Friday, October 9, 2015

Humble Student lives

I want to thank everyone who participated in the poll about the future of Humble Student of the Markets (see Humble Student turns 8 in Nov, time to retire?). It is gratifying to see that my writing has gathered such a following over the years. Thank you to each and one of you.

About half of the people who answered the survey, which is admitted a biased sample, said that they would pay for my writing. Based on the feedback that I got, I will be turning this blog into a pay-site, which I will detail later in this post.

A personal journey
First, I want to recount the personal journey that I underwent to write this blog and how I got to the point today. The story began in early 2007 when I left Merrill Lynch in New York to return to Vancouver, where I grew up. This was the parting email that I wrote friends and colleagues, entitled "am REALLY IS leaving to spend more time with his family":
After close to 30 years of being involved with the marketsI have decided to take early retirement and move to Vancouver with my family.
I went on to quote Todd Harrison of Minyanville:
Others have expressed my sentiments better than me:
I'm not going to say that success is insignificant, we know that's not true, but I can tell you, from experience, that if you look for happiness in a bank account, you're missing the bigger trade.
I have no immediate plans other than taking my daughter to school and helping her with her homework. We plan on moving in the summer when school is out and will be in the NY area until then.
I could claim that I was prescient and saw financial storm clouds gathering in early 2007, but the truth was, I was just lucky in my timing. We moved back to Vancouver and I settled into a daily routine. The first few weeks and months were relaxing. I will always be grateful for the last eight years, when my routine changed to getting up in the morning to make my daughter breakfast and school lunch. Then I would watch the markets (stock market opens at 6:30 am on the west coast and closes at 1:00 pm) over the day. Few people who work on Wall Street can experience that kind of father-daughter bonding. No amount of money can replace being present during that key period of our children`s formative years. I have never regretted making the decision to leave Merrill and slow down the pace of my life.

Nevertheless, I still had a passion for the markets. I found that I had all these opinions and comments to get out, but no one to talk to. Thus Humble Student of the Markets was born, mainly as a vehicle for me to talk out loud.

It was also very difficult to shake a lifetime of habits. I was used to be part of a team writing an extensive weekend market commentary. The lead analyst (and friend) of the team was Mary Ann Bartels. While everyone on Wall Street is hyper-competitive, I felt a special responsibility as we were walking in the footsteps of the legendary Bob Farrell. Even though our focus was technical analysis, our analysis was technical analysis with a quantitative flavor. For example, I pioneered techniques to reverse engineer the real-time exposures of hedge funds.

Thus the weekly market commentary was born and evolved. It grew and acquired a degree of following that I never expected.

Days turned into months and months turned into years. The tipping point for me was early September, when we took a brief trip to celebrate our 20th wedding anniversary and to re-visit the site of our wedding (see A geek's view of love and marriage). I found that I was on a laptop in the middle of nowhere posting on my blog.

Why? Is this blog that I was writing, which began as a simple hobby, taking over my life and taking time away from my family? I made the decision back in 2007 to slow down and spend more time with my family and now I was back at it again?

I had to rationalize the decision to continue spend time blogging, both to myself and my family. It was a fork in the road. The expressions of support that I received allowed me to turn my writing and analysis into a business venture gave me the focus to both keep writing and justify the use of my time to my wife and daughter.

I am listening
Many readers took the time to either comment on the blog post or took the time to write me emails. I heard one key message over and over again. What you valued the most about my analysis is the eclectic left and right brained multi-disciplinary approach to market analysis.

One of the best compliments that I received from another investment professional came from Bill Luby, of VIX and More, who wrote the following comment when I blogged on the policy costs of Spain's recent stellar economic performance:

Yet another excellent piece of analysis. I could have attached this comment to many other posts, but this one in particular caught my attention.

I want to reiterate that I appreciate all the wide-ranging issues that appear on this blog and the best part about it is that, unlike many other writers, I never know what to expect from you next.

Keep 'em coming!
Many are experts in their own silos of market analysis. Bill Luby is well versed in the nuances of the option market. Others are far better chartists than I am. What you appreciate about my analysis is my mutli-faceted approach, which can be found in a couple examples of posts written in the last week:
Less valued, for example, were my technical analysis and tactical market calls.

