Thursday, November 27, 2014

How cheap are stocks? (growth investor edition)

It's that time of year again, when Wall Street strategists and other pundits give their forecasts for 2015. This is not an unusual year in that we have seen some bullish, bearish and middle-of-the-road forecasts for the stock market. For me, it leaves the perennial question unanswered, "How cheap are stocks?"

On one hand, you have the likes of Henry Blodgett of Business Insider, who points to the Shiller CAPE and say that the market is overvalued. Though he is not selling his equity positions, Blodgett says that the degree of over-valuation suggests that investors should lower their long-term expectations for equity returns.

On the other hand, you have the likes of former bear David Rosenberg who believe that US equities are fairly valued to cheap when compared to other asset classes like 10-year Treasuries and cash (see interview here).

Who is right? What's the real story?

A value investor`s perspective
Rather than get into a debate about the validity of the Shiller CAPE ratio, one way of getting some perspective is to simply consider the EPS and EBITDA multiples of the SPX (via the excellent work done at Philosophical Economics). From those perspectives, US equities don't look very expensive at all:

Here is the P/B ratio, the conclusion is the same:

It could be argued, however, that the time horizon for these valuation multiples were too short as the above charts only goes back to the mid-1990's. Here is a very long term chart of the SPX P/E ratio. A very different conclusion can be drawn from this chart: Stock prices appear to be elevated on a P/E basis on a 100-year+ time horizon:

One problem with the P/E ratio is the "E" in the P/E can be noisy as earnings will fluctuate depending on the cyclical effects of the economic cycle. One alternative way to address some of the cyclical noise is to study the P/B ratio, because book value tends to be a more stable figure. While this chart is also a little dated and not directly comparable because it shows the Dow`s P/B ratio (and the current ratio is slightly higher at 3.1), the conclusion is roughly the same as the long-term P/E analysis. Current stock market valuations are above average, though they cannot be characterized as crazy nosebleed levels.

A growth investor's viewpoint
The aforementioned valuation metrics suggest that US equities are overvalued, but a growth investor would scoff at the discussion and asks, "Forget valuations, does the market have earnings visibility?" In the short run, valuations do not matter very much for growth investors, but it is earnings momentum that matters to growth investors. Indeed, as this chart from Factset shows, the SPX has been highly correlated with consensus forward 12 month EPS estimates.

Instead of focusing on pure earnings momentum of the growth-at-any-price approach, I prefer the a growth-at-a-reasonable-price (GARP) framework of, "How much am I willing to pay for a certain level of growth?"

To answer that question, we turn to the PB-ROE model, where:
If we were to decompose the elements of ROE and analyzing their past trends and future projections, we have a better understanding whether the market P/B multiple is likely to rise or fall. Here, we turn to the Dupont formula, where:
ROE = (net income / sales) * (sales / assets) * (assets / equity)
         = Net margins * Asset turnover * Financial leverage
Thus, the three elements of the Dupont formula are:
  1. Net margin, which is a function of operating margin, tax rate and interest expense;
  2. Asset turnover; and
  3. Financial leverage.
The analysis at Philosophical Economics showed many of Dupont formula components of ROE for the SP 500 for the last 20 years: First. we start our analysis by focusing on the ROE chart on the bottom left hand corner, where ROE has moved up and down with past cycles. Nevertheless, ROE will have to rise in order to see P/B multiple expansion. The question then becomes, how possible is that in the near future?

Now consider the Dupont formula components of ROE. The top left chart shows the net margin history of the SP 500. As the chart shows, net margins have been rising since 1996, though with cyclical hiccups. The top middle chart, however, shows a history of the operating, or EBITDA. margin. It indicates that EBITDA margins have been largely flat over this period. As I have pointed out before on this blog, the rise in net margins has largely been attributable to lower interest expense and lower effective tax rates. The top right chart shows ITDA, which is a measure of interest expense and tax retention rates, as a percentage of EBITDA for the last 20 years and it indicates that the tailwind from these factors have been steadily dissipating.

If we were to assume that the US is roughly in the mid-cycle of its economic expansion and, based on that assumption, EBITDA margins could rise for cyclical reasons over the next year as they have in the past at similar points of the cycle. However, that positive cyclical effects could be offset by the negative effects of rising interest rate and net tax rates. If I were to project the likely growth outlook for net margins for the next year, I would rank it as roughly neutral.

Another Dupont formula component of ROE is financial leverage. As the bottom right hand chart shows, financial leverage has been steadily falling this expansion cycle. Rank the growth outlook for financial leverage as neutral to negative.

The analysis from Philosophical Economics does not directly show history of the third component of the Dupont formula, but we can more or less back out the direction of change from the other two components. When I eyeball the progress in ROE (bottom left chart) and compare it to net margins (top left) and financial leverage (bottom right), I deduce that asset turnover has been roughly flat to down this expansion cycle.

Flat to falling asset turnover is not surprising, given the dismal record of capital expenditures during this recovery. This analysis is suggests that the world is suffering from a lack of demand, which is restraining the level of CapEx among companies, though the results are not necessarily conclusive.

Unfortunately, the stated level of CapEx may actually be exaggerated. Analysis from Francisco Blanch of BoAML shows that most of the CapEx seen this cycle has come from energy sector. Given the recent fall in oil prices, the outlook for CapEx acceleration is bleak (via Business Insider).

Large vs. small cap valuation
The mediocre outlook for the major components of ROE suggests that large cap stocks are no bargains for growth investors. Another way of thinking about the SP 500 is to look at the profitability and valuation metrics of the small cap Russell 2000.

This analysis from Principal Global shows that the P/B ratio for the large cap Russell 1000 and Russell 2000 have tracked each other relatively closely, except for the Tech Bubble of the late 1990`s. Viewed in that context, P/B ratio of the Russell 2000 is elevated and it is near the cycle peaks of the last bull market. However, the market remained at those P/B valuation levels for about three years before the bear market began in 2007. I conclude that while these valuation levels might be cause for concern, this level of P/B ratio for small caps does not represent a sell signal. even if we were to use the Russell 2000 P/B as a large cap valuation proxy.

Here is the chart showing the relative performance of the Russell 1000 relative to the Russell 2000 showing the huge outperformance of the large caps during the Tech Bubble which prompted the divergence in P/B valuation shown in the above chart.

Given the P/E and P/S ratios of the markets, Principal Global also backed out the implied net margins of large and small cap stocks. This chart shows the outlook to be neutral to slightly negative. The implied net margin for large caps have been rising, but net margins for small caps have started to roll over. Given the earnings headwinds posed by a strong USD to large cap multi-national companies, large cap net margins are more likely to follow the path of small cap margins than the other way around.

Don't panic, stocks won't crash
In conclusion, US equities look expensive from both a value and growth investor`s perspective. Valuation multiples appear elevated historically based on a P/B and P/E basis. From a growth perspective, it`s hard to see how much earnings visibility and momentum the stock market can show on an aggregate basis in the absence of a positive surprise.

On the other hand, these market levels are no cause for panic. Sure, stocks prices are elevated, but they are not at danger levels that a crash is imminent.

