Sunday, August 2, 2015

Bullish and bearish over different time frames

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

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

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

Trend Model signal history

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

A multi-horizon market review
I had several discussions in the past couple of weeks with people about my market views in which the question came up, "Wait a minute, but I thought you were bullish (or bearish)?" I then had to explain that my bullishness or bearishness depended on the investment time horizon.

It is therefore useful to lay out how I would be positioned based on different time frames. My focus is mainly on the path of US equities, though I do use the signals from other markets to make my points. If you don't want to read everything, here is the summary: I remain long-term bullish on US equities, but expect a correction to begin in the next few months, probably in the September-October time frame.

Long term (next few years) bullish
First, I am long-term bullish on US equities. Bill McBride at Calculated Risk highlighted an important chart in early July that the American prime age population was growing again.

This development has important investment implications. The chart below graphically shows how American age demographics are likely to develop over time.

The age demographic developments confirms the thesis advanced by two teams of demographic researchers that I had written about some time ago (see Wait 8 years for a new bull?, which was written in 2010, and A stock market bottom at the end of this decade). Two papers, one from the San Francisco Fed (see paper here) and the second from academics, i.e. Geanakoplos et al (see paper here) made the point that Baby Boomers are likely to take money out of the stock market as they retire. The outflows are offset by cash flows from Echo Boomers going into the market. The inflection point where buying pressure starts to become positive is somewhere between 2017 and 2021. As we approach the end of 2015, the turning point is not that far away and demographic based savings patterns are likely to change from a headwind to a tailwind for US equity returns.

If you are to be invested in equities, the US remains the place to be. I wrote in my last blog post (see Is China getting hit with THE BIG ONE?) that the major world economies are going through a deleveraging process. The US is furthest in the process, the eurozone is somewhere in the middle and China is just beginning to deleverage. The chart below shows the relative performance of SPX compared to global equities. US stocks remain in a well defined relative uptrend, largely because of the success of how US fiscal and monetary authorities have reacted to the Great Financial Crisis as compared to other major economic blocs. There is no reason to believe that this trend is likely to change.

While the above chart shows a relative performance analysis between the US and global equities, the chart below shows the relative performance of US equities and bonds. The bull market in risky assets that began at the 2009 bottom remains intact. As bear markets are caused by either recessions (none on the horizon) or overly aggressive Fed tightening (you've got to be kidding me), this equity bull still has a long way to run.

I would like to point out, however, that the shaded areas show periods of market consolidation and correction that have occurred in past secular bull markets. This secular bull is no different and we may be in for a corrective period ahead.

Intermediate term (next few months) correction ahead
If we were to shorten the time horizon a multi-year time one to the next few months, breadth and momentum indicators are lining up for a correction of unknown magnitude.

My greatest area of concern for stock prices has been the loss of momentum that has been observed in the past few months. The 20-year monthly SPX chart below shows the relationship between stock prices and price momentum, as measured by the MACD histogram in the bottom panel. Every time momentum has turned negative, stocks have either been in a bear phase or about to enter a bear phase (marked by vertical lines). Other research that goes back further reveal similar outcomes (see Why I am bearish (and what would change my mind)). Moreover, the chart below also shows that the market is losing momentum and the SPX is very close to breaking the trend line that began in 2009, which is another warning sign that a correction may be around the corner.

Then there are the breadth measures. Normally, I use words like "negative" to describe technical indicators, but a word like "negative" doesn't even begin convey the depth of the divergences we have seen recently. "Awful" and "abysmal" are probably better descriptions of how market breadth is behaving right now. The chart below shows different ways of measuring breadth. The green line in the top panel is the ratio of equal-weighted SPX to float-weighted SPX (apples to apples comparison with the same stocks, with different weights) shows the narrowness of the leadership and how it has deteriorated since April. The other panels of bullish percentage and % of stocks in SPX above their 200 dma also tell a similar story. The generals are leading the charge but the troops aren't following.

To be sure, Michael Batnick pointed out a breakdown in market breadth is not an immediate concern. On average, breadth top out about a year before the market does. In the case of the late 1990s, the Tech Bubble didn't pop until two years after the top in the NYSE Advance-Decline line.

This analysis from BCA Research (via Zero Hedge) shows, however, that depending on how you measure breadth, the top was seen as early as a year ago in 2014 (bottom panel). So are we due for a correction?

Batnick`s analysis does make the point, however, that breadth deterioration is nothing to panic about. As long as the heavyweights hold up and the fundamentals remain sound, the stock market can remain healthy. With that point in mind, I analyzed the quality of the current leadership from a sector perspective. The current sector leaders are Healthcare (16% of SPX), Consumer Discretionary (11%) and Financials (16%). The laggards are Industrials (11%), Energy (8%) and Materials (3%). So the bulls are winning with a combined weight of 43% in the winning sectors compared to 21% in lagging sectors.

Let's look at breadth in the winning sectors. Here is the profile of Healthcare stocks. The top panel depicts the relative performance of the sector compared to the market, which shows that Healthcare remains in a healthy relative uptrend, and the bottom panel shows the relative performance of the equal vs. float-weighted indices within Healthcare (apples-to-apples comparison of the same stocks with different weights). While the equal weighted outperformance ended in April, the bottom panel shows that they remain range-bound and therefore confirms the relative uptrend of Healthcare stocks. So far, so good.

The breadth picture of Consumer Discretionary stocks presents a very different picture. While the sector has been in a relative uptrend against the market, breadth has been deteriorating for all of 2015. Does this look like a healthy advance?

The same comment is true of Financial stocks. The sector began to outperform in May, but saw breadth deteriorate in April, a month before outperformance began.

What about the laggards? Here are the Industrial stocks, which is dominated by GE on a float-weighted basis. Even as the sector underperformed, the equal weighted index underperformed the float weighted index, which confirms the weakness.

Here is the chart of the other large laggard sector, Energy at 8% of the SPX. Even as this sector lagged the market, the troops are running away faster than the generals.

