Tuesday, March 24, 2015

A deceptively simple way to make money in the stock market

In a recent post, David Merkel had a warning about the speculative excesses of the stock market. He cited the tendency of Silicon Valley startups to offer downside protection to investors on their own paper:
Here’s my take. When companies try to offer protection on credit or market capitalization, the process usually works for a while and then fails. It works for a while, because companies look best immediately after they receive a dollop of cash, whether via debt or equity. Things may not look so good after the cash is used, and expectations give way to reality.
He also found the trend of finance professionals leaving for Silicon Valley disturbing:
We saw this behavior in the late ’90s — people jumping to work at startups. As I often say, the lure of free money brings out the worst in people. In this case, finance imitates baseball: those that swing for the long ball get a disproportionate amount of strikeouts. This also tends to happen later in a speculative cycle.
How worried should we about these signs?

Last week, I wrote about how valuation didn`t seem to matter to the stock market until it mattered (see Cheap or expensive? The one thing about equity valuations that few talk about). During the expansion phase of an economic cycle, the main driver of stock prices are economic and earnings momentum. It is only during the recessionary part of the cycle that valuation puts a floor on stock prices.

This framework is similar to the one voiced by David Rosenberg, who wrote that bear markets only occur because of recessions and Fed tightening cycles (via Business Insider). Well, sort of, I would generalize the cause of bear markets as recessions and Fed tightening causing recessions or creating recessionary fears.

Ed Yardeni more or less said the same thing as I did (emphasis addded):
A long expansion is a persuasive argument for buying stocks even though forward P/Es are historically high. Investors are likely to be willing to pay more for stocks if they perceive that the economic expansion could last, let’s say, another four years rather than another two years. The more time we have before the next recession, the more time that earnings can grow to justify currently high valuations.

If a recession is imminent, stocks should obviously be sold immediately, especially if they have historically high P/Es based on the erroneous assumption that the expansion’s longevity will be well above average. Bull markets don’t die of old age. They are killed by recessions.

A simple (and stupid) rule
In that case, we can create a some very simple rule for timing the stock market:
  1. Buy stocks during economic expansions
  2. Sell stocks as recessions approach
At this point, you may say, "Don't be an idiot, that's like saying buy stocks when they go up and sell them when they go down. Or 'Buy stocks when they go up, when they go down, don't buy them in the first place.'"

How can you forecast a recession?
The key issue is how we can tell if a recession is on the horizon.  Already, the likes of David Merkel are warning about the appearance of speculative froth, which is a sign that we are nearing the top of the cycle.

There are several deceptively simple approaches to watch for a recession. Doug Short has his Big Four Recessionary Indicators, which is a useful framework to use. New Deal democrat analyzes high frequency economic releases (his latest one is here). Neither is flashing recessionary signals at the moment.

Real-time forecast signals
While those kinds of approaches have great value and I use their output to supplement my model results, I find them unsatisfying. That's because you are using coincidental or lagging indicators to forecast a leading indicator. Economic statistics, which get released with a time lag (and may be a coincidental or lagging indicator). On the other hand, stock prices represent a leading indicator. 

This has been the Achilles Heel of macro forecasting, using economic statistics (which are released with a lag) to forecast stock and bond prices (which are forward looking) will inevitably cause you to miss the early warning signs of a recession.

There is a better way. There are continuous real-time signals that can give us clues about expansions and recessions. They are called market prices. Here are the three key assumptions to my model:
  1. Economic signals about expansion and contraction are persistent. Once an economy start to lose steam and roll over into recession, it will continue to do so until the fiscal and monetary authorities react (with a long lag). That`s why Doug Short`s Big Four Recessionary Indicators work in forecasting recessions. These kinds of indicators just operate with a lag and you will be long stocks as the economy rolls over.
  2. The US economy is an important part of the global economy. US recessions therefore will not occur in isolation, but we will see feedback loops with other parts of the global economy. 
  3. There are three major trade blocs in the world: US, Europe and Asia (China). Watching what happens with these three major economies will give you more or less everything you need to know about where the global economy is going. Note that they may not all expand or contract in a synchronized way, however.
That`s why I am a technician. It`s not that I believe that there is anything magic about technical analysis. They just happen to be the right tool to use in the current situation.

From model to buy-sell signals
With those assumptions in mind, here is my deceptively simple way of forecasting the US (and global economy). Use trend following models (because of the persistent nature of economic expansions and contractions) on:
  • US stock prices 
  • Non-US stock prices
  • Commodity prices. 
In particular, commodities can tell us a lot about how global demand is changing at the margin. In the last decade or so, they have been more about Chinese demand as China has become the major user  of commodities. 

Recognizing that the regional economies of the three major trade blocs are not always synchronized, give each of the components of the trend following model signals votes and let them tell you whether the world is in expansion or contraction. 

For investors, buy stocks when the global economy is in expansion, sell (or reduce) stock positions when they are moving into contraction.

For traders, watch for direction of the change of the signal. If the signal gets better, buy stocks. If the signal gets worse, sell stocks.

The proof in the pudding
In short, that has been the basis for my Trend Model. The proof is in the pudding and I have been running an account based on the trading signals of that model since September 2013. The latest report card can be found here. The chart below shows the history of the actual (not backtested) buy (dark blue arrows) and sell (red arrows) signals of the trading model.