Tuesday, November 25, 2014

Rebalancing your portfolio for fun and profit

This is part two of a two part post on portfolio rebalancing (see How to rebalance your portfolio (NAAIM maniac edition) for part one).

The standard practice among portfolio managers is to establish a rebalancing discipline for their portfolios. A typical process would involve the following steps:
  1. Determine the target asset mix, which could change depending on market conditions.
  2. Re-balance if:
    • The asset mix weights moves more than a certain percentage, e.g. 10%, from the target weight; or
    • Periodically, e.g. on an annual basis
These are all sensible rules that have long been practiced in the investment industry. In essence, the strategy involves taking profits on winning asset classes and averaging down on losers as a form of risk-control discipline.

Then I came upon an intriguing paper by Granger, Greenig, Harvey, Rattray and Zou entitled Rebalancing Risk. Here is the abstract:
While a routinely rebalanced portfolio such as a 60-40 equity-bond mix is commonly employed by many investors, most do not understand that the rebalancing strategy adds risk. Rebalancing is similar to starting with a buy and hold portfolio and adding a short straddle (selling both a call and a put option) on the relative value of the portfolio assets. The option-like payoff to rebalancing induces negative convexity by magnifying drawdowns when there are pronounced divergences in asset returns. The expected return from rebalancing is compensation for this extra risk. We show how a higher-frequency momentum overlay can reduce the risks induced by rebalancing by improving the timing of the rebalance. This smart rebalancing, which incorporates a momentum overlay, shows relatively stable portfolio weights and reduced drawdowns.

Monthly rebalancing does the worst
You would think that, for example, given the massive losses seen during the Lehman Crisis episode, that a rebalanced portfolio where the investor bought all the way down would see superior returns. Interestingly, that was not the case.

In the paper, the authors compare and contrast a simple drift weight strategy, i.e. not rebalancing at all, with a fixed weight monthly rebalancing strategy. The chart below shows how that the monthly rebalanced portfolio actually showed a higher risk profile than the passive drift portfolio. (There were other examples in the paper, but I will focus on this period for the purpose of this post).

By contrast, they advocate a partial momentum strategy. In essence, this amounts to the application of of a trend following system to rebalancing. The idea is, as the stock market goes down and the bond market goes up, you keep overweighting your winners (bonds) and don't rebalance the portfolio until momentum starts to turn. As the chart below shows, the portfolio with the partial momentum overlay performed better than either the monthly rebalanced or passive drift weight portfolio.

Talking their book?
These are intriguing results and a demonstration of the positive effects of using trend following techniques for portfolio construction. However, I would add a couple of caveats in my read of this paper.

First, three of the five authors work for MAN Group, which is known for using trend following techniques in their investing. While this paper does show the value of these kinds of techniques, I am always mindful that researchers may be "talking their own book". As regular readers are aware, I extensively use trend following models in my own work, but I am cognizant of the weaknesses of these models.

In particular, these models perform poorly in sideways choppy markets with no trends. As an example, consider this chart of sugar prices for the period from 1891 to 1938. Unless the trend following system is properly calibrated, the drawdowns using this class of model are potentially horrendous.

As another example, try wheat prices for the 1872 to 1944 period:

A second critique of the approach used by the paper is the use of monthly rebalancing as one of the benchmarks. In practice, no one rebalances their portfolio back to benchmark weight on a monthly basis. A more realistic rebalancing technique might be a rule based rebalancing approach of rebalancing either annually or if the portfolio weights drift too far from the policy benchmark.

To be fair, however, the monthly rebalancing approach is an extreme one that does differentiate between a passive drift weight and a more frequently rebalanced portfolio.

Value vs. Momentum
In summary, this is an intriguing paper that compares and contrasts the use of price momentum, or trend following, techniques of chasing winners to a value-based rebalancing strategy of buying assets when they are down.

Before going out and blindly implementing a trend-following based re-balancing program, I urge portfolio managers to further study these approach and adopt it to their own circumstances. Your mileage will vary.

Monday, November 24, 2014

The Grinch comes early for retailers

About a year ago, I warned about getting overly excited about the Black Friday hype (see Is Black Friday the time to sell the Retailers?). I had identified a seasonally weak pattern for retailing stocks in December. Hype about Black Friday retailing results didn`t help investors in these stocks either.

Sure enough, retailing stocks exhibited a pattern of outperformance into late November and then dropping off in December last year, as shown by the chart of the relative performance of XRT to SPY:

A glance at the seasonal relative return pattern for retailing stocks showed that they tended to underperform the market in December.

This year, I reiterate my warning. If you want to go shopping this Black Friday, I suggest that you don`t buy retailing stocks.

Sunday, November 23, 2014

Don't fight the tape (or central bankers)

Trend Model signal summary
Trend Model signal: Risk-on (upgrade)
Trading model: Positive

The Trend Model is an asset allocation model used by my inner investor. The trading component of the Trend Model keys on changes in direction in the Trend Model - and it is used by my inner trader. The actual historical (not back-tested) buy and sell signals of the trading component of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

No one ever expects the Central Banker street party!
In early November, when the BoJ unexpected announced another shock-and-awe QE program, I wrote (see Enjoy the party, but watch for the police raid):
While the BoJ party is just getting going, the partiers are spilling out onto the street and getting out of control. The neighbors are getting upset and they're about to call the cops. My inner trader remains wary of the time when the police show up and raid the party.
I identified two main risks to the "BoJ party". First, the latest round of Japanese QE will inevitably weaken the JPY against other major currencies and could invite a global currency war. In particular, it would make Japanese capital goods more competitive against eurozone (German) machinery exports and would weaken an already fragile European economy.

As well, I was concerned that China's economy was weakening rapidly and it was unclear how much more stress it could take. I asked:
How much stress can China take without taking action that reverberates around the world?
Up until recently, the PBOC`s modus operandi has been to launch either limited or covert stimulus if growth slowed too much for fear of sending the wrong message that Beijing was backsliding on its financial reform initiatives (via The Economist):
The central bank’s answer to this dilemma has been to loosen monetary policy, but in a covert fashion. It lent the state-owned China Development Bank one trillion yuan ($163 billion), according to rumours that dribbled into local media in June. Some likened it to Chinese-style quantitative easing (QE): the central bank had in effect printed cash to rev up growth. But whereas central banks in developed economies have explained every step of their QE schemes to markets, the PBOC did not even bother to announce its activity.

Then, in September and October, it launched a “medium-term lending facility”, injecting a further whack of cash—769.5 billion yuan, it turns out—into the economy via loans to commercial banks. Rumours spread for weeks before the central bank confirmed them on November 6th. As for the initial trillion-yuan loan, it eventually acknowledged the operation, though declined to say how much it had lent, at what rate or even to which bank.
Despite their size, these covert stimulus packages didn`t seem to be enough:
The combined amount of the infusions, if as big as reported, would be huge—equal to more than three months of America’s now-completed QE scheme when it was at its height, or to five months of Japan’s current programme. The impact of China’s easing, however, has been underwhelming. It has not reached the real economy. Short-term interest rates have fallen: a closely watched interbank rate is down by almost two percentage points this year, to 3.2%. But the rate at which banks lend to businesses, which matters more for growth, has remained stuck at about 7%.
The news about falling home prices in October may have been the last straw:

Finally, Beijing blinked and the PBOC unexpectedly announced an interest rate cut that is designed to effect a more broadly based stimulus program (via Bloomberg):
China cut benchmark interest rates for the first time since July 2012 as leaders step up support for the world’s second-largest economy, sending global shares, oil and metals prices higher.