I have heard it said that Technology has been one of the market leaders. That's not true. Large cap old Tech has performed roughly in line with the market. In fact, some groups within the sector, such as the semiconductors, have badly lagged the market. As well, equal and float-weighted breadth has deteriorated in the past month. However, the high beta glamour stocks, which include many Tech names, have been hot. As the relative performance chart below shows, momentum stocks (top panel) and the all important NASDAQ 100 (bottom panel) continue to lead the market.

There are trouble signs ahead. Conor Sen recently warned that the market action looked "heavy" and the market is not prepared to accommodate the companies in the IPO pipeline:
Good companies like LinkedIn and Tableau are trading down heavily on good earnings reports. Same to a lesser extent for Facebook – multiples are coming down as valuations shift from revenue multiples to EBITDA and earnings multiples.

If 80 unicorns all wanted to go public now, it’s not clear if there are enough I-bankers and underwriters to work the roadshows and make the deals all happen in a short period of time (the whole liquidity problem), to say nothing about prospective investor demand in the public markets.
In a separate post. he warned about the health of the IPO market:
Most of the tech IPO’s of this cycle have ranged between disasters and underwhelming. And yet there are 80+ unicorns in the pipeline, all of whom are dreaming of IPO riches to afford a middle class life in the Bay Area. Companies that…are trying to avoid going public as long as possible. While I’m always impressed by the talents of my friends in I-banking, it strains credulity to think that public investors will continue to line up at the trough for IPO’s when so few of them are winners.

Watch out for the Square S-1. Box took 6 weeks to go from confidential filing to S-1. If Square takes the same amount of time that’ll be mid-September. Tech market leadership has been thin, with a handful of companies accounting for all of the YTD index gains. If it looks like Square will be a busted IPO that could create a race to the IPO exits for unicorns.
Callum Thomas of AMP Capital also highlighted similar concerns about the health of the IPOs:
IPO (initial public offering) activity can provide clues to a top in the market and the cycle more broadly – but it’s not a perfect indicator.

As I was trawling through various datasets and trying to think up new things I thought it worthwhile comparing IPO stats to the SP 500 index to see if it provides any clues. There are some tentative clues but before we discuss the data and charts it’s worth thinking about the logic or intuition. More IPOs mean more supply of stock (all else equal – although it’s not quite equal because strictly speaking you should look at *net* supply - IPOs and capital raisings less buybacks). IPOs also happen in greater frequency in boom times because usually in boom times the economy is going well and it’s much easier for new companies to be successful and thus go on to do IPOs. Also, the pricing is better and the greater market enthusiasm increases the likelihood that the IPO will be successful.

So we can therefore say that there will be more IPOs when the market and economy are booming, and if the economy or market stops booming it will be harder to sustain IPO activity. So, we have a supply argument and a cycle argument that says there should be information in IPO activity. In terms of the charts there is a loose link: IPO proceeds (amount of capital raised) moves in line with the market as you would expect. When it rolls over it can mean a change in trend or rolling over of the cycle – however, it is more or less a coincident indicator. The monthly pace of IPO filings is also a potentially useful indicator where a surge in filings can flag a short-term top in the market. Looking at the longer-term data for the number of IPOs, it’s a little tricky because in the past there were many more IPOs than in recent times. So in terms of its efficacy it is ‘mixed’ but it is another information point worth considering. There is a potential red flag in that there was a surge in filings and the volume and proceeds seem to have rolled over.

As Batnick's analysis indicates, these are all warning signs of market weakness. None of them point to an imminent downdraft in the stock market.

Short term (next few weeks) bullish
Even though I believe that a correction is just around the corner, the environment for next few weeks are supportive of higher stock prices. First of all, the CNN Money Fear and Greed Index is too low and too far in fear territory. Major corrections and bear markets don`t start with this indicator at these levels.

We have gone through most of earnings season with 71% of SPX components having reported. The chart below from John Butters of Factset (annotations are mine) show that beat rates on the top and bottom lines are marginally below average. More importantly, the Street has responded by raising forward 12 month EPS estimates, which has been highly correlated with stock prices in the past.

As the majority of companies have reported, we can start looking at insider activity again. Even though this indicator is highly noisy, the Barron`s insider trading activity report shows that this is the second week in a row where this indicator is in the buy zone:
There may also be signs of a cyclical upturn. Maybe it's my imagination, but I am detecting the nascent signs of a turn in commodity prices, which could raise the outlook for global growth. NedDavis Research charted the relationship between consumer and commodity stocks. Even though they believed that the commodity bear is nowhere finished, this chart indicated that the decline is overdone and commodities are due for a bounce.

The conclusion of the NDR analysis is confirmed by what I am seeing in Asia. Even as I wrote about the possibility of impending doom in the Chinese economy (see Is China getting hit with THE BIG ONE?), I was struck by this chart of the stock markets of China's Asian trading partners. They are all below their 50 dma, except for (surprise!) commodity-sensitive Australia.

An examination of the price of Brent crude, which is unaffected by some of the transportation issues that have distorted the price of WTI, compared to EM currencies also showed a ray of hope for commodity prices. Even as EM currencies tanked in response to slowing Chinese growth and possibly in anticipation of Fed rate hikes, the price of Brent fell to a technical support level and did not make a new low. Is this a positive divergence?

Finally, a couple cyclical indicators are also early signs of bottoming. The top panel shows the price of gold and the silver/gold ratio. Silver has long been regarded as the more volatile and high-beta precious metal. Even as the gold price tanked, the silver/gold ratio turned up, indicating a possible bottom. The ratio of the DJ Transports to the DJ Industrials also provides an important clue as it turns upward. On the other hand, the bottom panel of the cyclically sensitive copper price to gold ratio has not risen yet. (Oh well, two out of three ain't bad.)

During this latest earnings season, one frequently cited excuse for poor earnings results has been the USD strength. Should commodity prices rally, the USD would likely fall because of their historical inverse relationship. A falling USD would therefore relieve some of the earnings pressures on US companies and raise EPS estimates and outlook for US stocks, at least for as long as greenback weakens (chart via Business Insider).