The performance of the account has been extraordinarily good and well beyond my expectations. It wasn't just the levels of the returns, which was embarrassingly high, but a number of other qualities:
  • The consistency of monthly returns, as the monthly batting average was over 70%;
  • The skew in the distribution of monthly returns, which suggests that the strategy is limiting losses while allowing winners to run; which leads to...
  • Better than expected risk characteristics in the form of drawdowns as the return to maximum drawdown ratio is an astonishing 5 to 1; and
  • The superior diversification effects of the strategy, as returns were negatively correlated to both stocks and bonds.
I would caution, however, that the this strategy has been benefiting from a friendly market environment for trend following models. The US equity market has more or less gone up in a straight line in this period. 2015 is likely to see a choppier market and that`s when this model will get an acid test. In that environment, I would expect that drawdowns will occur more often and be larger, which will lead to deterioration in average returns and the monthly batting average.

I am highly encouraged by these results and I will be monitoring and reporting on the results in the future.

Disclaimer: This blog post is for discussion only and I am not trying to sell anyone anything. I am not currently in a position to manage anyone`s money based on the investment strategy that I am describing. No offering will be done without the proper regulatory filings.

Sunday, March 22, 2015

The bulls are alright

Trend Model signal summary
Trend Model signal: Risk-on
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 (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.

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

A successful breakout-pullback-breakout pattern
This post will be somewhat shorter than usual, mainly because I feel like I am reiterating many of my comments from the last few weeks. Since mid-February, I have been using 2011 as a rough roadmap for the behavior of the equity market, largely because of the parallels with Greece. I believed that the market would see a series of choppy up and down moves and the pattern would resolve itself with a bullish trend as the political and financial difficulties resolved themselves (see 2011 all over again?). 

A couple of weeks ago, I brought up the 2011 and 2012 analogy again (see Bullish, but "data dependent"). Once the choppiness ended, the market staged an upside breakout, pulled back and then strengthened again in a classic breakout-pullback-breakout pattern:
As shown by the 2011 chart of the SPX below, the 2011 market was saw much up and down choppy action, which moved the market to an oversold reading on the 5-day RSI (blue vertical lines). It then staged an upside breakout, consolidated sideways and then pulled back below the breakout level. It finally resolved itself by staging a sustained rally after the pullback test (red vertical line).
The market in 2012 also saw a similar breakout, consolidation and pullback episode. Note the instances of short-term oversold readings marked by the vertical lines. In some cases, the market rebounded right away. In another, it required a final flush before seeing a durable bottom.

The breakout-pullback-breakout patterns from 2011 and 2012 appear to be repeating themselves today, which is bullish.

Synchronized global breakouts = Bullish
Further support of the bull case can be seen in synchronized global upside breakouts in major equity market indices. We are seeing upside breakouts in the FTSE 100, a continued uptrend in the Euro STOXX 50 and an upside breakout in the Shanghai Composite. The US market, as measured by the SPX, is somewhat of a laggard in that sense as it has only staged an upside breakout of the old resistance level at about 2093 and it has not tested its all-time highs yet. This kind of across the board global momentum is very bullish.

A closer examination of the SPX shows that this index has more room to rally. Neither the 5-day RSI (top panel), which is useful for short-term trading, the 14-day RSI (second panel), which is more useful for spotting intermediate term tops and bottoms, are overbought. Moreover, these indicators are exhibiting positive momentum, which is are confirmations of recent strength. 

The SPX, which remains in an uptrend, is also exhibiting a classic breakout-pullback-breakout pattern and the index has rallied above the breakout point as a sign of market strength. Moreover, the more broadly based Wiltshire 5000 also displays the breakout and pullback pattern and moved to test its old highs on Friday.

Signs of a mid-cycle expansion
I have written before that current conditions suggest that the economy is in the mid-cycle phase of an expansion and my views are unchanged (see 4 reasons why this is not a market top), namely.
  • Fundamental momentum is positive. Forward EPS estimates have stopped falling and they have started to climb again. The latest update from John Butters of Factset confirms the trend that began several weeks ago. As well, this week's monitor of high frequency economic releases from New Deal democrat also shows that the recent economic weakness seen so far seems to be abating. The latest BoAML Fund Manager Survey (FMS) shows that global growth expectations continue to turn up.

  • Market leadership points to continued economic growth. A study of sector leadership last week indicated that the market leaders consist of Health Care, NASDAQ and Consumer Discretionary stocks. Defensive sectors such as Consumer Staples and Utilities have been lagging. This is the picture of an economy in the mid-cycle phase of an expansion.

Sentiment supportive of rally
Another bullish factor can be found in the sentiment data. Despite some of my reservations about the construction of the index, the CNN Money Fear and Greed Index is in dead neutral, indicating that sentiment is nowhere near a crowded long reading, which implies that stock prices have further room to run.

The latest FMS also shows that cash allocations are still a bit on the high side relative to its own history, which suggests that institutional managers could potentially put more money to work in equities.

While the FMS shows that managers are overweight equities, the overweight is in eurozone and Japan. Managers have moved to an underweight position in the US, which make the region a contrarian buy:

Take a look at this chart of the relative performance of US stocks compared to the MSCI All-Country World Index. There are three major reasons to be overweight the US equity market. First, it remains in a relative uptrend compared to global stocks. It got ahead of itself in late December and early January and has since retreated from those excesses. Finally, sentiment readings (see above FMS chart) is tilted bearish, which is contrarian bullish.

Path of least resistance is up
In conclusion, I haven't seen such unambiguously bullish readings in such a long time. I suppose that as we get closer to a Fed liftoff on interest rates later this year, US equities could get the jitters and pull back. For now, the path of least resistance for stock prices is up.