Based on these comments, the focus of future posts will shift in the following way:
  • The weekly market comments will continue, as they seem to be the prime attraction.
  • More commentaries from my inner investor, such as on topics of investment policy, investment process and quantitative analysis. That is to say, the blog will have a greater strategic, rather than tactical focus.
  • Fewer commentaries from my inner trader and tactical market calls. When I do trading suggestions, I will be also focus on when they should closed, which is something I haven`t done in the past.
I did also receive a small number of comments to the effect that they would happily pay for trading recommendations, either on my service or on various online platforms. I decided against that course for several reasons. First and foremost, I agree with Charles Kirk when wrote that shadow trading doesn't help investors and traders learn and grow. I would therefore be doing a disservice to my readers by offering such a service:
If you engage in shadow trading, you must recognize and understand that there are some significant problems in doing so. For one thing, most of us can’t find someone who trades in a manner that also matches our own strategy, personality and goals. This results in inconsistent trading at best as we fight against or only selectively follow some recommended trades. And, even if we can find a good match, then we often just pick up the same bad habits and faulty process of those who we try to copy on top of our own weaknesses. You already have enough weaknesses right now that you certainly don’t need to add on top of those you already have.

Most importantly, the process of shadow trading itself can often retard if not serve as a major obstacle to what you really need to do to become truly successful in the markets. For many, it is ok to do this to some minor extent especially those just getting started and have no idea what they need to do to learn, but to really get where you need to go,you’ll need to venture out on your own.
Moreover, that kind of service is highly labor intensive and would take time away from  my core competence of a left and right brained approach to market analysis. As well, the going rate for similar trading advisory services seems to be about $100 per month, which is well beyond the budget of many readers. (For the tactically inclined, consider this list of people to follow - and they're free.)

Details of the new site
Based on the feedback that I received, the preliminary pricing schedule will be four access levels:
  1. Annual subscription: An annual subscription for $199 (all amounts are in USD).
  2. Monthly subscription: Monthly subscriptions for $20.
  3. Daily pass: Get a one-day pass for $5.
  4. Free: All content will be available to the public two weeks after posting. Anyone can subscribe to get email notifications of free content as they are released.
I believe that the pricing to be quite reasonable. Subscriptions to the WSJ or FT is over $300 a year. Investor's Business Daily is considerably higher. The basic level Value Line subscription is $199.

I am currently aiming for a December launch and will have further details as they develop. I will be migrating to a new website, but I will keep this site and its archives active for anyone who is interested in the old posts.

If you are interested in subscribing and haven't taken part in the poll, please do so as I will be offering an early bird discount coupon for anyone indicating an interest right now. I will leave the poll open until midnight, Sunday October 11, 2015 (Pacific Time).

Thank you for your support in keeping Humble Student of the Markets alive.

If you have any further comments, please email me at cam at hbhinvestments dot com.

Thursday, October 8, 2015

Bingo! We have a buy signal!

In my weekend post, I highlighted a possible setup for a Zweig Breadth Thrust buy signal (see Sell in May, ______ in October). The Zweig Breadth Thrust is an extremely rare buy signal that generally signals the start of a new bull market (see A possible, but rare bull market signal).

Steven Achelis at Metastock explained the indicator this way (emphasis added):
A "Breadth Thrust" occurs when, during a 10-day period, the Breadth Thrust indicator rises from below 40% to above 61.5%. A "Thrust" indicates that the stock market has rapidly changed from an oversold condition to one of strength, but has not yet become overbought.

According to Dr. Zweig, there have only been fourteen Breadth Thrusts since 1945. The average gain following these fourteen Thrusts was 24.6% in an average time-frame of eleven months. Dr. Zweig also points out that most bull markets begin with a Breadth Thrust.
As of the close today (Thursday October 8, 2015), we have another ZBT buy signal.

Learning from 2009
The last ZBT that I can find occurred at the market bottom in March 2009.

While history doesn't always repeat itself exactly, I can see a number of similarities that may give usa road map to how the market is likely to behave in the next few months. Here is what happened in 2009:

We can observe that breadth was improving when the market bottomed in March 2009. A ZBT is a powerful exhibition of buying momentum and RSI(5) has not unexpectedly flashed an overbought reading. Right after the signal, the market weakened and pulled back for two days and continued upwards, showing a series of "good" overbought readings as it advanced.

Today, we can observe similar conditions. Breadth measures have improved since the "bottom" last week, though the low last week did not exactly test the August panic lows.

The market has also become overbought on RSI(5). These series of charts from IndexIndicators (with my own estimate shown as a dot) also shows how overbought the market is on a 1-3 day time horizon:

...and longer term indicators with a 1-2 week time horizon, based on a net 20 day highs-lows measure. I would remind you, however, that overbought conditions can stay overbought (see the reference to "good" overbought readings above) and the market got off the charts oversold in the way down in August.

We see similar readings on an intermediate term 1-2 week basis using the average 14-day RSI indicator as well:

A powerful "buy" signal
If history is any guide, the Zweig Breadth Thrust is signaling that stocks are about to embark on another upleg. While the market is very overbought and I have no idea of what might happen in the next few days given the volatility seen during Earnings Season, these conditions are highly suggestive that downside risk is extremely limited and stocks will be significantly higher by year-end.