I have tried to reconcile my bearish view of an intermediate term correction with my shorter term bullish view, based on a robust and improving growth outlook. The key to squaring this circle is to look for a fundamental trigger for a correction. The most likely triggers are either be a negative reaction to a Fed rate hike (as per Jim Paulsen), which is likely to be in September, or the realization of the macro repercussions of a downshift in the Chinese growth outlook (see Is China getting hit with THE BIG ONE?). Or both.

My base case scenario calls for a stock market rally to test the old highs and possibly make new marginal highs, with a top in the September-October time period. Don't hold me to that forecast though, it's just a wild guess.

The week ahead: Uncertain
As I look ahead to next week, my inner trader is having trouble getting excited about being overly bullish or bearish. We saw a market bounce. Though I continue to believe that stocks are likely to pull back and possibly test the lows saw last Tuesday, it's not a high conviction call.

The SPY daily chart doesn't provide much clues as to market direction, though I am leaning slightly bearish. The RSI(5) or RSI(14) are both in neutral territory and the latter momentum indicator continues to be range-bound and has not flashed an overbought or oversold reading in all of 2015. However, volume studies does show that market rallies have been on declining volume and market weakness has been accompanied by rising volume, which is a cautionary sign. As well, the VIX Index (bottom panel) is at support and at the bottom of its 2015 range, which is also bearish.

The hourly chart of SPY also provides some bearish clues.SPY breached a short-term uptrend and it is rolling over. We are also seeing negative divergences on RSI(5) and RSI(14). While it does suggest that the market will weaken, it does not indicate magnitude. A test of the Tuesday lows is not necessarily in the cards next week.

On the other hand, any weakness may be short-lived. The ISE equity-only call/put ratio has shown two consecutive days when it has been below 100%. This is a rare event and Dana Lyons showed that such occurrences have been accompanied by a 1-2 day decline and a rebound in the 1-3 week time frame, though the sample size is very small at six. If this were to be the scenario, then look for a pullback, but don't expect a test of the lows seen last Tuesday.

My inner investor is waiting neutrally positioned and waiting for the correction to buy stocks at more attractive prices. The weeks and months ahead are likely to be volatile and full of twists and turns.

My inner trader is just confused. He is awaiting further developments before making any conviction bets on market direction.

Disclaimer: I have also noticed that from the tone of some Twitter questions and comments that suggest that some readers are following me carefully. Please view any replies or posts that I write in context. I have differing time horizons for different situations. In addition, my risk tolerance and pain threshold that are very different from yours.

Thursday, July 30, 2015

Is China getting hit with THE BIG ONE?

There has been a lot written on the Chinese stock market in the past few weeks. In case you missed it, CNN Money has a summary of what has happened here and J J Zhang of Marketwatch has a great on the ground view of investor attitudes here.

While market gyrations provide great headlines, what matters much more is the likely trajectory of the Chinese economy and the growth repercussions on world economy. Even before the Chinese stock market fell, there doesn't seem to be any doubt that Chinese economic growth was slowing, but... seems that the market meltdown may have pushed Chinese economy to past its tipping point as well.

Bridgewater turns bearish on China
Last week, one of the most prominent macro focused hedge funds did an about-face and turned bearish on the Chinese growth outlook, as per the WSJ. Here is Ray Dalio of Bridgewater and his U-turn on China:
Bridgewater Associates LP, one of Wall Street’s more outspoken bulls on China, told investors this week that the country’s recent stock-market rout will likely have broad, far-reaching repercussions.

The fund’s executives once had been vocal advocates of China’s potential. But that was before panic in the country’s stock markets shaved a third of the value off Shanghai’s main index, battering hordes of mom-and-pop investors and hedge funds alike, before partially rebounding.

“Our views about China have changed,” Bridgewater’s billionaire founder, Raymond Dalio, wrote with colleagues in a note sent to clients earlier this week. “There are now no safe places to invest.”


The change by Bridgewater is a particularly sharp reversal. Mr. Dalio has gone out of his way in the past to praise Chinese President Xi Jinping and has compared the country’s economic environment to a patient undergoing a heart transplant by a skilled surgeon.

In a note to clients in June, Mr. Dalio said China’s problems “represent opportunities” because they give policy makers a chance to make positive reforms. As recently as earlier this month, Mr. Dalio wrote that the stock-market move was “not significantly reflective of, or influential on, the Chinese economy, Chinese investors, or foreign investors,” with the market still largely driven by a small pool of speculative investors in China.

But this week, Mr. Dalio said he was particularly alarmed about the psychological damage of the stock-market decline. While prices remain above their levels from two years ago, many ordinary investors are sitting on losses because they piled in more recently, he said.

“Even those who haven’t lost money in stocks will be affected psychologically by events, and those effects will have a depressive effect on economic activity,” Mr. Dalio wrote.
FT Alphaville helpfully put the full Bridgewater note on their website here.

"Beautiful deleveraging"
To put those remarks into context, you have to understand Ray Dalio`s framework of analysis, which was revealed in his "beautiful deleveraging" thesis. In the wake of the Great Financial Crisis, Dalio believed that there are three broad possible policy responses: government austerity, financial restructuring, aka debt writeoffs, and quantitative easing, aka money printing. You can see him outlining his thoughts on this issue in writing here and in the video below.

If I were to add to Dalio`s analytical framework, I believe that we can describe the global economy as undergoing a process of deleveraging, which can take years and possibly over a decade to accomplish. In big picture terms, the US is the furthest along (and undergoing the "beautiful deleveraging" that Dalio described). Europe is still struggling and they are in the middle of the deleveraging process. China is just beginning the process after experiencing an unprecedented period of credit driven growth.