My inner investor continues to be overweight stocks. My inner trader is also long, but he is closely watching sentiment and momentum indicators should the SPX test its highs next week, which it will likely do. The market may become short-term overbought at that point and it may be prudent to trim back some long positions, but I don't want to be anticipating model readings. I will be updating any developments on my Twitter account @humblestudent during the week.

Disclosure: Long SPXL, TQQQ

Thursday, March 19, 2015

Searching for China's (financial) WMDs

I got a lot of feedback from my post last week on the effects of Chinese capital flight on the Vancouver property market (see Behold the tsunami of liquidity from China). While there were a few locals who had comments about the local real estate market, the majority of comments had to do with the risk of a RMB devaluation.

It seems that the issue of a CNY devaluation is a hot topic these days. Let me make this clear from the beginning. When I refer to a Chinese devaluation, I don't mean run of the mill operations like a RRR or interest rate cut, but a massive shock-and-awe effort like a QE program or an explicit announcement to widen the allowable CNY trading band. Such moves would send massive shockwaves around the financial world.

There has been no lack of warnings about the pressures on China as the latest round of economic weakness is highly suggestive of another round of stimulus. Even Xinhua, China's official news agency, raised concerns about currency pressures on Chinese exports:
The pressure is on Chinese exports as the euro sinks against the yuan, Ministry of Commerce spokesman Shen Danyang said on Tuesday.

The yuan was up 10.8 percent against the euro until March 13, when the euro devalued 13.2 percent against the U.S. dollar.

The price advantages of Chinese exports to the European market has been softened by the euro devaluation, said the spokesman. The weak euro will also incite eurozone exports to other markets, adding competitive pressure to China's high value-added exports.
The WSJ rhetorically asked, "Will China Break the Currency Truce?"
In the past five years, first the dollar, then the yen, and now the euro have tumbled as their respective central banks have undertaken large-scale bond-buying, or “quantitative easing” (QE). This is not a zero-sum currency war: QE sends money cascading across borders, bolstering asset markets and often triggering reciprocal monetary easing. Everyone wins.

But it’s a different matter if China devalues; that would kick off a currency war.
That's because a Chinese devaluation would amount to the detonation of a financial WMD, aimed at the heart of the economies of its major trading partners.
China is different because, even after significantly liberalizing its financial system, it still maintains controls over how much money can move in and out. When interest rates rise or fall, foreigners and residents can’t respond by moving money at will in and out of China, except surreptitiously. A repressed financial system means China has multiple tools for multiple targets: interest rates and credit guidance to target investment; reserve requirements to target bank liquidity; and the yuan to target trade.

This means that when China’s currency falls, its trading partners don’t get the usual benefits of easy monetary policy; there is no outrush of capital from China to other countries, and no boost to domestic spending to bolster imports.

That is why a move by China to devalue would arouse much more tension with its trading partners than the QE-driven devaluations by the U.S., Japan and eurozone. Whether that will happen is a matter of fierce debate.
In my previous post, I highlighted the analysis by David Woo of BoAML about a potential currency war and FX volatility (via Business Insider). Such volatility episodes have been associated with market turmoil in the past.

As the chart shows, the effects of a RMB devaluation would indeed look like a financial WMD.

How likely is a Chinese devaluation?
If I were a goldbug, or if I wrote for Zero Hedge, I would stop right here. The tail-risks are obvious and, while we have no way of knowing when Beijing devalue, disaster is just around the corner.

A more intelligent analyst might try to ascertain if China did possess such financial WMDs and, if they do, what the likelihood that the PBoC might use it.

Staying with the WMD analogy for the moment, suppose that you were an intelligence analyst and your job is to figure out if a certain country had WMDs. What would you do?

Modern military organizations are bureaucracies (as are finance ministries and central banks). ABC (Atomic-Biological-Chemical) warheads are volatile and difficult to handle. Moreover, their use can carry enormous political risk. The last thing you want is for some rogue officer to drag your country into a war you didn't start by firing off one of these weapons. Therefore the standard procedure is to create policies and procedures for the storage and release of these ABC weapons. Typically, one group of troops guard and store the warheads; and another delivers them.

As an example, I once spoke to a former Canadian Starfighter pilot who was stationed in Germany in the 1960s. He was part of a Starfighter squadron whose mission was to drop nuclear warheads on the advancing Soviet forces should war break out. The aircraft (delivery vehicle) was under Canadian control, but the warheads were under American control. Part of the procedure was the plane would sit, with the nuclear bomb attached, on alert on the tarmac.

One of the key failsafe procedures was that the Canadian pilot had to sit in the cockpit with the canopy open with both hands visible at all times holding the side of the fuselage. An armed American guard stood nearby, with orders to shoot the pilot should he move his hands inside the cockpit.

Who would get hurt should China devalue?
In the same spirit, we can look for possible policies and procedures that the PBoC may undertake should they decide to devalue the RMB.

We know that there are lots of reasons why Beijing might want to devalue, but there would be considerable damage done too, both to their economy and the economies of their trading partners. While the PBoC might not care about White People getting hurt, nor would they care very much about the Japanese, Koreans, Singaporeans and so on, they would care about the pain suffered in Hong Kong and by Mainland Chinese companies.

Marketwatch recently devoted an article about the vulnerabilities of Hong Kong should China devalue:
Hong Kong began the Lunar New Year with its chief executive imploring the population to be more like sheep. But investors should watch where they are being led: As currency wars threaten to engulf its giant neighbor and spur it to devalue the yuan, Hong Kong looks highly exposed.

Attention in recent weeks has focused on the possibility of yuan depreciation as China’s economy slows and as it suffers capital outflows.