The one-year lending rate was reduced by 0.4 percentage point to 5.6 percent, while the one-year deposit rate was lowered by 0.25 percentage point to 2.75 percent, effective tomorrow, the People’s Bank of China said on its website today.

The reduction puts China on the side of the European Central Bank and Bank of Japan in deploying fresh stimulus and contrasts with the Federal Reserve, which has stopped its quantitative easing program. Until today, the PBOC had focused on selective monetary easing and liquidity injections as China heads for its slowest full-year growth since 1990. 
Even before the news of the latest round of PBOC stimulus, Diana Choyleva of Lombard Street Research presciently wrote the following in the SCMP. She believed that China was preparing to kick the can down the road, but the road is quite long (emphasis added):
Surprise, surprise - Beijing has set its eyes on debt-fuelled growth again, this time boosting lending to households. China's total debt is not excessive, so Beijing can try this trick. But its efforts will end in tears without genuine redistribution of income towards consumers.

Some people argue China already has too much debt and has little scope to raise it further. True, total debt has surged since the global financial crisis, but it is not extreme, as in some other countries. Gross private non-financial debt and gross government debt added up to 2.4 times China's gross domestic product last year compared with close to four times for Japan and Portugal and more than three times for Greece and Spain.

Yet there is no magic number above which debt in an economy becomes excessive. Moreover, different economic structures, cultural habits and market perceptions lead to different levels of sustainability for household, company and government debt.

Even so, a global comparison suggests Beijing can continue to play the debt game a bit longer. Also, like Japan, most of the debt is owned domestically so China would not be under the same international pressure as Greece and Argentina.
She concluded that it will not end well and cited the problems encountered by South Korea, but that`s a problem for another day:
The more output growth weakens, the more likely it is Beijing will spur household borrowing. Expanding the underdeveloped mortgage market is not bad news, but if China relies only on household credit to power economic growth and pulls back from needed financial reforms, the omens are not good.

South Korea went down this path in the 2000s after the fallout from the 1997 Asian crisis, but failed to rebalance its economy towards consumer spending. It was left with the mess from a burst household debt bubble and an economy even more dependent on exports. China must heed the lessons.
In effect, the Chinese saw the party at the BoJ`s place and decided to throw one of their own. Party now, pay later.

The ECB will  "do what it must"
If the surprise PBOC announcement wasn`t enough to light a fire under the markets, Mario Draghi stated that it will “do what it must“ to raise inflation and inflationary expectations (via Marketwatch, emphasis added):
In a speech to a banking conference, Draghi said the ECB was prepared, if needed, to expand its purchases of assets, which raises the amount of money flowing in the economy. That heightened hopes in financial markets that the ECB may soon buy large amounts of government bonds of eurozone members, a path other big central banks have taken but the ECB has largely resisted.

We will continue to meet our responsibility — we will do what we must to raise inflation and inflation expectations as fast as possible, as our price stability mandate requires of us,” Draghi said.

If on its current trajectory our policy is not effective enough to achieve this, or further risks to the inflation outlook materialize, we would step up the pressure and broaden even more the channels through which we intervene, by altering accordingly the size, pace and composition of our purchases,” Draghi added.
To emphasize its resolve, it tweeted that it had start to buy ABS as part of its effort to expand its balance sheet:

The BoJ party wasn`t enough. The PBOC party wasn`t enough. The ECB has decided that it wants in on the party action too. So we now have a Central Bankers street party.

The music`s fine, drinks are free
In response to these announcements, commodity prices spiked in reaction to the Chinese stimulus news. In Europe, the STOXX 600 staged an upside breakout from a minor resistance level.

I also highlighted a number of positive European catalysts in my last post (Two contrarian plays that will make you queasy):
  • Falling unit labor costs in Greece, Spain and Ireland that make them competitive with Germany
  • Positive earnings surprise from European companies
  • Forecasts of robust European company EPS growth
In addition, BCA Research also made its case that positive momentum will result in a turnaround in eurozone equities:

In the US, a San Francisco Fed paper indicating that inflation may not rise as much as expected could provide cover should the Yellen Fed decide to lean dovishly on the timing of raising interest rates (via WSJ, emphasis added):
New research from the Federal Reserve Bank of San Francisco warns the U.S. central bank’s inflation target may prove more elusive than many policymakers now think, in a fresh wrinkle for any move by officials to end their easy-money policy stance.

The report, written by bank economist Vasco Curdia and published Monday, says the Fed may not see its 2% inflation objective achieved until “after the end of 2016.” The finding generates fresh uncertainty around current Fed projections, which hold that the likely range of inflation in 2016 will be between 1.7% and 2%. For 2017, the likely range seen by officials is 1.9% to 2%.
Combine the SF Fed paper with this detail in the latest FOMC minutes and "many participants" on the FOMC could find justification for delaying raising rates (emphasis added):
There was widespread agreement that inflation moderately above the Committee's 2 percent goal and inflation the same amount below that level were equally costly--and many participants thought that that view was largely shared by the public.
Back on Wall Street, the SPX staged an upside breakout to all-time highs last Tuesday and I tweeted that I was buying the breakout:

The market friendly news from the PBOC and ECB helped propel the SPX to further highs:

Building towards a 1987 event?
Currently, both the intermediate term fundamental and technical underpinnings of the stock market are supportive of further highs. The latest earnings analysis from John Butters of Factset shows that consensus US forward EPS estimates have stopped falling and appears to have started to slowly grow again. Such a development has to be regarded as putting a floor on the stock prices.

Conditions may be setting up for a blow-off top in the stock market. I had highlighted the bullish views of former Value Line Research Director Sam Eisenstadt (see my previous post Global healing = Buy the dips) where he targeted a SPX level of 2,225 in six months (via Mark Hulbert at Marketwatch on November 5, 2014, emphasis added):
This incredible bull market, which has earned the right to go sideways for a while, is instead going to keep powering ahead.

That, at least, is the forecast of the market timer who has more successfully called stocks’ direction in recent years than anyone I can think of. His latest forecast: The SP 500 will rise to 2,225 in six months, 10.3% higher than where it stands today.