So back to the Bridgewater note. Initially, Dalio believed that China could achieve a soft landing:
Our views about China have changed as a result of recent developments in the stock market. We previously conveyed out thinking about the debt and economic restructurings as being negative for growth over the near term and positive for growth in the long term - i.e., that it is a necessary and delicate operation that can be well managed.
No more. The bubble is bursting. Economic restructuring, real estate and stock market bubbles are all unraveling at the same time (emphasis added):
While we had previously considered developments in the stock market to be supportive to growth, recent developments have led us to expect them to be negative for growth. While we would ordinarily consider the impact of the stock market bubble bursting to be a rather small net negative because the percentage of population that is invested in the stock market and the percentage of household savings invested in stocks are both small, it appears that the repercussions of the stock market`s declines will probably be greater. Because the forces on growth are coming from debt restructurings, economic restructurings, and real estate and stock market bubbles bursting all at the same time, we are now seeing mutually reinforcing negative forces on growth. While at this stage it is too early to assess how strongly the stock market`s decline will pass through negatively to credit and economic growth, we will soon have indications of this. We will be watching our short-term indicators of Chinese credit and economic growth carefully to see what the pass through to the economy of these developments is lie, and we will continue to share our thought about what is happening. Since the linkages in China are broadly analogous to those in other countries that we do have good perspectives on, it is worthwhile to look at the dynamic with this perspective in mind. This is the same perspective as we have taken in looking at China`s debts and economic situation.
Their back of the envelope estimates of the stock market crash is 1.3% of GDP, but the concern is the psychological impact on growth:
The negative effects of the stock market declines will come from both the direct shifts in wealth and the psychological effects of the stock market bubble popping. Though stock prices are significantly higher than they were two years ago, the average investor in the stock market has lost money because more stocks were bought at higher prices that were bought at lower prices. We now estimate stock market losses in the household sector to be significantly -- i.e., about 2.2% of household sector income and 1.3% of GDP. However, these losses appear to be heavily concentrated in a small percentage of the population as only 8.8% of the population owns stocks. These are rough estimates. We don't know who is experiencing what losses. Such information usually surfaces in the days and weeks after the plunge. Even more important than the direct financial effects will be the psychological effects. Even those who haven't lost money in stocks will be affected psychologically by events, and those effects will have a depressive effects on economic activity.
They looked at past cases of bubbles bursting. Any way you look at it, the effects aren't pretty:

A 2012 study by Pierre-Olivier Gourinchas and Maurice Obstfeld revealed that the combination of high debt (check) and high real exchange rates (check) proved to be particularly toxic. Here is a summary:
In recent research (Gourinchas and Obstfeld 2012), we have tried to understand the divergent behaviour of mature and emerging economies by comparing the 2007–09 crisis to earlier episodes of banking, currency, and sovereign debt distress throughout the world. Drawing on earlier chronologies, and adding a bit of our own judgement and primary research, we develop a database of the various types of financial crisis events that occurred between 1973 and the early 2000s.2 We then rely on an event-study methodology to inspect the antecedents and aftermaths of crises, focusing our analysis on a limited set of variables that earlier researchers have identified as important empirical or theoretical indicators of impending financial stress.

Our primary goal is to see if there are commonalities in the prologues to past crises as between advanced and emerging countries, and if the relative fortunes of different global regions differed in the recent recession because of significantly different policy choices or financial-market developments. In turn, such information could aid in predicting future crises.

What are the ‘smoking guns’?

Our event-study analysis points to:
  • Escalating leverage as one of the key ‘smoking guns’ in the run-up to both banking and currency crises.
  • Real exchange rates tend also to be strong, relative to tranquil periods, before all types of crisis.

Managing the fallout
Faced with the twin problems of a teetering property market and a cratering stock market, the key question will be, who pays for the damage? Here is David Cui of BoAML on the fallout stock market losses (via FT Alphaville, emphasis added):
Unless the government is prepared to shoulder the ultimate stock-market related losses by itself, via CSFC or other vehicles, various financial products funding the leverage may suffer from trillions of Rmb losses when the dust finally settles, by our estimate. Given the particularly-thin capital base of the front line FIs, including brokers, trusts and TAMCs, we suspect that it’s a matter of time before banks may have to face the music – bank WMP is by far the largest indirect leverage provider. Banks can decide, voluntarily or forced by the potential of social unrest, to take the losses on their book, which means their capital base would suffer severely. If they decide to pass on the losses to WMP buyers, we expect the shadow banking sector to wobble. We believe that the natural reaction of WMP buyers is to stop buying, given that they have been buying based on implicit guarantees and have little visibility as to which products are supported given the low transparency in the financial system. That effectively would be a bank-run in China’s shadow banking sector because bank WMP is by far the largest “depositor” in the shadow bank.

It’s possible that banks may take the losses on their books without explicitly acknowledging it, i.e. not marking to the market. In this case, we expect them to be much more cautious granting loans going forward as they would know their balance sheets are weak – that’s how the Japanese banks behaved post the bust of the property bubble.

Whichever way we look at this, what just happened in the A-share market will likely have profound impact on China’s economy and financial system one way or another, by our assessment.
Here is Credit Suisse on the catalysts for a hard landing from the real estate bubble (via FT Alphaville):
If house prices fall by 15% or more, then we think that we are likely to get a hard landing and the authorities risk running out of fiscal firepower. We suspect that if house prices fell by that much, then the LTV threshold would be absorbed. Moreover, with housing contributing to a third of local government revenue, 56% of banks’ collateral and around a fifth of GDP, the knock-on impacts could be immense.

Twice in the past, NPLs have risen above 20%. If this were to happen again, on the current credit-to-GDP ratio, the cost of recapitalising the banks could easily be 50% of GDP, not to mention the deterioration in the fiscal position on account of the loss of fiscal revenue. At that point, most of fiscal flexibility would be used up; however, the authorities would still have the ability to expand monetary policy, cut rates and RRR.

The second catalyst we see for a hard landing would be if deposit growth at banks stopped [now the lowest on record at just 6% with external liquidity in the form of FX flows drying up], as this would essentially limit the ability of banks to roll over loans to SOEs, in our opinion.
I have seen comments in the past that "the government" is large and rich and it can afford to pay for these losses. Recognize that "the government" is just a transfer mechanism between different sectors of the economy. In this case, should "the government" socialize the losses, it will be ultimately be the household sector that bears the burden of adjustment. In that case, what happens to the the objective of re-balancing to the consumer and the path of future economic growth?

Turning Japanese
A recent Quartz article highlighted a disturbing divergence spotted by Wei Yao of Société Générale. He found that bank loans are falling. But how does bank credit decline in the face of 7% GDP growth?