It is worth considering the fallout for Hong Kong under such a scenario, given the extent to which its economy has become dependent on the supercharged stimulus of an artificially suppressed currency.
The Achilles Heel of Hong Kong is the Hong Kong Dollar and its USD peg, which has spawned a currency and interest arbitrage carry trade (emphasis added):
Analysts have been sounding the alarm over the growth of a huge “invisible carry trade” of lending into the Chinese mainland in recent years.

As China’s currency appreciated, borrowing in Hong Kong dollars became extremely popular, not only because of the much lower interest rates than on the mainland but also due to the attraction of taking out a liability in a depreciating currency. The kicker would come from sticking this money into high-yielding shadow-banking products.

Brokerage Jefferies was flagging this a year ago, describing an almost parabolic increase in lending to mainland China.

Bank of America echoes such concerns in a recent report, detailing how lending exposure has reached 160% of Hong Kong’s entire gross domestic product, up from 20% in 2006. It cautions that instability and imbalances can be caused by currencies that have been on a predictable, stable trajectory, fomenting the belief that the trend will be permanent.
Bloomberg recently highlighted a BIS report indicating that while Chinese USD offshore liability growth had slowed, total Chinese USD liabilities amounted to USD 1.1 trillion:
U.S. dollar-denominated borrowing by companies in Asia was fueled in recent years by lower interest rates and abundant liquidity offshore. Now, as the Federal Reserve prepares to raise interest rates and the greenback strengthens, heavily indebted companies face the prospect of higher repayments.

“The growth of claims on China by BIS reporting banks slowed down sharply,” Claudio Borio, the BIS’s head of the monetary and economic department, told reporters. “The possible turn in domestic financial cycles as U.S. dollar funding is set to tighten deserves close watching.”

Dollar credit to Chinese borrowers has reached $1.1 trillion, the BIS said in a January report. Asia’s largest economy has the world’s biggest corporate liabilities that Standard and Poor’s estimates stood at $14.2 trillion in 2013.
In another words, there has been an enormous “invisible carry trade” where Mainland Chinese companies either borrow in HKD or USD in Hong Kong at lower interest rates, move the funds back into China and invest the proceeds into shadow banking products at mid to high single digit interest rates. A simple devaluation would blow an enormous financial hole in the Chinese financial system as the value of those liabilities skyrocketed. Moreover, it would crater the Hong Kong financial system, as the lending exposure of 160% of GDP is comparable to the exposure of Cypriot banks at the start of their financial crisis.

Beijing will have to tread carefully in formulating RMB devaluation policy and procedures. Bloomberg wrote about the kinds of risks faced by EM economies, especially as the Fed enters a tightening cycle. While Chinese USD debt amounted to USD 1.1 trillion, total offshore USD debt was 9 trillion. These issues were raised at the last G20 meeting (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.

Watching for the "sequencing" of events
If China were to devalue, it desperately needs to insulate both Hong Kong and their domestic companies from the worst effects of the coming storm. One of the key telltale signs of impending RMB devaluation would be the announcement of closer ties, cooperation,  or coordination between the PBoC and the HKMA. Another telltale sign might be steps that Beijing takes to insulate Mainland companies from their USD 1.1 trillion debt, such as the establishment of dollar swap lines with the Federal Reserve.

As an example, one step that Beijing seem to be taking as part of their financial liberalization is to use the power of the central government's balance sheet to alleviate the financial pressure faced by local authorities. They recently announced an initiative to replace part of local government debt with central government debt (via China Daily):
More than half of the high-interest local government debt that falls due this year will be covered under a debt swap plan arranged by the Ministry of Finance, which said on Friday that the swap would not raise the debt level further.

The ministry on Monday disclosed that it had ordered issues of 1 trillion yuan ($160 billion) of low-yield municipal notes that will replace legacy liabilities, in a bid to ease local governments' mounting interest repayment pressure.

An audit in June 2013 found local governments faced repayments of 1.858 trillion yuan in 2015. The debt swap covers 53.8 percent of that amount, and the conversion could reduce interest payments by 40 billion yuan to 50 billion yuan a year, according to the ministry.
Arguably, the formation of the Asian Infrastructure Investment Bank (AIIB) lays the groundwork for mitigating potential damage from a Chinese devaluation. The participation of major US allies such as the UK, France, Germany and Italy, in the AIIB are positive steps in the globalization of this initiative. In addition, countries like Australia, Switzerland and South Korea have expressed interest. However, the AIIB must be regarded as a long-term project and it would not be in a position to mitigate damage should the PBoC take steps to devalue in the immediate future.

In summary, just as the military intelligence analyst looks for signs that another country has WMDs, or is preparing to use them, the investment analyst can look for similar signs of central bank or finance ministry policy.

For now, I see little evidence of the sequencing of steps which indicate that the PBoC is getting ready to devalue the RMB in a massive way. While I recognize that pressure is building, the doomsters can rest easy - at least for now.

Monday, March 16, 2015

Cheap or expensive? The one thing about equity valuation that few talk about

Barry Ritholz recently set off a minor debate on valuation when he wrote that the market was fairly valued, rather than being overvalued as many pundits would have us believe:
Let’s take a look at the valuation of U.S. markets. This is relevant to investors, as valuation determines future expected returns.

