Market thinks where we are in the cycle. While its views may not be necessarily right, it does measure market expectations.

Here is an idealized version of a market cycle and how market leadership evolves over the course of that cycle:

Early cycle: The economy is in recession or on the edge of a recession. In response, the central bank stimulates the economy with low interest rates (or unconventional policy). As a result, stock begin to rise, led by interest sensitive sectors, such as Financial and housing related stocks.

Mid cycle: Some analysts split this part of the cycle into several pieces, but here is roughly how market expectations change. The economy gets better, or is perceived to get better. More jobs are created and consumers have more money to spend. Corporations find that they start to get capacity constrained. They respond by hiring more people, which leads to a virtuous cycle of more consumer spending, and buy more capital equipment. During this part of the market cycle, Consumer Discretionary, capital equipment sensitive sectors like Technology and Industrial stocks lead the market higher.

Late cycle: The economy starts to overheat and inflation starts to tick up. At this point, inflation sensitive commodity related sectors like Energy and Materials start to outperform. The central bank responds to rising inflationary pressures by raising interest rates, which leads to...

Bear phase: The stock market falls because of the expectations of higher interest rates and falling growth. Defensive sectors such as Consumer Staples, Utilities and Healthcare outperform during this phase.

There are a number of important caveats to this analytical framework. First, this is an idealized cycle which ends with either an inventory recession or the expectations of slowdown caused by an inventory recession. What we went through was not a typical inventory recession but a balance sheet recession, which recovered very slowly.

More importantly, I am describing a market cycle and not an economic cycle. Realize that this framework is based on technical analysis and not economic analysis. A market cycle behaves like an economic cycle, but it only describes the market response to expectations, not the actual economic result. As an example, the economic cycle started at the trough of the Lehman Crisis in 2008-09, but I believe that the market cycle actually began in late 2011, when the markets got over the trauma of the debt ceiling impasse in Washington and the ECB acted to relieve the pressures of the eurozone crisis with its LTRO program.


A market cycle map
With that in mind, let us consider what has happened in the past few years in the context of the market cycle framework. I will be showing a series of charts below. They are all market relative charts - charts of the performance of sectors and industries relative to the market as measured by the SP500. You will see relative uptrends, where the sector or industry outperformed and downtrends, where they underperformed. Keep that in mind when you look at these charts. Moreover, you will see that the time frames for these charts is all three years, in order to maintain an easy apples-to-apples visual comparison of where each group is in the market cycle.

What happened?

As expected, interest sensitive stocks led the market upward in late 2011. As the relative chart of Financial stocks show, they led the market upward, but their relative performance has stalled in the last year or so and they have been consolidating sideways relative to the SP 500.

The homebuilders is another interest sensitive group that displayed a similar pattern as the financials. They initially led the market upward, but their relative performance has been rolling over. In fact, homebuilders have recently suffered a relative breakdown through a critical level of relative support.

Notwithstanding the debate between New Deal Democrat and Calculated Risk on the tactical outlook for housing, Barry Ritholz wrote about the secular headwinds faced by the homebuilding industry in the wake of the Great Recession:

When you consider the chain of purchasers that typically occurs in a residential real estate market, you will understand why homeowner equity is so important. Any home sale is usually part of a series of interdependent transactions. The newlyweds who buy a starter home are usually doing so from a married couple, who have a 3-year-old and another on the way. They want to buy a larger home with more bedrooms for the kids, and purchase that from the couple who are trading up to a nicer home in a better school district. Those sellers purchase their new home on more land, or with a better view or some other factor. The long chain of buyers and sellers, beginning with the first-time buyers, explains why household formation is so crucial.

But beyond the first-time buyers, there are other problems with the links in the home-selling chain. Jonathan Miller of Miller Samuel Inc. noted the down-payment issue was directly related to the low-equity problem...

This also creates a problem with decreased inventory, which drives prices higher and paradoxically hurts first-time buyers.