I’m referring to Sam Eisenstadt, the former research director at Value Line Inc. Though he retired in 2009 after 63 years at that firm, he continues in retirement to update and refine a complex econometric model that generates six-month forecasts for the benchmark stock market index.
Coincidentally, Jeremy Grantham postulated a bubble market where the SPX starts to get bubbly at 2,250 in the latest GMO quarterly letter. Eisenstadt's target is 2,225 and Grantham is thinking 2,250, which, as the saying goes, is close enough for government work:
My personal fond hope and expectation is still for a market that runs deep into bubble territory (which starts, as mentioned earlier, at 2250 on the SP 500 on our data) before crashing as it always does. Hopefully by then, but depending on what the rest of the world’s equities do, our holdings of global equities will be down to 20% or less. Usually the bubble excitement – which seems inevitably to be led by U.S. markets – starts about now, entering the sweet spot of the Presidential Cycle’s year three, but occasionally, as you have probably discovered the hard way already, history can be a snare and not a help.
Dana Lyons also observed that the SPX is well above its trend on an inflation-adjusted basis. The only other time it has been this far above trend was the March 1998 to July 2001 period, which was at the height of the Tech Bubble. I would note, however, that the last time these overbought conditions appeared, it took a full two years before the excesses began to correct themselves. Overbought markets can get more overbought:

As well, Byron Rich is projecting a SPX target of 2917 by the end of 2015 in a Forbes article:
If we applied the long-run annualized return for stocks (8%) to the pre-crisis highs of 1,576 on the SP 500, we get 2,917 by the end of next year, when the Fed is expected to start a slow process toward normalizing rates. That’s nearly 45% higher than current levels. Below you can see the table of the SP 500, projecting this “normal” growth rate to stocks.

Notwithstanding Rich`s *ahem* outlier forecast of a 45% SPX gain, consider this Twitter observation from Jesse Livermore, the blogger at Philosophical Economics, that puts some perspective on the current advance in US stocks from 2009:

I got to thinking. Eisenstadt is a well-respect market analyst who uses models that are tilted towards growth and momentum. Grantham is a well-respected value investor - and value investors tend to be conservative and early. If they are both thinking 2,225 to 2,250 on the SPX, might it overshoot to the 2,400 level, where the combination of over-valuation and some macro event, e.g. Fed tightening, cause the market to crash?

Let me make this very, very clear. I am not forecasting a market crash, but a scenario involving melt-up followed by a market crash is within the realm of possibility. These figures put forward by Eisenstadt, Grantham, Lyons and Livermore certainly puts some parameters of the upside potential in a bull run.

Under these circumstances, let`s enjoy the potential market melt-up first instead of worrying about a market meltdown, Party now, pay later.

The road ahead
In the short term, I am seeing signs of positive momentum everywhere. The latest BoAML Fund Manager Survey is seeing a renewal of optimism about global growth but the bullishness is not excessively high:

Fund managers have expressed a desire to pile into equities:

While their positions are above average, the BoAML comment is that readings are only 0.7 standard deviations above average and not stretched:

Technically, the SPX touched its weekly upper Bollinger Band on Friday but did not close above it. Episodes where the market has closed above the upper weekly BB are rare and has tended to signal impending weakness. However, as the market did not punch above its upper weekly BB, it may be poised for a multi-week ride on the upper BB, where the index rises along with the upper band:

In addition, BoAML has pointed out that Thanksgiving Week has been historically seasonally positive for equity returns (via ZH):

In the meantime, it`s a great party. Don`t be such a worrywart about what might happen next year. My inner trader tells me:
Don`t fight the tape (or central bankers, for that matter). It's a new era of financial hedonism.

A personal thought for Thanksgiving 
As my American friends look forward to their Thanksgiving celebrations, let me take this opportunity to launch my personal appeal for support of the Vancouver Youth Symphony Orchestra, to which I am a volunteer board member. I have kept my writing free since I started this blog. If you have found my work to be valuable, please show your appreciation by donating to this worthy cause by clicking here.

I have long believed that one of the ways to nurture youth is to give them a focus in their lives, whether it be music, sports or other pursuits. This is especially critical during their adolescent years as they start to form their own identities. It's one of the key reasons why I became involved with the Vancouver Youth Symphony Orchestra Society. Participation in a VYSO orchestra teaches young musicians to focus on both their individual musical and orchestral skills. The latter is particularly important as many people can learn to play music, but a different skill is required when the conductor points to a section and have them all play the same sound at the same time. It's much like the difference between learning to walk and learning to march in formation.

The Vancouver Youth Symphony Orchestra Society is a registered charity and tax receipts are available to contributors who are Canadian residents.

Thank you for your support.

Disclosure: Long SPXL

Thursday, November 20, 2014

Two contrarian plays that will make you queasy

In a recent post, I wrote that being a contrarian investor can be a lonely task and can involve considerable career risk (see Do you have what it takes to be a contrarian investor?). The point being that contrarian investments are non-consensus investments that make you queasy.

With that in mind, here are a couple of contrarian plays guaranteed to make you queasy.

Worried about deflation?
Consider, for example, that the latest Bloomberg Global Investor Poll indicated a high degree of concern over deflation:
The world economy is in its worst shape in two years, with the euro area and emerging markets deteriorating and the danger of deflation rising, according to a Bloomberg Global Poll of international investors.

A plurality of 38 percent of those surveyed this week described the global economy as worsening, more than double the number who said that in the last poll in July and the most since September 2012, when Europe was mired in a recession.

Much of the concern is again focused on the euro area: Almost two-thirds of those polled said its economy was weakening while 89 percent saw disinflation or deflation as a greater threat there than inflation over the next year. Respondents said the European Central Bank and the region’s governments are making the situation worse by pursuing too-tight policies, and fewer expressed confidence in ECB President Mario Draghi and German Chancellor Angela Merkel.
Even the Fed is worried about deflation, according to the latest FOMC minutes. "Many participants observed the committee should remain attentive to evidence of a possible downward shift in longer-term inflation expectations," according to the minutes. "Some of them noted that if such an outcome occurred, it would be even more worrisome if growth faltered."

Ambrose Evans-Pritchard added fuel to the fire by highlighting deflationary concerns in East Asia causing a debt crisis:
Deflation is becoming lodged in all the economic strongholds of East Asia. It is happening faster and going deeper than almost anybody expected just months ago, and is likely to find its way to Europe through currency warfare in short order.

Factory gate prices are falling in China, Korea, Thailand, the Philippines, Taiwan and Singapore. Some 82pc of the items in the producer price basket are deflating in China. The figures is 90pc in Thailand, and 97pc in Singapore. These include machinery, telecommunications, and electrical equipment, as well as commodities.

Chetan Ahya from Morgan Stanley says deflationary forces are “getting entrenched” across much of Asia. This risks a “rapid worsening of the debt dynamic” for a string of countries that allowed their debt ratios to reach record highs during the era of Fed largesse. Debt levels for the region as a whole (ex-Japan) have jumped from 147pc to 207pc of GDP in six years.
Indeed, Thomson-Reuters reported that Chinese disinflationary forces taking hold:

Evans-Prichard warned about how deflation is threatening the Chinese economy which, if forced into a hard landing, could send shock waves throughout the global financial system:
China itself is now one shock away from a deflation trap. Chinese PPI has been negative for 32 months as the economy grapples with overcapacity in everything from steel, cement, glass, chemicals, and shipbuilding, to solar panels. It dropped to minus 2.2pc in October.

The sheer scale of over-investment is epic. The country funnelled $5 trillion into new plant and fixed capital last year - as much as Europe and the US combined - even after the Communist Party vowed to clear away excess capacity in its Third Plenum reforms. Old habits die hard.