There are three commandments to consider:
  • Thou shalt consider a full assortment of all valuation metrics;
  • Thou shalt not cherry-pick only those metrics that support your preferred outcome;
  • Thou shalt focus on the very best measure of market valuation, according to academic research and data.
These should have the force of moral law for anyone who wants to understand whether stocks are cheap or expensive.
I do consider different valuation metrics and I came down in the overvaluation camp. I wrote about a year ago that based a very long (100 year history) of PE, PB and dividend yield, US equities are expensive, but not stupidly high (see More evidence of a low-return outlook). I am in good company. Consider:

  • BCA Research, who focuses mainly on forward PE to reach their conclusion.
  • John Butters at Factset, who also highlighted the fact that forward PE ratios are historically high. Since that note was published, his latest update shows that forward PE had retreated somewhat to 16.8x earnings:

  • James Paulsen at Wells Capital Management, who studied median PE and PB ratios within the SP 500 and concluded valuations are stretched.

  • Meb Faber, who pointed to the history of the Price to Sales ratio, as well as various versions of PE10.
  • Shane Leonard, who has railed about the nosebleed valuations of Silicon Valley start-ups. Also see the Fortune article by Bill Gurley predicting 'dead unicorns' in start-up land.
  • Philosophical Economics, who developed a new Total Return EPS Index, based on the assumption that companies did not pay dividends but engaged in share buybacks instead. Based on that metric, he came to a SPX target of about 2150.in 2020, indicating stretched valuations.

Does valuation even matter?
Despite the warnings about how expensive equities are, stock prices have continued to advance. That's because, for investors and traders with relatively short (1-3 year) time horizons, valuations have a habit of not mattering until they matter.

Using shorter term time frames, what matters more to stock prices is macro-economic and earnings momentum. Macro Man recently created a simple model that regressed retail sales, industrial production and durable goods, ex-transportation, to the stock market. The fit is remarkably good.

This wasn't meant to be a rigorous study and we can argue about the problems of data co-linearity, backtesting and data fitting. Nevertheless, he made the point that stock prices respond to macro signals about growth. 

Regular readers also know that I have regularly monitored Factset for the evolution of forward 12 month EPS, which, incidentally, have begun to slowly rise again after suffering a large decline (mainly due to the negative effects of falling energy prices).

The next bear market could be a real doozy
Despite the spirited debate over valuation, the analysis that I have presented so far suggests that valuations do not matter to stock prices. That is certainly not true. Doug Short had an interesting insight on this topic:
I had a fascinating conversation with Neile Wolfe, of Wells Fargo Advisors, LLC. Based on the underlying data in the chart above, Neile made some cogent observations about the historical relationships between equity valuations, recessions and market prices:
  • High valuations lead to large stock market declines during recessions.
  • During secular bull markets, modest overvaluation does not produce large stock market declines.
  • During secular bear markets, modest overvaluation still produces large stock market declines.
Here is a table that highlights some of the key points. The rows are sorted by the valuation column.

During economic expansions, earnings and economic momentum growth drives stock prices. In a recession, it is valuation that provides a floor on equity values. Short concluded:
Neile and I discussed his thoughts on the data in this table with respect to portfolio management. I came away with some key implications:
  • The SP 500 is likely to decline severely during the next recession, and future index returns over the next 7 to 10 years are likely to be low.
  • Given this scenario, over the next 7 to 10 years a buy and hold strategy may not meet the return assumptions that many investors have for their portfolio.
  • Asset allocation in general and tactical asset allocation specifically are going to be THE important determinant of portfolio return during this time frame. Just buying and holding the SP 500 is likely be disappointing.
  • Some market commentators argue that high long-term valuations (e.g., Shiller's CAPE) no longer matter because accounting standards have changed and the stock market is still going up. However, the impact of elevated valuations -- when it really matters -- is expressed when the business cycle peaks and the next recession rolls around. Elevated valuations do not take a toll on portfolios so long as the economy is in expansion.
Do valuations matter?
I have two key conclusions from this analysis. Yes, valuations do matter - but only for investors trying to project returns as part of an investment plan and policy.

For investors with shorter time horizons, you should only be watching for signs of recession. Equities appear to be expensive right now, but don't worry as there is no sign of a recession on the horizon. That's why it is important to pay attention to Doug Short's Big Four Recession Indicators, whose signals remain benign for the moment.

Our friend, the bear
For investors with long time horizons who have formed an investment policy, ugly bear markets are not necessarily disasters. If the account is taxable, bear markets can be welcome periods to re-balance an equity portfolio in a tax-effective manner. You can harvest capital losses and match them against positions with large capital gains in order to free up some cash to look for better investment opportunities.

As well, bear markets are opportunities to better re-invest income and dividends at much lower prices. That's why people like Warren Buffett do not fear them. Philosophical Economics pointed out that an investor with a 30 year time horizon actually had better returns by investing in November 1929, the month after the market crash, than in September 1980.

He concluded:
Ultimately, the outperformance was driven by three factors: (1) stronger corporate performance (real EPS growth given the reinvestment rate was above average from 1929-1959, and below average from 1980-2010), (2) dividends reinvested at more attractive valuations (which were much cheaper, on average, from 1929-1959 than from 1980-2010), and (3) shortcomings in the CAPE and Q-Ratio as valuation metrics (1929 and 2010 were not as expensive as these metrics depicted.)
For long-term investors who want to stick with a buy-and-hold policy for their equity holdings, this suggest a re-investment based strategy:
  • When valuations are high, tilt towards value and high yielding stocks so that in a bear market, you can have more income to re-invest at much cheaper valuations
  • When valuations are low, focus on growth and low yielding stocks to more effectively take advantage of capital appreciation. 
A recent post by A Wealth of Common Sense shows that it can be very profitable to invest during recessions. Long term investors should be hoping that they get a few and to have the resource available to enhance their returns during such periods.