We can argue that Chinese statistics are made up, but to characterize them as just "made up" is wrong. "Distorted" might be a better description. In the end, the figures have to balance.
Those data were from the National Bureau of Statistics. Weirdly, central-bank data show overall bank lending rising at a much faster clip than growth in financing for FAI projects:
Christopher Balding, associate professor at Peking University HSBC Business School, Shenzhen, explained the bank loan growth mystery this way:
“Given the rise in credit and the fall in actual investment, you have to really wonder where these loans are going,” says Balding. “China hasn’t grown enough Silicon Valleys [meaning, high-growth sectors] to change the entire financial landscape in a year. This indicates a large number of bad loans, and liquidity problems.”

To unpack what Balding means, a company that can’t pay back a loan has a few options. It can fire workers and sell off assets, file for bankruptcy, borrow from someone else to cover the debt, convince the bank to extend the loan for another year or so, or get the bank to lend it even more money. Why would a bank manager do the latter two options? Insolvent loans put bank managers in a tough spot. Cut off the money, and when that customer defaults the bank has to write that money off. That could cost the manager her job.

This is why these companies are dubbed “zombies”—keeping them on a steady drip of financial life-support prevents the dead from truly dying.
In other words, China is turning to the Japanese solution of corporate zombification:
The gap between credit and investment suggests this is happening. The reason banks are so hungry for more money is because, quite simply, they’re not being paid back. This is potentially a big problem for China’s growth outlook; bank loans account for three-quarter of China’s total financing. That compounds itself—slower growth makes it even less likely that banks will eventually get paid back. As more and more money shifts toward keeping “zombie” companies alive, there’s less and less that can go to entrepreneurs and households that could really use it.
Once the Zombie Apocalypse grips the economy, it gradually rots away and cannabalizes growth potential:
But the horror movie analogies don’t stop there. When debt hits a certain level, an economy starts to cannibalize itself, devouring its own potential. Credit that could support good companies goes to postpone defaults. Corporate profits go to pay off debt, and aren’t reinvested in expansion. Shriveling demand drags down prices.

Soft on the inside, hard on the outside
To summarize.  Ray Dalio believes that China has hit the tipping point and its stock market crash is the trigger for a debt unwind. Under such circumstances, the natural reaction of the fiscal and monetary authorities is to try to prevent a Russia, Lehman or Creditanstalt Crisis style meltdown of the financial markets. Beijing seems to be well down that path and they appear to be adopting the Japanese solution of corporate zombification.

Such a course of action would imply that the household sector would bear the most of the burden of any adjustment. Economic growth would therefore have to decelerate sharply. The same-old-same-old model of debt financed infrastructure spending is broken. The economy will be unable to shift to the Third Plenum objective of re-balancing to the consumer because the consumer will have to bear the cost of all these bad debts, either in the form of further financial repression, higher taxes, or other measures.

Despite all these problems, China should be able to achieve a soft landing.

I have also heard the comment that describes a Chinese landing as “hard on the outside and soft on the inside“. China will achieve a soft landing (inside the country). On the outside, however, the countries and companies doing business with China will not be so fortunate (hard landing for outsiders).

Already, we are seeing signs of the hard landing on the outside:
China's Asian trading partners will get hit hard in any slowdown. In addition, Germany is a also a major exporter of capital goods to China and falling Chinese growth will hit the eurozone economy hard. Resource based economies, such as Australia (bulk commodities), New Zealand (milk), South Africa (mining), Brazil (mining) and Canada (energy and mining) will also feel the brunt of a "hard on the outside" effects of a China hard landing. Already, this chart shows that global merchandise trade is slowing:

In the US, latest earning season warned of disappointing corporate developments in China. Numerous companies as diverse as CAT, UTX (capital goods), COH, YUM and GM (consumer) will be affected should Chinese growth nosedive. Despite the upbeat AAPL earnings call message about China, BI recently highlighted a Cowen research note indicating that Chinese iPhone demand was light. Longer term, however, slowing growth is likely to result in an American Renaissance as cheaper input costs from lower commodity prices and an onshoring revival sparks US growth (see my previous post How inequality may evolve in the next decade).

Over the next few quarters, however, the markets will likely focus more on the negative effects of this transition. Spreadsheets will have to get revised with lower growth projections and risk premiums ill rise (and PE ratios will fall). 

That is, of course, assuming that you accept the Bridgewater thesis that China is unraveling and the Chinese economy is getting hit with THE BIG ONE.

The canary in the coalmine
One quick-and-dirty key indicator I am watching is the art market. CNBC featured a report about how the Chinese could crash the art market:
"I think there will definitely be an impact," said Ken Yeh, director at Acquavella Galleries and former chairman of Christie's Asia. "Chinese collectors have become a very important part of the market."

Even before China's recent stock-market slide, there were signs that some Chinese collectors were paring back their spending. According to Artnet, total art sales in China and Hong Kong fell 30 percent in the first half of 2015 to $1.5 billion from $2.2 billion.

During the spring sales in Hong Kong, "I heard many dealers talking about how weak the sales were. It's definitely down," Yeh said.
The art market warning did come with caveats, though:
While some market watchers are drawing comparisons to the Japan-led art boom of the late 1980s, which crashed with the Japanese property market in 1990, others say today's art market is far more diverse and durable. Even if the Chinese collectors put down their bidding paddles, buyers from the U.S., Middle East and Europe will step up in their place.

"In the late 1980s, the market was so much smaller," Gyorgy said. "The Japanese were just about the only ones buying. Now we're working with collectors in Asia, Latin America, the U.S., Europe and so if one segment goes away, another segment comes back."
Yes, but what if the deflationary effects of a slowdown in the Chinese economy spreads globally?
Yet the big test for the market will be in October and November, during the fall sales in Hong Kong and New York. Last fall, Sotheby's and Christie's sold $1.78 billion worth of art, with many of the bids coming from Chinese buyers.

Gyorgy said all it takes is one weak auction to damage the already fragile confidence of Chinese buyers.

"Everyone is going to be watching this very closely," she said. "Art is as much a psychological market as a financial one. If there is one sale that isn't strong, people get spooked."
If you want the real-time market reaction to any possible China slowdown, watch this chart of Sotheby`s.