Tuesday, October 6, 2015

Margin pressures = Subdued L-T equity returns

In a recent post (see Why this is not the start of a bear market), I raised the question of how a maturing economic cycle might pressure margins. My thesis was mainly based on analysis from Jim Paulsen of Wells Capital Management who believed that operating margins face a lose-lose situation in 2016 (emphasis added):
Earnings performance is well past its best for this recovery and investors need to consider whether earnings growth will prove sufficient to support current stock market valuations. The rapidly aging earnings cycle is perhaps best illustrated by an economy nearing full employment with corporate profit margins near record highs. Should global growth remain tepid and overall sales results modest, since profit margins are unlikely to rise much, earnings trends will also likely prove disappointing. Conversely, should global growth and corporate sales results accelerate, because the U.S. is nearing full employment, companies may soon face cost-push pressures and margin erosion which will likely off set improved sales results.

Essentially, it is difficult to see how earnings growth will be adequate during the rest of this mature recovery to support current price/earnings multiples. Is a relatively modest earnings growth against a backdrop of rising inflation and higher interest rates sufficient to support
The Atlanta Fed`s Labor Market Spider Chart shows the continued robustness of the US labor market as metrics have improved in the last six and twelve months, despite the disappointing Employment Report last Friday.

Indeed, the Atlanta Fed Wage Growth Tracker shows that wage pressures have been rising at a healthy clip, with prime age wage growth, which adjusts for the the demographic effects of aging Baby Boomers, up at 3.4% in August.

With the labor market still tight, you have to wonder to what extent rising wages are going to squeeze operating margins.

More long-term headwinds
So far, the case for margin compression has been an investment story for 2016. A Bloomberg article recently came across my desk indicating longer term global pressures on corporate margins.

That's because the demographic tailwind from a rising global labor supply is turning into a headwind:
Goodhart argues that since roughly 1970, the world has been in a demographic sweet spot characterized by a falling dependency ratio, or in plainer terms, a high share of working age people relative to the total population. At the same time, globalization provided multinational companies the ability to tap into this new pool of labor. This positive supply shock was a negative for established workers, forcing down the price of labor as capital flowed to these areas.

"Naturally, and quite properly, the West supplied much of the management; the East supplied the labor," wrote Goodhart.

Outsourcing labor to less costly locales kept wages at home from rising too fast. This, in turn, entailed that inflationary pressures were benign, as best depicted by the concept of the Great Moderation, or the idea that central bankers were better able to stabilize the business cycle.

As companies were encouraged to boost capacity with workers rather than capital equipment, this put downward pressure on the cost of the latter.

"Access to a new reserve army of cheap global labor through globalization has encouraged companies to invest in this workforce rather than in capital at home. A garment company, for example, could choose to build a highly automated, capital-intensive factory in the U.S. or build a low-tech, high-labor factory in the Far East," said Toby Nangle, who published a column on the connection between labor power and interest rates in May. "For years, companies have been choosing the latter option, which reduces the requirement for capital in the West, thereby reducing the price of that capital."

The positive operating margin effects of globalization are coming to an end as global population is aging.

Such a demographic development translates into wage and inflationary pressures (emphasis added):
Unlike many other economists, Goodhart does not believe the demographic backdrop of an aging population is inherently deflationary. The pool of labor around the globe that kept wages suppressed domestically on the island nation has nearly run dry; Japan, in other words, was a victim of circumstance. More generally, in order to meet the obligations of the state, the shrinking pool of workers will be forced to pay higher taxes at the same time that they'll be in a position to haggle for better wages.

"This is a recipe for a recrudescence of inflationary pressures," wrote Goodhart. "The present concerns about deflation are fleeting and temporary; enjoy it while it lasts."
Please note that the points raised in the article refer to long term forces affecting corporate profitability that stretch out decades into the future.

The McKinsey view
A Harvard Business Review article, which was adapted from work from the McKinsey Global Institute, told a similar story of a negative reversal in the effects on corporate operating margins from globalization:
[T]he favorable cost drivers that Western multinationals were able to exploit have largely run their course. Interest rates are now so low in many countries that borrowing costs simply can't fall much further and might even be starting to rise. The big tax-rate decline of the past three decades also seems to have ended. Indeed, tax inversion schemes, offshoring, and the use of transfer pricing are drawing political flak in several deficit-ridden countries.

As for labor costs, wages in China and other emerging markets are rising.