Sunday, March 15, 2015

4 reasons why this is not a market top

Trend Model signal summary
Trend Model signal: Risk-on
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 (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.

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

Bear markets just don't start this way
Last week, I wrote that I remained bullish but there were lines in the sand for the bears to cross (see Bullish, but "data dependent"). While I remain data dependent, I continue to give the bull case the benefit of the doubt for the following reasons:

  • The intermediate bull trend remains intact
  • Markets are oversold and sentiment is moving to a crowded short reading
  • Fundamentals are poised to turn around
  • The internals of market leadership do not suggest the start of a bear phase

Bull trend still intact
Last week, I wrote that the SPX was tactically oversold on the 5-day RSI and could be due for a bounce. We saw a weak rally on Monday, which I interpreted in a tweet to a weak bounce and believed that a final sell-off was in order.

At the close on Tuesday, I wrote that the it appeared that we were getting close to a capitulation bottom (see Getting close to a ST market bottom) and confirmed my beliefs in a tweet at the close on Thursday.

However, instead of the bulls delivering a follow-through rally as they have done in the past rallies off V-shaped bottoms, the markets instead saw a Friday the 13th surprise sell-off. The bull trend was saved by a bounce off the uptrend line that began last October. In fact, a review of the charts, both within the US and globally, indicate that the bull trend is still intact. The chart below of global, US and European equity averages show a pattern of a pullback to successfully test the uptrend.

A crowded short is developing
In the meantime, the market is getting oversold and sentiment readings are turning bearish, which is contrarian bullish. Bespoke reports that AAII bullish sentiment has dropped like a rock, though bearish readings have not risen as the (former) bulls turned neutral.

As well, the latest NAAIM survey shows that sentiment has fallen precipitously from 92 to 65 in a single week, which indicates panic among the RIA community. Here is the chart of sentiment readings:

Here is the data:

Here are also some selected charts from IndexIndicators.com, which show that the SPX to be oversold enough that it has staged short-term rallies in the past. It does not mean, however, that the market cannot get more oversold. Here is a chart of the % of SPX stocks at 20-day lows:

And average 14-day RSI of SPX components:

You get the idea. While I believe that stocks are poised to rally, we have a wildcard in the form of the FOMC meeting next week, which could create further asset price volatility. 

Poised for a turnaround
Sentiment has become so negative that any hint of good news may create a melt-up in the price of risky assets. As an example, the much better than expected Employment Report on March 6 swung psychology to a June Fed rate hike, but inflation and inflationary expectations remain tame (see Why the Fed may stay "patient" for a little longer). While the FOMC may drop the word "patient" in its March statement, the possibility that it could be replaced by some equally dovish language under the circumstances.

In addition, there has been much concern over the GDPNow estimate of Q1 GDP from the Atlanta Fed, as those readings have been falling rapidly:
The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2015 was 0.6 percent on March 12, down from 1.2 percent on March 6. The nowcast for first-quarter real consumption growth fell from 2.9 percent to 2.2 percent following this morning's retail sales release from the U.S. Census Bureau.

As well, Bloomberg reported that their ECO US Surprise Index, which measures economic data relative to market expectations, has fallen to levels not seen since 2009:

A turnaround may be at hand, according to New Deal democrat, who provides a far more nuanced interpretation of macro data by segregating them into coincidental, short and long leading indicators (emphasis added):
Negative coincident indicators have generally abated, with the big exception of Steel.

Among long leading indicators, yields on corporate bonds and treasuries are still positive although less so. Money supply is even more positive. Real estate loans, and house sales as reported by DataQuick were positive. Mortgage applications were mixed

The short leading indicators also returned to generally positive readings. Oil prices fell back to their January low. Industrial metal prices rose slightly, but were still close to their recent low. Spreads between corporate bonds and treasuries improved slightly and I scoring them a slightly positive. Temporary staffing also returned to being positive. Gas prices and usage remained positive, and initial jobless claims improved within their positive range.

As indicated above, coincident readings largely abated from being quite negative. Rail, which had been awful, was mixed. Consumer spending as measured by Gallup was just barely positive yet for the first time in weeks, while Johnson Redbook was again only weakly positive. The TED spread and LIBOR have leveled off as barely negative. Shipping turned more positive, and tax withholding was positive as well. Only steel production was negative, and in a big way.

Last week the weakness in the high frequency data spread from coincident to short leading indicators. I remained positive, since this is not the order in which I would expect the economy to turn. This week's data bears that out. In particular I said, "I will be paying particular attention to rail and to Gallup consumer spending to see if they turn positive in the next several weeks, and to see if the temporary staffing downturn was just one week of noise." This week all three were positive.
In addition, the latest report from John Butters of Factset shows that bottom-up EPS estimates continue to recover from their recent weakness (annotations in red are mine):

For another viewpoint, I turned to Brian Gilmartin, who keeps a close eye on the earnings outlook, Gilmartin believes that USD strength has eclipsed falling energy prices as a worry for forward EPS and that those concerns are overdone:
I think there is a lot of bad news in the current 2015 earnings forecasts and numbers. I think the dollar is as much of an issue maybe more than Energy at this point, since it is tougher to quantify. Personally, despite the worries about the forward growth rate of the SP 500 earnings estimate going negative, I dont think we are anywhere close to a 2008-type scenario in the stock market. Despite the headline to this weekend’s update, I’m not that worried about SP 500 earnings.
He concluded:
Even if the dollar were just stable for a month, and the euro stopped plummeting, I think that could take some pressure off estimates.
Should a dovish Fed statement next week send the USD lower, it would precisely set up that kind of market psychology where USD weakness translates to greater EPS growth optimism.