Monday, July 27, 2015

Time to buy Canada?

A recent BNN report indicated that the Bank of Canada is confused as to why Canadian exports aren't picking up:
Bank of Canada Governor Stephen Poloz called the persistent weakness in Canada’s non-energy exports “puzzling” in the central bank's latest assessment of the economy. And a former colleague of the central bank governor at Export Development Canada (EDC) is confused by the shortcoming in exports as well.

“We can attribute some of this. But a bunch of it we can’t,” Governor Stephen Poloz told reporters in the question and answer session that followed the Bank of Canada’s second rate cut of the year.

After crude oil and natural gas, Canada's largest exports to the U.S. include vehicles, machinery, and plastics.

Peter Hall, vice president and chief economist of Export Development Canada, says the lower loonie is only an effective stimulant to the export economy when it coincides with a groundswell of demand from our neighbours to the south. The problem, he explains, is that groundswell hasn’t materialized despite a bevy of strong U.S. economic indicators.

“They’ve got job growth. They’ve got real income growth. They’re confident again. They’ve reorganized their debts, and they have lower gas pump prices that are giving them $100 billion extra to spend. Put that all together. They should be spending. What are they doing? They’re saving at the moment. They’re as nervous as everybody else about the wiggles in the economy after six years of flat performance,” said Hall, who worked alongside Poloz at EDC for nine years.
Here is the reasoning. The Canadian economy is reasonably well diversified between the resource producing regions and the industrial heartland. When commodity prices boom, the resource provinces benefit and the CADUSD exchange rate rises. When they retreat, the exchange rate falls, which makes the manufacturing centres more competitive, which raises exports to Canada’s largest trading partner, the United States.

This time, the BoC is puzzled why manufacturing exports aren't rising. In a separate report, the Globe and Mail quotes BoC governor Stephen Poloz as being puzzled:
Canada’s non-resource exports have “faltered” of late and remain “a puzzle that merits further study,” according to central bank Governor Stephen Poloz. One thing is clear, however: Canada’s share of U.S. goods imports has eroded over the past four decades. “Notably, the U.S. now imports roughly equal dollar amounts of goods from Mexico and Canada, versus 10 years ago when they brought in $1.70 (U.S.) from Canada for every $1 from Mexico,” Robert Kavcic, senior economist at BMO Nesbitt Burns, said in a note.
Canadian market share of US imports 

Faltering competitiveness
I addressed this issue in a post in early June (see Uh-oh Canada!). The competitiveness of Canadian manufacturing has markedly deteriorated between 2004 and 2014. A BCG study showed that the cost structure of Canadian manufacturing is behind that of its NAFTA partners, the US and Mexico. The Canadian Dollar, or loonie, would have to fall to between 0.72 and 0.78 before it starts to become competitive with these other countries.

Since I wrote that blog post, CADUSD has fallen to below 0.78.

Canadian equities have fallen as well. The chart below depicts the TSX Composite (priced in CAD) in the top panel and Canada iShares (EWC, priced in USD). The TSX is holding at a key support zone, but a look at the USD denominated ETF shows that it has violated support.

What now, should you buy Canada?

Hollowed out manufacturing
If the question is whether you should buy the Canadian equity market, the answer is an emphatic no. In the past, the manufacturing heartland of Ontario and Quebec were populated by lots of manufacturers that would benefit from a falling exchange rate. So I took a look at the components of the TSX Composite to see what non-resource exporting companies might benefit from a falling loonie (note that this is only a list and does not constitute a recommendation to buy any of these stocks): What I came up with is a rather sad list:

  • Amaya Gaming Group (AYA)
  • Avigilon Corp (AVO)
  • Bombardier Inc (BBDb)
  • BRP Inc (DOO)
  • Descarte Systems Group (DSG)
  • Enghouse Systems Ltd (ESL)
  • Gildan Activewear (GIL)
  • Intertain Group (IT)
  • Intertape Polymer Group (ITP)
  • Magna International (MG)
  • Martinrea International (MRE)
  • Open Text Company (OTC)
I may have left out one or two, but this is an extremely small list and some of these stocks are not very liquid. The two large caps on that list are Bombardier (aircraft manufacturing) and Magna (auto parts). The rest are mainly software service providers with a global customer base. Is that all that’s left of Canadian manufacturing?

I deliberately left out companies that are unlikely to significantly benefit from a falling loonie because its costs are not in Canadian Dollars, such as Thomson Reuters, whose operations are not really located in Canada, Restaurant Brands International, which operates Burger King and Tim Hortons and Lululemon, which produces its products mainly in Asia.

The remainder of the TSX Composite are resource companies (energy and mining), REITs and financials and consumer products and retailers serving the Canadian market. Both of the latter are vulnerable should the Canadian economy roll over into recession as it seems to be doing,

Given current macro conditions, why on earth would anyone want to buy Canadian equities?

As for the loonie, I have estimated the equilibrium rate at between 0.72 and 0.78. However, we know that markets overshoot equilibrium. I would therefore be not surprised to see the loonie trade at 0.65 or even lower before the current adjustment period is over.

Even though I live here, my inner investor continues to prefer US over Canadian assets as much as possible.

Sunday, July 26, 2015

How the USD explains and predicts stock prices

Trend Model signal summary
Trend Model signal: Neutral
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.

Choppy until September
I've been thinking a lot about how US Dollar strength has affected the markets. New Deal democrat wrote an intriguing post last week indicating that the strength of the USD explains the combination of a weak industrial recession and a robust consumer. If we were to accept that currency-based explanation of the US economy and markets, then USD strength is in effect doing some of the Fed's job of tightening. At about the same time,  Jim Paulsen of Wells Capital Management expressed some concern that the financial markets may be in for a rude awakening when the Fed finally raises rates.

In the meantime, Trend Model readings have improved from "risk-off" to "neutral", largely on the back of a better eurozone growth outlook and the reduction of Greek tail-risk. When I put it all together, it suggests that US equity markets are likely to chop around in a range-bound pattern for a little longer until the Fed finally starts to raise rates, which will probably be in September. That could be the signal for the negative breadth divergences to resolve themselves into a long awaited correction.