Rather than continuing to reap gains from labor arbitrage, companies will fight to hire skilled people for management and technical positions. New jobs require disproportionately greater skills, especially in science, engineering, and math. In China, once the main source of new workers, the demographic pressures of an aging population and falling birth rates could further increase the country's labor costs. And most other emerging markets do not yet have the high-quality rural education systems required to build a disciplined workforce.
If the world is becoming global, then global wage pressures are likely to rise:
The result is an intensifying global war for talent. In a recent McKinsey survey of 1,500 global executives, fewer than one-third said that their companies' leaders have significant experience working abroad-but two-thirds said that kind of experience will be vital for top managers in five years.
Companies are seeing other challenges. The business models of many companies have changed. New entrants are not necessarily focused on profitability, but market share:
The growth of these players has been supported by their ownership models.

Major U.S. and European companies' broad public ownership, board structure, and stock exchange listings typically enforce a sharp focus on near-term profitability and cost control. But many emerging-market firms are state- or family-owned and so have different operating philosophies and tactics. Many of the new competitors take a longer-term view, focusing on top-line growth and investment rather than quarterly earnings. Growth can be more important than maximizing returns on invested capital: Chinese firms, for example, have grown at a blistering pace-four to five times as fast as Western firms over the past decade, particularly in capital-intensive industries such as steel and chemicals.
It`s not just the emerging market players, many of which are state-owned, that go into a market and drive down prices by focusing on market share, but western companies in the technology space, such as and numerous tech start-ups intent on grabbing as much virtual real estate as they can:
Tech firms share some intriguing similarities with the new emerging-market giants. Both can be brutal competitors, and both often have tightly controlled ownership structures that give them the flexibility to play the long game. Many tech firms are privately held by founders or venture capital investors who prioritize market share and scale rather than profit. Amazon, Twitter, Spotify, Pinterest, and Yelp are on the growing list of companies that focus on increasing revenue or their user networks even while losing money over extended periods. That mindset-and the control of founders-sometimes persists even after the companies go public. Among NASDAQ-listed software and internet companies, founder-controlled firms have 60% faster revenue growth and 35% to 40% lower profit margins and returns on invested capital than do publicly held firms.
The study concluded that, much like the internet boom of the late 1990s, the benefits may accrue to the end user rather than the corporate provider of the new services:
But whereas the outlook for revenue growth is good, the profits picture looks less promising. Consumers could be the big winners, as could some workers-especially those in emerging markets and those with digital and engineering skills, which are in short supply. As we've seen, many companies' profit margins are being squeezed. Hospitality, transport, and health care have all experienced price declines in recent years because of the emergence of new platforms and tech-driven competitors. Similar effects could soon play out on a larger scale and expand to sectors such as insurance and utilities. Nobody is immune, but companies particularly at risk include those that rely on large physical investments to provide services or that act as intermediaries in a services value chain. Large emerging-market firms in less traded capital-intensive industries such as extraction, telecom, and transportation have been relatively protected so far, but that is changing, in part because of greater deregulation. Profits are not only shrinking but also becoming more uncertain. Since 2000 the return on invested capital has been about 60% more volatile than it was from 1965 to 1980.
These factors all combine to squeeze operating margins.

For investors looking out for 10 years or more, such a scenario translates into rising inflationary pressures (bonds will be poor performers) and lower corporate margins (diminished equity returns).

Don't abandon stocks!
While the apparent long-term outlook appears dire for both equity and fixed income, all is not lost. What demographics takes away, it can give back as well. In a past post, I had highlighted rising demographically driven for equity investments (see A new golden age of demographic growth).

A San Francisco Fed study showed that P/E ratios are influenced by age demographics. It projects a bottom in P/E ratios around the end of this decade and a rise afterwards.

History doesn't repeat, but it does rhyme. When I put it all together, the combination of rising margin pressures and demographic changes suggest that returns for equity investors will reasonable and not disastrous in the 2020s. On the other hand, don't expect a repeat the secular bull that we experienced in the 1980s and 1990s.

If you found this post to be valuable, please help me make a decision on the future of Humble Student of the Markets by completing a simple two question survey (if you haven't done so already). More details here. I will be announcing a decision on the fate of this blog late this week.

Sunday, October 4, 2015

Sold in May, ______ in October

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bullish

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

My inner trader uses the trading model component of the Trend Model seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below.

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

Karmic re-balancing?
I have been saying for the past few weeks that while the technical picture for the stock market looked shaky, the macro and fundamental outlooks appeared constructive and that's why I remained constructive on stock prices (see Why this is not the start of a bear market). Now we are seeing a reversal of those trends, perhaps in a Cosmic Karmic re-balancing sort of way. The technical indicators are improving, but we are seeing signs of macro and fundamental deterioration.

While I am still believe that equity prices are likely to be higher by year-end, this change may mean that there may be some more near-term weakness ahead. Weakness in macro and fundamental factors can be triggers for slow, but big money, institutional investors to de-risk.

Let`s go to the numbers.