Consumer prices are starting to track factory prices with a long delay. Headline inflation dropped to 1.6pc in October. This is so far below the 3.5pc target of the People’s Bank of China that it looks increasingly like a policy mistake. Core inflation is down to 1.4pc.
With widespread concerns over deflation and falling inflation, I sense a disconnect in the Bloomberg Global Investor Poll(emphasis added):
When asked which asset they would short if they had the opportunity to choose just one, 20 percent of participants in a poll of 510 Bloomberg customers picked government debt, making it the most-popular choice, while 17 percent said junk bonds.
Moreover, the outlook for the 10-year Treasury yield remains bearish, which is confirmed by other institutional sentiment surveys (see What do the pros REALLY think about the market?):
Wall Street prognosticators were just as bearish on bonds at the start of the year, bolstered by signs U.S. demand would allow the Fed to end its unprecedented stimulus and lead the central bank to raise interest rates from close to zero.

Based on a Bloomberg survey of economists and strategists in January, they foresaw yields on the 10-year Treasury note, the benchmark for trillions of dollars of securities, rising to 3.44 percent by year-end, from 3.03 percent at the end of 2013.
So let me get this straight. The market is worried about deflation, but bearish on Treasury bond prices, presumably because few could bring themselves to buy bonds with yields this low. Isn't that the classic definition of Treasuries climbing a wall of worry? Aren't those good enough reasons to be a contrarian buyer of Treasuries here? (I told you that being contrarian would make you queasy).

How low can Europe go?
How low can Europe go? Here is the relative returns of US and eurozone equities relative to the MSCI All-Country World Index (ACWI). All returns are shown in USD so that currency effects are neutralized.

There have been lots of hand wringing over Europe (via the Washington Post, emphasis added):
In the Guardian, Cameron described the euro zone as “teetering on the brink of a possible third recession, with high unemployment, falling growth and the real risk of falling prices too.”

Add in stalled trade talks, conflict in the Middle East, fighting in eastern Ukraine and the alarming spread of the Ebola virus, Cameron warned, and the world is functioning against “a dangerous backdrop of instability and uncertainty.”

Cameron’s bleak prognosis came at the end of the Group of 20 summit in Brisbane, Australia, where leaders of the world’s biggest economies struggled with strategies for kick-starting growth. Similarly negative pronouncements have echoed from other sources in recent days, particularly in relation to Europe.

Mark Carney, the governor of the Bank of England, told reporters in London last week that “a specter is now haunting Europe — the specter of economic stagnation.” International Monetary Fund chief Christine Lagarde has warned of “the risk of a new mediocre” in Europe, with low growth, low inflation, high unemployment and high debt.
While we saw a ray of hope for the eurozone, the latest round of weakness has not been helped by German intransigence on monetary and fiscal stimulus. To put some perspective on the German problem in Europe, here is Wolfgang Münchau's latest column in the FT. The opening sentence is hilarious:
German economists roughly fall into two groups: those that have not read Keynes, and those that have not understood Keynes. To describe the economic mainstream in Germany as conservative misses the point. There are some overlaps with the various neoclassical or neoconservative schools in the US and elsewhere. But as compelling as a comparison between the German mainstream and the Tea Party may appear, it does not survive scrutiny. German orthodoxy straddles the centre-left and the centre-right. The only party with some Keynesian leanings are the former communists.
Münchau concluded (emphasis added):
The ordoliberal doctrine may even have worked well for Germany, though I suspect that the country’s economic success is due mostly to technology, high skills and the presence of some excellent companies, rather than to economic policy. Through its dominance of the euro system, Germany is exporting ordoliberal ideology to the rest of the single currency bloc. It is hard to think of a doctrine that is more ill suited to a monetary union with such diverse legal traditions, political system and economic conditions than this one. And it is equally hard to see Germany ever giving up on this. As a result the economic costs of crisis resolution will be extremely large.
In all seriousness, it seems that even as the eurozone slides into deflation, German intransigence and continued opposition to fiscal stimulus is the only thing that stands between growth and another recession. Antonio Fatas commented on German stubborness this way:
Here is my guess from what I have learned from many heated discussions over the last years about economic policy in Europe: the resilience (stubbornness) of this view on economic policy comes from a combination of faith and the inability of the economic profession to apply enough real world filters to models.

Faith in a certain economic model comes from many years of being trained about the beauty of markets and all the inefficiencies that governments generate. But faith also comes from the belief that only through (individual) hard work and sacrifice (saving) one can achieve any economic progress. In this world (what Wolfgang Munchau refers to as Germany's parallel universe) there is no room for an economic crisis caused by lack of demand. Recessions only take place as a result of misbehavior, debt and lack of willingness to work hard (and reform). The only way to get out is to behave.

Are European equities contrarian enough for you?
Are European equities hated enough for you? Despite the high levels of investor skittishness, I am seeing enough upside potential in Europe to believe that it warrants a second look for a number of reasons.

First, despite the very much publicized problems in the eurozone periphery, some peripheral countries have made tremendous strides in making adjustments through the process of internal devaluation. Data from this site of Euro area statistics show that unit labor costs, adjusted for productivity, in Ireland, Greece (yes, that Greece!) and Spain have fallen considerably and now competitive with German costs. (It may not be that long before BMW locates that next plant in Valencia or Thessalonika):

To be sure, not all countries have sufficiently adjusted to the new reality, which will give the Germans will continue to lecture their European partners:

In addition, I discovered and started playing with a neat country valuation screen from StarCapital. When I screen on cheap valuations (CAPE under 14, PB less than 2) and positive price momentum, most of the countries that appear are European. These readings confirm my Trend Model readings of a region that has dipped into deep value territory that is exhibiting positive momentum (see Why I am not (just) a technician).

Click to enlarge

Credit Suisse confirmed the positive momentum seen in Europe with a series of tweets on European equities. They highlighted the extraordinarily high of positive earnings surprise shown by in the latest quarter:

In addition, CS also pointed out their forecast for robust eurozone equity earnings growth:

In Europe, we have a beaten down region with attractive valuations and emerging positive momentum, which is often an indication that a value investment is starting to turn up. Value investors can't ask for too much more than that.

Wednesday, November 19, 2014

How to re-balance your portfolio (NAAIM maniac edition)

Here is a real head scratcher that`s been bothering me for the past several weeks. I have had a number of discussions with investment professionals and I have had no satisfactory answer. Why does the NAAIM survey of equity exposure experience such wild swings (chart via agd capital management)?

As the chart shows, the NAAIM equity exposure index has swung wildly from under 20% to over 80% in the past four years. These kind of volatility is more consistent with panic and euphoria of swing traders or reflect the risk tolerance of hedge funds than plain vanilla individual investor investment mandates.

Most professional investors would have a process where they establish an investment objective for their client, with an asset allocation benchmark, e.g. 50% stocks, 50% bonds. They would then vary their exposure by 5-10% around that benchmark. Under extreme market conditions, a typical target variance from benchmark might be 20% from policy weight.

So how does the NAAIM sample have such wild swings?