As households have been deleveraging from the mid-2000s credit binge, they also have maintained a low savings rate. Combine that with relatively low household equity -- as well as no-equity and underwater households -- and you end up with a housing market that lacks a crucial ingredient for a robust recovery.

Ritholz's observations were confirmed by a study by the St. Louis Fed, entitled "Housing Crash Continues to Overshadow Young Families' Balance Sheets", which came to a similar conclusion.


Mid-cycle sectors faltering
After the interest sensitive stocks, the leadership baton was passed on to the mid-cycle groups. As this chart shows, Consumer Discretionary stocks have been on a tear since the market bottom, but they have start to roll over on a relative basis. Note, however, that the date of the relative peak is later than that of the interest sensitive groups.

Macro Man recently weighed in on the US consumer and stated that his model of consumption is weak, largely because the restraints put on consumption from the tepid pace of the rise in housing prices (see analysis above about housing).

One characteristic of a mid-cycle expansion is rising employment and I nearly fell off my chair when I saw this chart. Despite the blowout Non-Farm Payroll release last Friday, the relative performance of the business training and staffing agency stocks is highly disappointing. This group broke down through a relative uptrend that began in late 2012 and they are now in an accelerating relative downtrend. You have to ask what Mr. Market is trying to tell us about expectations of the employment outlook when these stocks display this kind of performance.

In addition to rising employment, mid-cycle expansions are accompanied by increasing investments in technology and capital equipment. Technology, another mid-cycle sector, never got the chance to assume the leadership mantle very much until about a year ago. Their leadership soon faltered by early 2014.

The capital equipment sensitive Industrial sector bottomed out on a relative basis in October 2012. They began to lead the market in earnest starting May 2013. Like the Technology sector, they peaked out on a relative in early 2014 and they are now consolidating sideways. This is a critical sector for the health of the bull as the US economy is mid-economic cycle where capex should begin to accelerate (see What the equity bulls need for the next phase). The reports for this group this Earnings Season contained good news and bad news. The good news is that earnings and the earnings outlook were generally positive. The bad news is that these companies continued to lack visibility in sales growth, either in their Q1 reports or their forward guidance (see CapEx: Still waiting for Godot).

Another test of Mr. Market`s views about mid-cycle strength has been the relative performance of cyclical stocks. This relative performance chart of the Morgan Stanley Cyclical Index looks a little iffy. Cyclical stocks bottomed out on a relative basis at about the same time as Industrial stocks and they have been on a relative uptrend ever since. Depending on how you draw the trend-line, these stocks are either testing the relative uptrend, or they are faltering and doing the dance between the downside and the upside of the relative uptrend line.

To be sure, the cyclical picture is not out-and-out bearish. The relative performance of the cyclically sensitive Transportation stocks show that they remain in a step-wise uptrend, which leads to a bullish interpretation. Note the timing of of the bottom of these mid-cycle groups, which all occurred at about the same time.

Late cycle sectors revive
What I do find disturbing, however, is that late cycle stocks are starting to bottom and outperform. This relative chart of the Material sector is that they rallied out of a relative downtrend about a year ago, consolidated sideways and they have staged an upside relative breakout indicating a possible leadership change.

As well, Energy stocks have also rallied out of a relative downtrend and started to move up on a relative basis.

Indeed, several alternative measures of inflation are ticking up. The Dallas Fed`s measure of Trimmed Mean PCE rose to 1.9% in March on the annualized headline figure and 2.1% on an ex-food and energy basis. While these figures only represent a single month of data, they are very close to the Fed`s inflation target of 2% and should bear watching carefully.

As well, the crowd-sourced inflation measure from the Billion Prices Project shows that their measure of inflation is significantly higher than CPI.

In addition to worries about rising inflation and inflationary expectations, inter-market analysis of the US Dollar, commodities and stock prices raise another level of concern. The chart below shows the USD Index, commodity prices as measured by the CRB Index in green and the correlation of the USD with the SPX in the bottom panel. As the chart shows, USD levels are roughly inversely correlated with commodity prices, which have been rallying recently. The USD is now testing a critical level of technical support that stretches back several years. If the greenback were to rise, it would create a headwind for stock prices. The bottom panel shows the rolling 20-week correlation of the USD with the SPX, which has tended to be negative.