Bear market internals don't look like this
Further, a review of stock market sector and industry leadership is highly suggestive that this is not an intermediate term market top. Typically, topping patterns are preceded by the relative deterioration of high-beta glamour groups and the outperformance of defensive sectors. Here is a chart of the relative performance of two major defensive sectors. Are they beating the market? Tops normally don't start this way.

The underperforming groups are natural resource related, which is not a surprise given what has happened to oil and other commodities:

Here is a chart of the market leaders, which consist of Health Care, which has been a secular leadership sector this cycle, NASDAQ and Consumer Discretionary stocks. This pattern tells me that Mr. Market still believes that we are in the mid-cycle phase of an economic expansion:

A closer examination of the Health Care sector that leadership has not been just restricted to biotech stocks, which have gone from strength to strength this cycle, but other individual industries in the sector:

Consumer Discretionary stocks have also been on a tear. Strength has been evident in virtually all consumer spending related groups:

NASDAQ stocks have also been showing strength. Glamour groups have also been showing rising relative strength, with the exception of the range-bound Social Media stocks,

Limited downside risk
When I put it all together, the big picture tells a story of some short-term weakness in the context of intermediate term strength. Expectations have been beaten down and crowded short positions are being formed. On the other hand, there is little sign of intermediate term weakness, either from a technical or fundamental perspective.

This doesnt mean that stocks will go up in a straight line, as the market reaction to the FOMC meeting is unpredicatable. However, I believe that downside risk is relatively limited. The SPX has the support of the uptrend line depicted below. Should that fail, recent episodes of weakness has been arrested at the 150 dma, which is about 1.5% below the levels seen on Friday.

My inner investor remains overweight risky assets.

My inner investor is long the market as he is positioned for the potential rebound to come. The key test for the stock market is what happens after the oversold rally peters out. Will it continue to grind upwards, exceed the old breakout at about 2093 and test new highs? Or will market strength stall out?

Disclosure: Long TQQQ

Wednesday, March 11, 2015

Behold the tsunami of liquidity from China

I generally don't write about the local real estate market, but this analysis pertains to a more global investment issue - the internationalization of the RMB, but in a way that Beijing may not have intended.

Prices of Vancouver property have been very high and deemed to be unaffordable by most price to income metrics for quite some time. A recent study indicated that Vancouver is the second least affordability city in the world, after Hong Kong. Anecdotal evidence suggests that money from Mainland China has pushed up prices, which has made the locals rather upset because they are being priced out of the market.

An article in the local newspaper, The Province, tells the story of the flood of money coming in from Mainland China (emphasis added):
Kirk Kuester, executive managing director of Colliers International Vancouver, said the pool of money from Mainland China seeking investments in Metro Vancouver is so vast right now that he has to turn away potential clients.

“The money is staggering, quite honestly,” Kuester said.

“It is essentially from Mainland China. They were looking at private houses in residential developments in Vancouver, and it really seemed to accelerate in mid-2013. It’s a security play, and a diversification play.

“But now we are seeing them look for cash flow from commercial sites. The biggest challenge we face is scale and process.”

Kuester said a range of Chinese investors — from state-backed funds to smaller players with just tens of millions — expect to quickly ink deals for land by offering sky-high bids. But they are sometimes frustrated by the politicized nature of development deals in Vancouver, and multi-bid processes.

Kuester said, for example, that on Wednesday he had two or three potential clients with “half-a-billion” in private funds ready to put to work, but there are simply not big enough deals to satisfy them.

“Some of these groups want to buy the biggest sites in the city and do developments that are comparable to projects in China, but would be on the upper end of anything ever done here,” Kuester said.
In addition, a study by the Conference Board of Canada shows a high degree of correlation between Chinese GDP growth and Vancouver real estate prices:
Statistical analysis confirms the importance of China’s economic health to Vancouver’s housing markets. Standard tests find significant correlations between the country’s real GDP growth and three important market yardsticks: existing home sales, existing home price growth and total housing starts. By contrast, local employment growth is significantly correlated to none of these and the five-year rate related to only the resale variables. This could mean that a substantial proportion of Vancouver real estate purchasers do not need local jobs to buy any home (new or existing) and that many do not need a mortgage to buy a new home. On the other hand, better economic health in China gives its residents wealth to spend on Vancouver housing.
The anecdotal and statistical evidence in intriguing, but the flow of funds effects are hard to quantify. Sure, Vancouver is a nice place to live. The climate on the west coast is mild compared to the rest of Canada. Here is just a sample from my tweet on February 17:

No doubt Vancouver real estate deserves to trade at a slight premium, but how much? How much of the elevated prices can be attributable to the Mainland China effect?

The Vancouver-Victoria premium
One way of measuring the foreign money effect is to analyze the relationship between property prices between Vancouver and nearby Victoria, which is located on Vancouver Island. Victoria is a smaller city, also on the coast. The main sources of employment in Victoria are government, as it is provincial capital, tourism and the local university (in that order). While Vancouver Island has seem some retirement emigration from Boomers from the rest of Canada seeking a better climate and slower lifestyle, it has seen little overseas investment compared to Vancouver, which is the major Canadian metropolis on the west coast.

Using data from the University of British Columbia, here are the quarterly real estate prices from each city starting in 1975:

Here is the Vancouver-Victoria house price ratio for the same period, smoothed by a rolling four quarter average as quarterly figures can be volatile.