Questions for your manager
If I were an individual investor entrusting my money to a discretionary RIA, which is the NAAIM membership is drawn from, I would ask the following questions, which would be entirely appropriate as discretionary managers are held to a fiduciary standard:
  • As you have assessed my personal financial objectives, what do you consider to be my proper policy weight?
  • How much variation would you tolerate from policy weight as an active decision?
  • What is your re-balancing process? How often do you re-balance and what kinds of events would cause you to re-balance the portfolio?
The wild variation of the NAAIM survey sample can be explained in two ways. First, it could be the result of passive drift. In a raging bull market, equity weights could creep up to a level way beyond target weight. Conversely, in a devastating bear market, equity weights could plummet to extremely low levels.

As well, the swings in NAAIM equity weights could be the result of active decisions by the managers to buy or sell equities. However, it is hard for me to comprehend that in the space of last few weeks that the NAAIM managers panicked and sold their equity positions down to historically low levels and then panicked again to buy back into the stock market. Do they have a process, or are they just flying by the seat of their pants?

What is the re-balancing process?
For well constructed balanced portfolios. the last round of stock market weakness should not have been a disaster. US large caps, as measured by the SP 500, down about 10% peak-to-trough and small caps seeing a substantially higher draw-down, but the bond market rally has offset much of those losses.

A saner question might be: Once you've established a policy or target weight, when should you re-balance your portfolio?

Regardless of what path you or your investment manager chooses to create a portfolio re-balancing process, make sure that there is a process, rather than the apparent seat-of-the-pants approach shown by the NAAIM survey sample. In a future post, I will discuss different ways of re-balancing portfolios - sort of a "re-balancing your portfolio for fun and profit" post.

Tuesday, November 18, 2014

Falling inequality = Bear market?

Gavyn Davies wrote a fascinating FT article this weekend about the long-term outlook for stock prices. In essence, he attributes much of the current secular bull run to rising inequality in the developed economies:
Thomas Piketty’s work has shown that a rising wealth/income trend is not a “natural” state of affairs in the very long run. He argues that, in many economic growth models, the wealth/income ratio is broadly stable in equilibrium, and his data suggest that this has been the case in the UK and France for several centuries

The opposite has been true in recent decades. Two factors are primarily responsible: the long term decline in the global real rate of interest, and the continuous rise in the share of profits in national income.

This combination has led to rising expectations of future profits, discounted at ever lower real interest rates, a recipe for surging equity prices. Lower inflation has also reduced the inflation risk premium, which has further exaggerated the gains in both bond and equities.

Davies explains that as long as the holders of capital have the upper hand against the suppliers of labor, equity returns will continue to be elevated:
Charles Goodhart and Philipp Erfurth at Morgan Stanley suggest that these factors are directly linked. All of them are basically caused by a long term decline in the ability of labour to maintain the growth of real wages in line with productivity. Until this is reversed, the very long run trends in asset prices may survive intact.

It is obvious that the inability of workers to maintain their previous trend growth in real wages would tend to increase the share of profits in GDP, and therefore be beneficial for equities, but why has this also led to a decline in real interest rates? The reason given in the Goodhart/Erfurth paper will be familiar to readers of recent work by Lawrence Summers and Paul Krugman on secular stagnation.
Fiscal and monetary policy are then caught in a bind and their response has had the unintended effect of further raising returns to capital (emphasis added):
Essentially, the argument is that lower real wages have increased inequality in the western economies, and this has depressed aggregate demand by redistributing real income and wealth away from the relatively poor towards the rich. Since the poor have a higher propensity to consume than the rich, this redistribution reduces consumer demand.

The decline in demand is then addressed by policy makers, either by fiscal expansion (reducing taxes and increasing subsidies on the poor) or by reducing interest rates set by the central banks. Since the fiscal response results in bigger budget deficits and higher public debt/GDP ratios, more and more of the burden of policy adjustment eventually falls on the monetary authorities. It is likely that this feedback loop will tend to increase both asset prices and inequality from one cycle to the next.

A pernicious additional consequence of this loop is that private sector debt/GDP ratios are also likely to rise through time. Falling real interest rates increase the incentive to borrow, while rising asset prices, especially in the housing market, increase credit worthiness and therefore the ability to borrow.

Debt ratios rise until they cause a crash, which of course is what occurred in 2008. This causes even greater and more permanent declines in real interest rates, which adds another twist to the cycle.
Davies warned investors that this trend cannot continue forever:
In the very long run, investors should also be looking at the fundamental driving force for the entire long term process of rising wealth, i.e. the drop in the labour share in national income. If this were to reverse, demand would rise more rapidly and real interest rates could be allowed to increase, bringing down the rate of growth in private debt. Although this would be healthy from many points of view, it would also deliver a double blow to equities by reducing expected profits growth and raising discount rates.

Global vs. local inequality
By way of illustration, here is a fascinating gif chart of the evolution of American inequality which depicts the share of wealth of the top 0.1% (red line) compared to the bottom 90% (blue line, via Vox with data from The Economist). The top 0.1% share of the pie is roughly equivalent to their share roughly 100 years ago, before the emergence of the affluent middle class that began about the time of the Second World War.

As well, here is a chart of inequality by country, as measured by Gini coefficients (via Business Insider). The highest levels of inequality exists in EM countries in Africa and Latin America. Of the developed economies, northern Europe had the lowest level of inequality, while American inequality is roughly equivalent to the levels found in China and Turkey.

If the investment thesis outlined by Davies is correct, it brings up a number of interesting questions:
  1. What would it take for the suppliers of labor to regain more bargaining power?
  2. If labor compensation were to rise, which would result in falling inequality, does that mean necessarily mean that the returns to capital would have to fall?

The best of both worlds?
I would contend that 1) Inequality is being lessened now; and 2) Falling inequality does not necessarily mean lower returns to capital.

In a recent post (see How inequality may evolve over the next decade), I outlined research by Branko Milanovic showing the winners and losers of the globalization drive of the past few decades. The chart below shows how global inequality has progressed. The winners were the rising middle class of the EM economies and the suppliers of capital (rightmost group in chart) as they were the main beneficiaries of globalization. The losers were the people in subsistence economies who were too poor to benefit from globalization (leftmost group in chart) and the middle class in the developed economies.

Fast forward to today. China is facing its Lewis turning point and the low hanging fruit from globalization is gone. There are no Chinas in the world with a similar population size that could cause the same kind of disruptive change to the global economy.

As I pointed out in my previous post, the decision to offshore is no longer a no-brainer for multi-national companies. In fact, China is no longer the low-cost supplier of labor and onshoring is becoming a viable possibility for many companies.

Now consider the following scenario for the coming decade. Onshoring becomes a trend as the economics of offshoring jobs to low-cost countries becomes less attractive. The suppliers of labor in the developed economies then gain more bargaining power because of increased demand. Developed market economic growth improves because of higher propensity of the DM middle class to spend. 

In a Piketty framework, the owners of capital lose ground. I would contend, however, that the Piketty framework is overly narrow in that it only analyzes local (within country) inequality without paying attention to how global inequality evolves. Under the scenario that I outlined, the relative winners of the onshoring drive would be the DM middle class, the relative losers the EM middle class. But since the owners of capital directed the re-allocation of capital from one region to another, it is hard to believe that they would lose ground on a relative basis.