Defensive sectors take the lead
In conjunction with relative rallies of the late cycle sectors, defensive sectors have also begun to take a leadership position. These developments are all suggestive of a bearish overtone to the stock market outlook. This chart of shows the relative performance of Utilities is turning up:

Consumer Staples have also started to turn around on a relative basis:

As an aside, astute readers may have noticed that I excluded the chart of Healthcare stocks in my analysis, as that sector has been thought to have defensive characteristics. I decided to exclude that sector because of the recent rise and fall of the biotech stocks, which is part of the sector, because their returns only serve to confuse the issue.


Market weakness ahead
So far, I have described what I consider to be the idealized market cycle (remember, it`s not an economic cycle but a market cycle). Every cycle is different, but the market leadership pattern of the current market cycle conforms to the template of many other cycles.

There are two obvious differences. First, we came out of a balance sheet recession and not an inventory recession, so the magnitude of the responses were different with past cycles. As well, the performance of commodity sensitive sectors have been much affected by the economic cycle in China, which can distort the interpretation of cycle work.

When I put it all together, the mosaic that I see is a market all have bearish overtones because of the nature of the change in market leadership. Add in the news about growing individual investor participation (see A warning from the retail investor), rising volatility (see Interpreting a possible volatility regime change) and the seasonal effects of the mid-term election and the Sell-in-May effects, my conclusion is there is equity market weakness ahead.

Would this weakness be a correction or a full-blown bear market? The most likely proximate cause of a bear market would be the anticipation of an economic recession. Since most recessionary indicators show a low probability of a recession in the near-term, my conclusion is that we are likely to see a mid-cycle correction of 10-20%.


Bearish seasonality
Indeed, analysis from Steve Suttmeier of BoAML indicates that the most likely outcome is a 10-20% correction during the May-October period during a mid-term election year. In fact, the combined probability of a correction of 10% or more during this period is 57%.

As well, Christopher Mistal updated his mid-term election year analysis of the major US averages. I have no strong opinions about the daily twists and turns of the stock market, but given my previous analysis this looks about right to me:

The NASDAQ, which recently cratered, is projected to get clobbered even more:

In conclusion, this is the whole story of how I came to my scenario of a 10-20% correction in the stock market this summer, not just a simple Sell-in-May seasonal analysis.






Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

A warning from the retail investor?

Macronomics highlighted some interesting fund flow statistics from the BoAML's client flows. It seems that institutional investors have been consistent size sellers of equities; while hedge funds had been sellers since late last year but recently started to buy; and individual investors have been buying stocks like they were Black Friday door-crasher specials. Bear in mind that when institutions change direction, they move glacially but move tends to be long lasting, while hedge fund and retail investor money tends to be much more nimble.

Other data sources have confirmed the individual investor stampede. TD Ameritrade maintains an Investor Movement Index (IMX) which measures individual investor activity. While the latest numbers are only to the end of March and the April figures will not be updated for another week or so, the readings from IMX also confirms substantial net individual investor buying. March 2014 IMX levels are now at all-time highs since the inception of the index and, if the BoAML data is accurate, April will show further highs indicating more buying.

Ryan Detrick made one observation about the progression of margin debt as how it relates to the net speculative activity of individual investors:

High margin debt by itself isn’t bearish.  In fact, new highs in margin debt usually have marked very strong stock markets (think the past 12 months).  The catch is once margin debt is high and it ROLLS OVER, then you better start to worry.

The latest observation shows that margin debt has started to roll over:

I am not going to make trite comments about who the smart money or the dumb money is. but when you add it all up, does this sound like a warning about the level of risk in equities?




Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui’s blog to ensure it is connected with Mr. Hui’s obligation to deal fairly, honestly and in good faith with the blog’s readers.”

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.