Macro disappointments
Last week saw a couple of disappointments in big headline macro releases for the US economy. It wasn't that the big miss in the Employment Report that was disturbing, but the ISM Manufacturing number came in below expectations as well.

The Citigroup Economic Surprise Index, which measures whether high frequency economic releases are beating or missing expectations, tell the story well. US macro have begun to deteriorate relative to expectations. This may presage a period of near-term softness in the US economy.

Indeed, the Atlanta Fed "nowcast" of GDP growth has been tanking as well. GDPNow fell to 0.9% last week, which is well below the consensus forecast.

Mid-cycle pause?
Last week, I highlighted a downtick in forward EPS estimates, which I viewed as a cautionary sign but could have been just a blip in the data. The latest update from John Butters of Factset shows that forward EPS fell again for another week (annotations in red are mine).

The combination of weakening macro and a deterioration in Street EPS expectations can be red flags for institutional investors, the big but slow money in the market. Ed Yardeni found that forward EPS to be correlated with coincidental economic indicators. This may signal a period of greater cautiousness among the big money players as we await developments from Earnings Season.

I remain optimistic on the US economy. The excellent summary provided by New Deal democrat of high frequency economic releases puts the current macro and fundamentals into context, as he dissects macro releases into long leading, short leading and coincidental indicators. Long indicators remain relatively strong, but short leading indicators and coincidental indicators are mixed:
Among long leading indicators, interest rates for corporate bonds and treasuries remained neutral. Mortgage rates, and purchase and refinance mortgage applications are positives. Real estate loans are positive. Money supply is positive.

Among short leading indicators, the interest rate spread between corporates and treasuries remains quite negative, as is the US$. Positives included jobless claims, oil and gas prices, and gas usage. Commodities remain a big global negative. Temporary staffing is negative for the 20th week in a row, and more intensely so for the 2nd straight week.

Among coincident indicators, steel production, shipping, rail transport ex-intermodal, the TED spread and LIBOR all are negative. Tax withholding and consumer spending are now uniformly positive if weakly so.
Slicing and dicing differently, he concluded that the global economy is weak while the American consumer remains strong, which is consistent with his call a few months ago for a weak industrial recession:
We continue to have a stark bifurcation. Consumer-related indicators - mortgages, oil and gas, jobless claims, and consumer spending - all remain positive. But those portions of the US economy most exposed to global forces, including the US$, commodities, and industrial production and transportation, are all firmly negative. Employment on net is still a positive, though more weakly so. Housing and cars, those two most leading sectors of the US economy remain positive (with a post-recession record for motor vehicle sales last month), and thus so do I.
In other words, this is shaping up to be a mid-cycle pause in growth. On the other hand, the current patch of softness in the data may be reflective of that bifurcation.

Gavyn Davies analyzed the slowdown in global industrial activity and found that there are signs for optimism (emphasis added):
This month we introduce a new feature that examines the growth of the global industrial sector, with the latest month (September in this case) being estimated from our “nowcast” models. The full set of graphs for all the major EM and DM economies is attached here for reference.

Although the industrial sector is typically around 20-30 per cent of GDP, it is more volatile than the rest of the economy, and it therefore accounts for a large part of the quarterly swings in global activity. Furthermore, the marked weakness of manufacturing in the middle of 2015 raised serious concerns about global recession risks. It therefore offers a good cross-check for our nowcast estimates for overall economic activity.

The most interesting feature of these industrial production figures this month is that the growth rate has now bounced to a monthly rate of 0.2 per cent, up from zero in 2015 Q2. While many commentators have been worrying about industrial growth in China, the main contributor to recent fluctuations in global industrial growth has been the US, where the collapse in the energy sector, and inventory shedding in the manufacturing sector, have had a marked effect. As these negative impacts on growth have faded, the global industrial sector has bounced back a little, which is reassuring.

In other words, there is no need to panic. Neither the world nor the US is rolling over into recession. My inner investor remains constructive on the longer term fundamental outlook and he continues to buy stocks on weakness.

An improving technical outlook
The biggest surprise to me was how the stock market reacted to the big miss in the Employment Report. The numbers looked terrible on all dimensions, from the headline number to participation rate. The fact that stocks rallied in the face of bad news is an indication of a washed-out market.

The technical signs were there. The SPX fell last week and appeared to be nearing a test of the panic lows of August, though those support levels were never reached. We saw positive divergence in RSI(5) and RSI(14) at the time of the near-test of the lows - which is a bullish sign.

The broader Wiltshire 5000 Index did test the August lows last week and the same positive RSI divergences were observed.