In effect, I would expect an American (and developed market) Renaissance over the next decade, where middle class incomes grow again but without significant impairment of returns to capital.

Sunday, November 16, 2014

Why I am not (just) a technician

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

The Trend Model is an asset allocation model used by my inner investor. The trading component of the Trend Model keys on changes in direction in the Trend Model - and it is used by my inner trader. The actual historical (not back-tested) buy and sell signals of the trading component of the Trend Model are shown in the chart below:

Update schedule: I generally update Trend Model readings on my blog on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.

Consolidation scenario in play
The major US equity averages eked out a small gain in the week, but ended essentially flat. I wrote last week that the intermediate term trend remained bullish, but the consolidation scenario was in play. It appears that the market is taking a breather to digest and consolidate its gains and that is the likely outcome for the next week or two. Pullbacks should be relatively minor. My inner trader is keeping some powder dry and he is poised to buy the dips.

I could just repeat my market commentary from last week (see Global healing = Stay long, buy the dips). Instead, I would like to use these pages to outline my investment approach using the framework of three of the 4Ps used to evaluate investment managers: Philosophy, Process, Performance and People, the last of which is omitted as I am not selling anyone anything. In particular, I would like to explain why I am not just a technician, but a market analyst who uses TA tools.

Street smart, but are technicians book smart?
In my last post, I warned against book-smart quantitative analysts who were not street smart (see Can a quant make a fruit salad?). When I read the writings of many technical analysts, we seem to have the opposite situation. The majority of technicians are very street smart and market savvy, but many lack book smarts in that many do not have the critical training to understand what makes a good investment or trading model.

As an example, I received a comment from one reader highlighting analysis warning of a possible stock market top. The concerns had to do with poor leadership, deteriorating breadth and excessively bullish sentiment. While I understand the concepts behind leadership, breadth and sentiment measures, I haven`t seen many technicians analyzing the elements of technical models, taking the model apart and seeing how they work.

There are two things that a model should do, at a minimum. First, it must have sound theory behind it (book smart). Second, it has to make money (street smart).

For instance, the following breadth indicator chart of small vs. large cap performance, % above 200 dma and % bullish (with point and figure buy rankings) all look ominous as they all exhibit negative divergences against the SPX.

Here's the theory behind the concerns raised about the stock market. These three indicators all measure market breadth in some form. The best metaphor of market breadth is the story of the generals and the troops. You would like to see an army (the market) advancing with the troops (all stocks) moving in the same direction. If the generals (large caps) are leading but the troops (broader market) are not following, then we have a picture of narrowing leadership and a warning of an unsustainable rally.

OK, how well did breadth indicators work in practice? Here is a chart of two of the aforementioned indicators going back 20 years. I have marked the negative and positive divergences with arrows. The blue arrows indicate that the signal worked and the red arrows show where they didn`t. This analysis shows that breadth indicators have had a mixed record at calling market direction.

In particular, breadth indicators can be extremely early in calling market turns. They incorrectly turned bullish with a series of higher highs and high lows during the NASDAQ bust bear phase. In addition, they were overly cautious during the market advance of 2004-2007. Most recently, they turned bearish in early 2013 and missed most of the market advance since then.

What about the current small cap divergence?  Could that be a warning of deteriorating breadth, of the generals leading the charge while the troops waited behind? Here is a 20 year chart of the Russell 2000/SP 500 ratio, which is shown in the middle panel. If you followed small cap divergence as a market timing tool, you would have missed the entire Tech bull market of the late 1990's (being short during those five years would have been extremely painful and likely a career ending exercise). Moreover, you would have bought the market after the Tech Bubble popped (if missing the Tech run didn't end your career, buying into the NASDAQ bust certainly would have hammered the nail into the coffin).

A more savvy analyst would recognize that there is a fundamental difference between US large caps and small caps. Large cap companies tend to be more international in scope and do more of their business outside the US. As it turns out, the relative performance of small to large caps correlate very well with the US Dollar (blue line, middle panel). A falling USD benefits large caps, because their margins expand because of their non-US sales, while a rising USD hurts large caps and benefits small caps.

OK, what if we looked at the relative performance of large caps (SP 500) to mega-caps (SP 100), which is shown on the bottom panel? They are all large cap stocks and they all have lots of overseas sales, right? That ratio should mitigate a lot of the currency effect observed in the Russell 2000/SP 500 ratio. It turns out that the SPX/OEX ratio roughly mirrors the relative performance of the Russell 2000/SP 500. I marked the divergences in blue, where the signals worked, and in red, when they didn't work. Even this ratio, which took out much of the foreign sales effect, had a mixed performance record.

In conclusion, it seems that small and large cap relative performance is a so-so indicator of future market direction. The large and small cap cycles appears to march to the beat of its own drummer. Right now, small cap relative performance seems to be rolling over.

The trouble with sentiment
What about the excessively bullish sentiment readings? Could that be a sign of an impending top?

One of the problems with sentiment models is there are many ways to measure sentiment (see my previous post on measuring professional investor sentiment and the different answers that you get: What do the pros REALLY think about the market?). The second issue is the interpretation of the underlying theory. Assuming that you've correctly measured investor sentiment, do you bet with it or against it? And why?

Consider the following 20-year chart of II sentiment, shown with bullish sentiment (green bars), bearish sentiment (red bars) and the bull/bear ratio (bottom grey bars). Technical analysts generally use II sentiment as a contrarian indicator to buy the crowded shorts and sell the crowded longs. A review of the chart highlights a number of problems. First, how do you calibrate the buy and sell points of the model?

For the purposes of this exercise, I have focused on the II bull/bear ratio (bottom panel) to make buy and sell decisions. As the market rallied off the 2003 bottom, the bull/bear ratio moved above 3 - a sell signal that occurred far too early. Anyone using II sentiment for market timing would have missed most of the bull run from 2003-2007. That`s because a regime change occurred with the onset of the 2003 bull and the II bull/bear ratio shifted upwards, perhaps permanently.

Using the rule of buying when the II bull/bear ratio is below 1 and selling when it's above 3, I have highlighted the buy signals with blue vertical lines and sell signals with red vertical lines. The record of the II bull/bear ratio can charitably be described as "spotty". Anyone following this model would have missed the 2003-2006 bull and bought in late in mid-2006. Though the ratio did identify the top in 2007, it bought far too early and anyone following this model would have suffered through the Lehman Crisis crash. After the Crash, it flashed a series a sell signals and was far too cautious, only to get long at the 2011 bottom and selling in late 2013. II bull/bear readings seem to have moved to a new plateau in the past year. Could this be a sign of another regime change?