However, I would view the current bullish trading signal purely as a tactical call and in the context of the formation of an intermediate term top (see my previous post Why I am bearish (and what would change my mind)).

The USD theory of everything
Last week, New Deal democrat highlighted a fascinating New York Fed study of the effects of USD appreciation. In that study, they modeled the GDP growth effects of a 10% appreciation in the USD.

Here is New Deal democrat:
Of course, appreciation of the US$ doesn't happen in isolation, but the effect is significant enough that it can tip an otherwise soft economy into recession.

As the below graph shows, the recent appreciation of the US$ was about 12% against all trading partners, and it took place over 3 quarters rather than one (red, left scale), but the decline in industrial production that began last November (blue, right scale) is in accord with the NY Fed's analysis:

These effects are consistent with the shallow industrial recession that he has been observing, whose negative effects have been offset by a strong consumer.
So why hasn't the US tipped into recession? Because, in part due to a steep decline in gas prices, consumer spending, which is 70% of the US economy, has powered right along:

Market action has certainly been consistent with this hypothesis. A glance at the market leadership show that cyclical stocks have been lagging the market, which is reflective of a shallow industrial recession. The chart below depicts the market relative performance of cyclically sensitive industrial, semiconductor and resource stocks relative to SPX, as well as the relative performance of the DJ Transports to the DJ Industrials. All of these groups are underperforming.

By contrast, the market leaders have been Consumer Discretionary stocks, high-beta glamour stocks (which I warned about last week as being extended, see A warning for growth investors) and financials. Consumer Discretionary outperformance is no surprise under the circumstances. High-beta leadership is a little worrisome, especially in light of its narrow breadth. The outperformance of financials appear to be related to the expectation of better margins from higher interest rates. The chart below shows the relative performance of the financial sector, which are mainly large banks, and the relative performance of broker-dealer stocks. If the bulls were truly in charge of the tape, then we would see the leadership of financial stocks accompanied by its high-beta group, the broker-dealers. In this case, the broker-dealers have not participated in the relative rally in the last couple of months and they have performed in-line with the market in that period instead.

One important point of the New York Fed study is that it demonstrated the contractionary effects of a rising exchange rate through the trade channel. American consumers and importers share the benefits of cheaper imports when the USD rises:
A stronger dollar makes U.S. imports relatively cheaper than domestically produced goods, which pushes consumers to substitute towards imported goods and provides firms with relatively cheaper inputs from abroad. Though both consumers and importing firms benefit from lower import prices, the data show that the extent of the benefit is limited because exchange rate movements are not fully passed through into prices seen by U.S. buyers. We estimate that a 10 percent rise in the dollar results in a 3.8 percent decline in nonoil import prices. Instead of adjusting prices charged to U.S. consumers by the full exchange rate change, firms exporting to the United States adjust their profit margins. Because import prices do not adjust by the full extent of the appreciation, the increase in demand for import quantities in response to the appreciation is moderated. The New York Fed trade model suggests a 10 percent appreciation of the U.S. dollar in one quarter (which then persists) results in 0.9 percent increase in real import values, as shown in the table below.
On the other hand, exporters get hurt because their margins get squeezed:
On the export side, a stronger dollar makes the price of U.S. exports more expensive when converted into foreign currency terms, reducing U.S. export growth. In order to try to maintain competitiveness, U.S. firms adjust their markups rather than pass on the full exchange rate appreciation into foreign prices. That is, U.S. exporters take a hit on their profit margins in order to maintain market shares. The New York Fed trade model suggests that a 10 percent appreciation of the U.S. dollar is associated with a 2.6 percent drop in real export values over the year. Consequently, the net export contribution to GDP growth over the year is 0.5 percentage point lower than it would have been without the appreciation and a cumulative 0.7 percentage point lower after two years.
In other words, a rising USD has a similar effect as raising interest rates. The strengthening exchange rate has, in effect, done some of the Fed`s tightening work for it. If it were to raise interest rates this year, the US economy would suffer the double whammy from the effects of rising currency and rates. Moreover, the divergent path taken by the Federal Reserve compared to the other major central banks of the world would put further upward pressure on the US Dollar.

Markets vulnerable to rising rates
Jim Paulsen of Wells Capital Management expressed concerns that, unlike previous episodes when the Fed raised rates, the markets may be caught off-guard this time.
Several aspects surrounding today’s stock market make it appear abnormally vulnerable as the Fed begins the process of finally raising interest rates. First, the current price/earnings (P/E) multiple is among the highest of any Fed initiation cycle. Second, investor sentiment is probably a bit too calm since the stock market has not experienced a correction for more than 900 trading days, the third longest in post-war history. Third, the Fed begins this tightening cycle from the lowest unemployment rate of any post-war recovery. Finally, tightening begins when corporate profit margins are near historic highs and while earnings growth is already well past its best growth rates of the recovery.

Perhaps the stock market will be little affected by the Fed finally lifting interest rates from zero. However, these notable vulnerabilities suggest at least some period of stock market turbulence as the Fed begins to normalize monetary policy.
You would think that a September rate hike has been well telegraphed and priced into the markets, but Marc Chandler made the following observation:
Surveys suggest that a little more than 80% of the economists expect the Federal Reserve to hike rates in September. The September Fed funds futures, the most direct market instrument, has only about a 50% chance discounted.
In addition, there have been numerous warnings about the possible emerging market contagion effects from rising US rates. The IMF fretted about this issue in a publication, Spillovers from Dollar Appreciation (emphasis added):
The recent strong and sustained appreciation of the U.S. dollar (USD) raises questions about possible financial spillovers to emerging markets (EMs). The global economy is steering away from the Great Recession, but the recovery is still uneven, with marked divergences in the pace of growth among major economies. Specifically, the U.S. economy has gathered strength, suggesting a normalization of Federal Reserve monetary policy in the next few months. In contrast, growth in the euro area and Japan is still subdued, and their monetary policies are easing further. Reflecting these divergences in the outlook and expected monetary policies, the USD has appreciated considerably against most major currencies, especially the euro and the yen, over the past year. The USD has also strengthened vis-à-vis most emerging market currencies, particularly those of commodity-exporting economies. Historically, periods of sharp USD appreciation have been associated with an increased number of external crises in emerging markets—hence a key concern relates to possible spillovers from a sustained period of USD appreciation on the financial stability of EMs, specifically through effects on global capital flows, exchange rates, and EMs’ balance-sheet exposures.
The most glaring problem is the USD carry trade that will have to be unwound. In my previous post The key tail-risk that the FOMC missed (and you should pay attention to), I had highlighted a Bloomberg report indicating that there was about $9 trillion in offshore USD loans sloshing around the global financial system (emphasis added):
When Group of 20 finance ministers this week urged the Federal Reserve to “minimize negative spillovers” from potential interest-rate increases, they omitted a key figure: $9 trillion.