I would also mention that sentiment models remain at a crowded short, which is contrarian bullish. The latest reading comes from NAAIM (via Ryan Detrick):

At the same time, Barron's reports that insiders are still buying stocks hand over fist:

Another tantalizing clue came in the form of a setup for a Zweig Breadth Thrust. I highlighted the possibility of a ZBT in late August but that setup failed (see A rare but possible bull market signal), I would note that while a ZBT would confirm a bullish reversal, stock prices can rise without one, as they did during the 2011 bottom.

Will the Breadth Thrust succeed and signal a new upleg? That's the challenge the bulls face next week and they only have a mere ten days to complete the task. This chart from IndexIndicators show that short-term breadth is nearing overbought levels on a 1-3 day time frame. Will we see a pause and pullback as institutions get cautious, or will momentum carry the day and signal a ZBT?

My inner trader is sitting this one out for now. He got faked out/stopped out of his long position on Friday on the Employment Report sell-off early in the day. He has gone to cash and he is waiting a few days to see how the market resolves this short-term tension between the bulls and bears.

My inner investor is asking, "Regardless of what happens next week, if you sold in May and went away, what should you be doing in October?"

If you found this post to be valuable, please help me make a decision future of Humble Student of the Markets by completing a simple two question survey if you haven't done so ahead. More details here. I will be announcing a decision either Thursday or Friday.

Thursday, October 1, 2015

Trans-Atlantic opportunities in Energy and Healthcare

Sometimes it can be useful to step back from focusing on the specifics of a single market to think about the relative performance of sectors globally and how macro conditions affect each region. In a lot of cases, the relative performance of American and European sectors to their markets track each other closely and their divergence can yield insights about either opportunity or macro differences between economic blocs.

For example, here is a chart of the relative performance of financial stocks on both sides of the Atlantic. They are highly correlated and there are no special insights to be gained here.

An opportunity in European Energy
By contrast, a relative performance gap has opened up between US and European Energy stocks. European energy stocks have far underperformed US energy on a relative basis and they are sitting near all-time relative performance lows stretching back 18 years.

On a cap weighted basis, the characteristics of the European and US sectors are fairly similar. The European Energy sector is dominated by mostly megacap integrated companies, e.g. Royal Dutch, Total, etc., while smaller names include the likes of ENI and Repsol - all of which are well diversified integrateds. By contrast, the US has far higher higher beta exploration and oil service companies in its energy universe.

As oil prices have cratered, it makes no sense that European large cap integrated oils should underperform more than American ones, especially when you consider that the price of Brent has performed better in euros than USD.

This pricing gap suggests a couple of opportunistic trades:

  1. Buy European large cap energy and short US large cap integrated energy
  2. Buy a long Europe Energy/European market pair, while short US Energy/US market pair
Unfortunately, there are no US listed ETFs that American investors can readily get easy exposure to European energy stocks. The alternatives are either a European listed ETF (example here), or create a custom basket of US-listed European energy stocks, all of which have US listings.

Is the Healthcare sell-off overdone?
By contrast, there seems to be a different kind of opportunity in Healthcare. The chart below shows that Healthcare stocks (read: Big Pharma) have tracked each other fairly well across the Atlantic for many years. Undoubtedly that can be attributed to the fact that the pharmaceutical business is a global business and these companies sell their products worldwide.

What the chart does show is that while US Healthcare stocks have weakened significantly relative to the SPX recently, their European counterparts have held up quite well. It could be argued that the sell-off could be attributed to a Hillary Clinton comment on drug pricing. If that were true, then shouldn't European drug companies that sell into the American market suffer equally?

This relative performance anomaly is therefore suggestive a relative bargain in US Healthcare stocks.

What I find equally intriguing is that a review of the latest BoAML Fund Manager Survey shows that institutional managers have roughly the same levels of relative exposure to both Energy and Healthcare. When I combine the FMS results with the relative pricing anomalies, it suggests that there are Trans-Atlantic opportunities for traders in these two sectors.

If you found this post to be valuable, please help me decide on the future of Humble Student of the Markets by completing a simple two question survey. More details here.

Tuesday, September 29, 2015

Humble Student turns 8 in Nov, time to retire?

Almost eight years ago, I wrote my first post on Humble Student of the Markets. While others have blogged in support of other business activities, such as financial advisory or asset management, this blog has been a labor of love. Other than the occasional seasonal charitable appeal, I have not asked my readers for anything other than their feedback and financial camaraderie.

While I continue to enjoy sharing my thoughts about the markets, what was once a simple sideline has turned into a significant drain on my time. In particular, the weekend market commentaries with its many charts and multi-dimensional analysis of macro, fundamental, technical and geopolitical analysis is exhausting for what amounts to be a "hobby".

I now face a critical decision, either significantly scale back or stop writing, or turn Humble Student of the Markets into a members only pay-site. Blog posts will be available and free to the public two weeks after they are published, while members get immediate and unlimited full access.