We can observe the effects of foreign money on Vancouver property prices by measuring the Vancouver-Victoria premium. Vancouver has seen three waves of Chinese money coming in over the past few decades. First, there was a wave of Taiwanese immigration in the late 1980s. Ahead of the 1997 British handover of Hong Kong to China, there was an additional flood of money flooding into the Vancouver property market. Today, we are seeing the effects of Mainland Chinese funds flooding into Vancouver, as per the comments from real estate agents in the story quoted above.

Further, this analysis suggests that Vancouver is roughly 15% overvalued relative to Victoria. A correction could see prices plunge further as downturns often overshoot the fair value estimate. Both the Taiwan and Hong Kong buying episodes saw prices rise to a premium and a correction afterwards. Does this mean that Vancouver property prices are on the verge of collapse?

Correction, or buying panic?
There are two possible scenarios at play here. The current price surge episode in the Vancouver-Victoria premium that is similar in magnitude and duration as the previous two buying frenzies. The simplistic conclusion is that we could see a run of the mill correction in Vancouver property prices of 15% or more.

On the other hand, prices could melt-up for several reasons. First of all, the scale of the Chinese economy is an order of magnitude bigger than either Taiwan or Hong Kong, especially in light of a 2013 Bain study indicating that 60% of Chinese multi-millionaires would like to obtain either a foreign passport or residency status. Put the relative scales of population of China compared to Taiwan or Hong Kong into context, it suggests that the liquidity flood effect from China may not be over.

As a consequence, Chinese capital flight is occurring and flooding into places like the Vancouver real estate market. The chart below shows that the USD Index is in an extended, but secular uptrend. USD strength therefore puts tremendous downward pressure on the RMB, what happens if China were to devalue the RMB. Could that flood of money turn into a panic driven tsunami? Add to the mix the fact that as the USD strengthens, the CAD weakens and makes the CADCNY exchange rate more attractive for Chinese buyers of Canadian property.

Indeed, charts from Business Insider of the most important charts in the world show that the market is starting to price in a devaluation in the RMB-USD exchange rate:

David Cui of BoAML believes that pressures are building and Beijing will be forced to choose between devaluation or unemployment:

Martin Enlund of Nordea Markets more or less said the same thing. The RMB is overvalued compared to EUR and JPY, which puts pressure on Beijing to devalue:

FT Alphaville reports that we are already seeing signs of Chinese capital flight:
Charts from Nomura showing, on the left, China’s largest cumulative two-month decline in FX purchase positions on record occurring despite a record trade surplus over the same period and, on the right, the probable hoarding of foreign currency as reflected in a sharp monthly rise in foreign-currency deposits in January.
Or to paraphrase a bit further: more signs of capital flight and depreciation pressure in China.
In short, capital flight seems to be increasing and there are reports of ingenious ways of getting around Chinese capital control regulations. I have no idea of how this all plays out, but we can always depend on Zero Hedge for the Apocalyptic view of a global currency war:
What all of the above means is that China is suddenly finding itself in an unprecedented position: it is losing the global currency war, and in a "zero-sum trade" world, in which global commerce and trade is slowly (at first) declining, and in which everyone is desperate to preserve or grow their piece of the pie through currency devaluation, China has almost no options.

Well, that's not true. Because if China wants to enter the global currency wars, and it will soon have no choice, it has - according to Cornerstone - several options with which to stabilize its economy, but really all of which, due to the size of China's epic credit and investment bubbles, and keep in mind that China's housing bubble has not only burst, but is now deflating at a faster pace than what happened in the US after Lehman...

... boil down to just one: QE.

From Cornerstone:
Do you remember that from 2007 to late 2008, U.S. fed funds dropped 500 bp, and then the Fed still needed to do QE? The backdrop for China looks a bit similar. We had a credit bubble, they have a credit bubble. We had a housing bubble, they have a housing/investment bubble. Will China eventually have to go down the same path as the U.S., and the Eurozone? Roberto Perli believes the PBoC will first cut rates to 0%, before contemplating QE.
Do you remember that from 2007 to late 2008, U.S. fed funds dropped 500 bp, and then the Fed still needed to do QE? The backdrop for China looks a bit similar. We had a credit bubble, they have a credit bubble. We had a housing bubble, they have a housing/investment bubble. Will China eventually have to go down the same path as the U.S., and the Eurozone? Roberto Perli believes the PBoC will first cut rates to 0%, before contemplating QE.

There you have it: the flowchart for what is in store for the world for the next 12-24 months - an ongoing deterioration in Chinese economic conditions, coupled with a weaker, but not weak enough, currency, before the PBOC first go to ZIRP, and then engages in outright QE.

And once China, that final quasi-Western nation, proceeds to engage in outright monetization of its debt, then and only then will the terminal phase of the global currency wars start: a phase which will, because global economic growth and that all important lifeblood of a globalized economy - trade - at that point will be zero if not negatve, will see an unprecedented crescendo of money printing by absolutely everyone, before coordinated devaluations mutate into uncoordinated, and when central bank actions morph from "all for one" to "each man for himself."

A blow-off top?
Should China choose the RMB devaluation route - and there are some very compelling reasons to do so, we could see a further surge of funds out of China from the johnnies-come-lately who missed the boat on the initial wave of capital flight. While I am not predicting that this is my base case scenario, such a turn of events would likely result in a final blow-off wave of liquidity which buoys property prices in places like Vancouver and Sydney to insane levels.

In that case, I leave the last word to David Woo of BoAML. FX volatility would skyrocket to levels last seen in past financial crises.

You can imagine what might happen to global asset prices were that to occur.