Indeed, Ryan Detrick highlighted conditions when AAII and II bulls were showing crowded long readings. Past occurrences of such conditions are not necessarily bearish:

Though he was recently writing about sentiment in gold, Pater Tenebrarum had the following cautionary message for anyone relying on sentiment models:
One must be careful with sentiment data during a clear trend, as they simply tend to follow prices to a large extent. They can serve as an additional input, but cannot really be used for precise timing. And yet, once people start saying that there simply is no reason at all to be bullish, and the bullish consensus according to positioning and sentiment data plumbs all time lows or multi-year lows, we have what is essentially a textbook contrarian situation on our hands.
That said, sentiment models do have their place. I have stated in the past that I would prefer to use sentiment data which indicate what market participants are doing with their money, rather than surveys showing opinions. Watch what they do, not what they say.

Not just TA, but thoughtful inter-market analysis
Having trashed the art of technical analysis, or TA for short, let me explain how I use TA techniques for market analysis, using the framework of Philosophy, Process and Performance.

I believe that markets are global in nature and what happens to the other engines of growth can significantly affect the growth outlook of the US economy, its markets and risk appetite.

I apply trend following techniques to inter-market analysis to arrive at my intermediate term forecasts. I supplement my intermediate term forecasts with short term forecasts using primarily option-based sentiment models, largely because trend following models do not behave well in choppy markets. (More on this below).

The actual history of my model signals are shown regularly in the chart below (reproduced from above) and the latest report card of my actual trading is here.

Global economy, global markets
The form of TA that I practice is known as inter-market analysis, because I believe we live in an interconnected global economy with global markets. There are three primary trade blocs and engines of growth in this world:
  • The United States
  • Europe
  • China.
I apply trend following techniques to each of these markets to determine what phase of growth they are at. Each of these components vote and my Trend Model arrives at a composite score for a risk-on or risk-off forecast. More importantly, my trading model tracks the rate of change of the Trend Model. In other words, is the condition of each of the components improving or deteriorating?

With that preface in mind, here is a review of each of the three global engines of growth, starting with the United States. The US economy is furthest along of the major global economies in terms of its progress in recovering from the Great Financial Crisis of 2008. The American economy is growing, albeit in an anemic fashion when compared to past economic recoveries. The latest weekly review of the high frequency economic indicators by New Deal democrat captures the state of the US economy very well:
Watching the three time bands of indicators move is something like watching a snake, or the movement of traffic. Different segments are moving at different speeds. The immediate present looks weak, although still positive. Out a few months looks much stronger. Out about a year is positive, albeit not so much as before.

While the big decline in commodities might be a very negative signal for the international economy, for the US economy it is going to power consumer and business buying and investing.
A look at the SPX tells the story of a market that is in an uptrend, though it appears to be a little extended short-term. The Trend Model would interpret those results bullishly, both on an intermediate and short term basis.

Across the Atlantic, growth continues to sputter. Bloomberg reports that confidence in the major leadership in the eurozone (Merkel and Draghi) is falling rapidly:

Last week, the latest report showed that German GDP eked out a 0.1% growth, thus narrowly avoiding a technical recession, and French growth beat consensus expectations. The STOXX 600 tells the story of Europe: Positive momentum, but not enough to overcome growth concerns. The Trend Model would interpret that as neutral intermediate term, but bullish short term because of positive momentum exhibited by the STOXX 600.

Moving our sights to China, It is well known that Chinese growth has been decelerating for the past several years. The latest statement from the Chinese leadership captures what Xi Jinping calls the "New Normal", where Beijing guides down market growth expectations while trumpeting the high absolute level of economic growth:
China's economy is going through a "period of pain" as authorities try to shift it toward slower, more sustainable growth, with the rapid expansion of its shadow banking sector a major problem, the vice finance minister said on Saturday.

"We do have problems that have been accumulating over time," Vice Finance Minister Zhu Guangyao told reporters at the G20 Leaders Summit in Australia.

Zhu reiterated President Xi Jinping's catchphrase of a "new normal" for the Chinese economy, saying it would be "running at relatively high speed instead of super high speed."

"We are changing gear and our economic structure is undergoing a period of pain and a period where we are absorbing the large-scale stimulus packages we rolled out earlier," he said.
Instead of analyzing the progress of the Chinese stock market, I analyze indirect measures of Chinese growth, such as the AUDCAD exchange rate, as both Australia and Canada are both commodity producers but Australian growth is more levered to China than Canada, and the price of industrial commodities, to which China is the largest marginal consumer. Both of these indicators tell the story of a decline, which created a Chinese growth scare several months ago, and stabilization today.

Putting the Trend Model readings of these three engines of global growth together, I get the picture of a global economy that is growing slowly and below potential, but the short-term momentum is neutral to slightly positive. Thus, the Trend Model has a intermediate term rating of "neutral" and a short-term bullish rating.

A better way to use sentiment
The Trend Model is based on the readings of trend following models, which have two shortcomings. First, they tend to be late at turning points. In addition, they don`t behave well in trend-less sideways markets. To address these weaknesses, I have supplemented my trading model with market-based sentiment models.

Market based sentiment models are different from sentiment surveys in that they show how people are voting with their dollars, not just their opinions in a survey. I find that option-based sentiment is the most useful as they predominantly measure fast-money sentiment, which is what a trading model should do.

I have written extensively about using the VIX/VXV ratio to measure the term structure of the VIX as a way to show how future expectations of volatility, or the market fear gauge, is evolving. A backtested rule of buying the market when the VIX/VXV ratio when it is below 0.92 and selling when it is above that level have yielded good results. The chart below shows buy signals as blue vertical lines and sell signals as red lines. These signals appear to have a far better track record than either the breadth or II sentiment signals shown previously.

I tested the following trading rules for the VIX/VXV indicator:
  • Buy the market when the VIX/VXV ratio falls below 0.92.
  • Go to cash when it is above 0.92.
  • Short the market when it is above 1.20, which indicate extreme fear and a high risk of market crash.
The backtest formed three portfolios. A simple buy-and-hold on SPY; a long-only portfolio based only the above rules that is not allowed to short; and a long/short portfolio. There are no frictional costs in this test and the assumed executed price is the closing price the day after the signal is triggered. Cash is assumed to earn 0%. The equity curves of the three portfolios are shown in the chart below.

The VIX/VXV long-only portfolio was able to achieve excellent risk-adjusted returns relative to the buy-and-hold SPY portfolio, mainly because it avoided the bear phases of 2007-2009 and 2011. However, it has become more cautious recently and thus detracted from performance. The long/short portfolio achieved better returns compared to the buy-and-hold with a lower maximum drawdown. However, its results were far more volatile than the long-only portfolio.

I take these results with a grain of salt because they are backtested and not actual results. However, this does represent a proof of concept showing that option-based sentiment can add value as a component of a trading model.

Market outlook
We come to the end of the journey. Having toured the world and analyzed short-term sentiment, where does that leave us?

As the markets are roughly unchanged from last week, I would reiterate the same comment from last week:
My inner investor is cautiously bullish and he is inclined to tilt his portfolio with an overweight position in the market leaders. As the theme of this post has been healing, the consistent market leadership in the current bull phase has been the Healthcare sector (see my previous post The one sector every US equity investor needs to look at).
My inner trader believes that the consolidation scenario is very much in play, as per my tweet last Wednesday:

Since then, the market has moved sideways. In response, my inner trader has moved to cash in anticipation of buying in at lower levels. He believes that the market is too extended to buy, but too strong to short.