Please help me with my decision by completing the simple two question survey below (if the survey doesn't work, please use this link). If you have any comments or questions, feel free to email me at cam at hbhinvestments dot com.

Past posts of interest
Here are a few key highlights of Humble Student of the Markets:

Weekly market comment: The weekly market is what gets read the most. The latest one is here.

Timely market calls
Phoenix rising? Buy low-priced stocks a week before the March bottom in 2009, many of which doubled or tripled within a year

Why I am bearish (and what would change my mind) May 2015

Big picture macro analysis
Mario Draghi reveals the Grand Plan The eurozone Grand Plan for reforms - this has been the road map all along, ignore at your own peril
China turns Japanese? The long-term challenges to China's growth outlook
Inequality and the genetic lottery: Two views How the Left is both right and wrong on inequality
More evidence of a low return outlook Elevated valuations are pressuring long-term returns
A new golden age of demographic growth Expect a demographic tailwind for stocks and real estate by the end of this decade

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Examining your assumptions: The Fundamental Law of Active Management Using Grinold's Law of Active Management in real life
The limitations of Altman Z Why the Altman Z-Score doesn't work in all cases of solvency analysis

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The ABCs of financial planning Investment policy and asset-liability management concepts
Investment policy: Not just for pension funds Why you need an investment policy statement

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Monday, September 28, 2015

Poised for a successful re-test of the August lows

I reported on the weekend that my inner trader got caught in a "low conviction long trade" (see A choppy bottom). The sell-off on Monday signaled that the market seems poised for a test of the August lows and possibly the October 2014 lows.

Despite the reversal, my inner trader decided to take his lumps and stay long. Based on my latest estimates of the analytics from IndexIndicators, the market is highly oversold on a 1-3 day time frame:

...and also on a 1-2 week time frame:

Moreover, my Trifecta Bottom Model flashed an "Exacta" buy signal and it is very close to flashing a full Trifecta signal. All that means, of course, is that the market is very oversold, - but then you knew that.

The caveat, of course, is that August experience showed us that oversold markets can get even more oversold.

A critical technical test
Most of the bearish chartists I read on social media are positively giddy right now, but Northman Trader offered a more balanced and nuanced take on the technical condition of the US equity market. He has been watching the 5 month EMA and 20 month MA and believes that the market is at a critical technical junction:
Let me highlight the key issue. Look at this monthly $SPX chart below. For many months we have been following two specific moving averages the 5EMA and 8MA. Every month, like clockwork, these 2 MA’s have acted as critical support. This support was decidedly broken with the August flash crash. In October 2014 the break was saved into month end. Unless something magical happens this coming week it appears these 2 MAs will not be recaptured by month end. However, that’s not quite the main critical issue.

More relevant is what happens whether the shorter term 5EMA and longer term 20 MA cross over each other:

He outlined the dire consequences of a cross-over:
The consequences of a crossover are pretty clear: As we’ve outlined previously the larger macro fibs indicate a market retrace to the 38.2% Fib which coincides with the 2007 highs. Pretty solid confluence.
Incidentally, we have seen the cross-over as of the close today, but the bears have to maintain that condition until month-end, which is two days away.

Standing in the way is positive seasonality for the markets:
In my mind the October 2014 lows need to be broken in the next 3 weeks or it’s game over for bears it seems. Lest not forget that in 2014 the correction ended in the middle of October as well and managed to produce a massive rally through year end...

As we outlined last week bulls need a 1998 like save or markets face a structural break targeting 2007 highs.

Curiously the recent action in price continues to show a similar structure to 1998 so a spike into month end before renewed selling into October would not surprise:

Incidentally, when did the 1998 correction bottom? October 8.

When did the 2011 correction bottom? October 4.

When did 2014 correction bottom? October 15.

He concluded (emphasis added):
So bears. To re-iterate: The monthly MAs need to be crossed and the neckline needs to be broken and STAY broken below October 2014 lows.

And bulls. You absolutely need an October magic show and get back above the daily 200MA (currently 2065) or the jig is up for a long time to come.

We will know who the winner is by the end of October at the latest.

Looking for the rally catalyst
I don't pretend to know what the market will do in the couple of days, other than to observe that it is highly oversold and poised to test the August lows. If we were to see a support violation in the next two days, we are likely to see a positive divergence, or non-confirmation of the lows, on the daily RSI14 indicator.

Sometimes being contrarian is highly painful and people like to tell you that you are wrong. I turned cautious on the market early this year and, after much criticism, wrote a post detailing my reasons on May 18, 2015 (see Why I am bearish (and what would change my mind)).