That’s the amount owed in dollars by non-bank borrowers outside the U.S., up 50 percent since the financial crisis, according to the Bank for International Settlements. Should the Fed raise interest rates as anticipated this year for the first time since 2006, higher borrowing costs for companies and governments, along with a stronger greenback, may add risks to an already-weak global recovery.

The dollar debt is just one example of how the Fed’s tightening would ripple through the world economy. From the housing markets in Canada and Hong Kong to capital flows into and out of China and Turkey, the question isn’t whether there will be spillovers -- it’s how big they will be, and where they will hit the hardest.
FT Alphaville pointed out that these loans are offshore loans are beyond the control of  the Federal Reserve;
But we’re now at a point where, unless all those external debtors have an organic way to keep dollars flowing into their coffers — i.e. without dependence on financing from non-US dollar pool sources — the value of all those loans, as well as the external US dollar pool itself, could quite abruptly and violent collapse in value.
To summarize the case for how the USD drives markets. The strength in the USD has had a negative effect on US growth (NY Fed) The markets may not be fully prepared for when the Fed actually raises rates because of high valuation, excessive investor complacency and the fact that the Fed may be behind the curve (Paulsen) . In addition, there is a vast USD 9 trillion in offshore USD loans to EM credits that create a high degree of vulnerability with unknown contagion effects (IMF and others).

A Trend Model score upgrade
Despite all these potential negatives, the Trend Model has improved from a "risk-off" reading to "neutral", largely because of an improving Europe. As the chart of the STOXX 600 shows, European stocks rallied on the news of a resolution of the Greek impasse and the index remains above both the 50 and 200 dma. These signs of market strength shifted the composite model from negative to neutral.

From a macro viewpoint, the growth outlook in Europe is improving. Callum Thomas pointed out that the recent ECB bank loan survey is suggestive that the eurozone may grow as fast as 3-4%, which is an astounding rate for the region.

Thomas also highlighted that of all the different regions, Europe stands out the most in forecast 2016 EPS growth:

The Trend Model signal has also been aided by stability and slight improvements in the US outlook. The latest update from John Butters of Factset indicates that this earnings season is turning out to be a fairly typical one. With 37% of the SPX components reporting, the earnings beat rate is slightly above average and the revenue beat rate is slightly below average.

The most important metric is the evolution of the forward 12 month EPS estimates, which is rising again after experiencing a minor hiccup last week. As the 10-year history of the chart shows, stock prices are highly correlated with forward EPS (annotations are mine).

The combination of an improving Trend Model reading, which translate into a trading buy signal, and possible tail-risk from Fed tightening suggests a scenario where US equities are likely to be choppy and range-bound until the likely September FOMC interest rate liftoff meeting.

I would caution, however, that the bullish view is only a trading and not an investment call, I continue to believe that US equities are forming an intermediate term top. Doug Ramsay of Leuthold Group is the latest of many to call for a market top because of poor breadth and narrow leadership. The chart below is only one example of the abysmal market breadth which was evident for most of 2015 and accelerated to the downside in the past couple of week.

Under the circumstances, traders should be tactically focused on trading overbought and oversold readings until the intermediate term market direction is resolved.

The week ahead
Last week, the trading model flashed a sell signal after a short-lived buy signal (see From oversold to overbought to...). Little did I expect that stock prices would flip back to an oversold condition after registering overbought readings a week ago.

I tweeted Friday afternoon that I had taken profits and covered all of my short positions. The following two charts from IndexIndicators show the market`s technical conditions with varying time frames. Shorter (1-3 day horizon) indicators such as the percentage of stocks above their 10 dma reveal an oversold reading, which suggests that a bounce,

Longer term (5-10 day horizon) indicators such as the net 20-day highs - lows, however, show that readings are barely in oversold territory and stock prices could move lower before seeing a durable bottom.

My inner trader realized some profits last week and he is staying flexible in the week to come. I have two likely scenarios in  mind for the coming week, which are shown by the annotations in the chart below. An assessment of market conditions indicate that 1) trading gaps have been filled; and 2) stocks are sufficiently oversold on RSI(5) that a bounce is highly likely. However, the lack of even a 2015-style mild oversold reading on RSI(14) and the inability of the VIX Index to rally above its 20 dma suggests that there may be some limited downside to this market.

My first and preferred scenario calls for a brief 1-2 day rally, followed by a decline and re-test of the lows set on Friday. The template for this action (remember that history rhymes but doesn't repeat) is the market action in late June and early July, where the market fell to an initial low (as it did on Friday), rallied and weakened again to test the previous low, but saw non-confirmation on momentum indicators such as RSI(5) on the re-test. The second but less likely scenario would see the market continue to fall on Monday to make a durable V-shaped bottom. Both of these scenarios would be followed by a rally to a possible test of the old highs.

The main reason for the choppy outlook because sentiment has deteriorated to a crowded short reading. As an example, the CNN Money Fear and Greed Index is already at an extreme reading. It would be difficult to envisage a major bearish impulse starting from these levels. I would like to see sentiment improve to at least a neutral reading before a corrective phase could begin in earnest.

My inner investor`s asset allocation remains at policy targets. He continues to hope for a market downdraft so that he can buy stocks at much cheaper prices.

Disclosure: No positions