It seems that I am undergoing a mirror image of that experience now. Today, sentiment is showing a crowded short across many measures and it would only take a positive catalyst for the market to melt up. But what might that catalyst be?

The answer might lie in a cyclical upturn. A clue came from David Rosenberg who pointed out that the American consumer could ride to the rescue yet once again (via Business Insider):
Yes, we hear constantly about how China's share of global GDP has risen inexorably over the decades, but that obscures a huge point.

China's contribution to global producers has been in the basic material sphere as the country absorbed so much of the world's resources in its quest to build mega cities and build a world-class industrial infrastructure, but that is about it.

China, for years, racked up massive trade surpluses as these mega cities became home to low-cost export regions.

The reliable buyer of last resort, outside resources, was never China. It was and continues to be the United States.

The American consumer, if it were a country of its own, would be the largest economic base in the world. That's right — even bigger than China's entire economy.

A glance at the relative performance of Consumer Discretionary stocks show that they are on fire. Homebuilders are surging on a relative basis. Does this look like the signs of a slowing US economy?

As for China, I have pointed out before that stress levels in the Chinese economy are falling. In particular, Chinese property prices in Tier 1 and 2 cities are turning up again. Don`t forget that most of the leverage in their financial system is in real estate  (via Callum Thomas):

Should China stabilize, we may see commodity prices bottom and start to turn around - and that would also alleviate much of the angst in the emerging market economies. Jim Paulsen of Wells Capital Management recently postulated such a turnaround and indicated that commodity prices have historically slowed in mid-cycle in the past:
As we examined in an earlier research note (see the Economic and Market Perspective from August 25, 2015), a significant collapse in commodity prices during the middle of an economic recovery is actually quite common. Chart 1 shows the S&P GSCI Spot Commodity Price Index since 1970. The collapse in commodity prices since last summer is similar to past recoveries and like then, it does not suggest economic growth is about to slow.

In three of the last four recoveries (i.e., the late-1970s, 1980s and 1990s recoveries), commodity prices suffered a severe decline “during” an ongoing economic recovery. In each of these cases, the economic recovery persisted well beyond the bottom in commodity prices. Indeed, in the past, once commodity prices bottomed, the pace of economic growth accelerated and the recovery did not end until commodity prices had substantially recovered. For example, in the late-1970s recovery, commodity prices bottomed in July 1977 and the recovery did not end until January 1980. Similarly, commodity prices bottomed in July 1986 but the economic recovery continued until July 1990. Finally, commodity prices bottomed in early 1999 but the recovery did not peak until March 2001. As shown, a significant decline in commodity prices usually points to stronger rather than weaker future economic growth. Moreover, once commodity prices do finally bottom, they have typically risen throughout the balance of the economic recovery.

Although most believe oil prices (and overall commodity prices) are continuing to collapse, chart 2 suggest they have been in a bottoming process since early this year. While the spot price of WTI crude oil did collapse last year, it is currently about $45, a level it first reached in mid-January. We suspect the commodity markets are about to embark on a multi-year advance which will likely alter leadership in the economy and in the stock market.
Right now, market psychology is overwhelmingly negative and I have no idea what would turn it around. However, with an oversold market with traders at a crowded short, should evidence emerge of a nascent cyclical rebound, stock prices would respond by melting up.

I remain wary of pressing any short positions right now. Instead, I would likely be watching for signs of a capitulation low to add to my long posiition.

Sunday, September 27, 2015

A choppy bottom

Trend Model signal summary
Trend Model signal: Risk-off
Trading model: Bullish (upgrade)

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

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

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

My inner investor: Still buying weakness
This will be a somewhat abbreviated post compared to past weeks.  Not that much has changed from my inner investor`s point of view since my last post (see Why this is not the start of a bear market). To briefly recap, I analyzed the market in four dimensions and here are my conclusions:
  • Technical:  Very bearish.
  • Sentiment: A crowded short, which is contrarian bullish. Who is left to sell?
  • Macro: Mixed, mildly bullish.
  • Fundamental momentum: Was mildly bullish, but has weakened to neutral.
My conclusion was that US stock prices have limited downside and this is not the start of a bear market. My inner investor therefore remains in a buy on weakness mode.

Here are the updates.

Sentiment remains a crowded short
Virtually every few days I see another item come across my desk showing an off the charts reading in bearish sentiment. The latest comes from Mark Hulbert, who reported that a purified version of his Hulbert NASDAQ Newsletter Sentiment Index, which is "purified", or adjusted for market action, is showing extreme levels of bearishness, which is contrarian bullish.

In the meantime, Barron`s reports that "smart money" corporate insiders continue to buy heavily.

Macro fears are falling
Here is the summary of New Deal democrat`s weekly review of high frequency economics, indicating that the "forces of darkness are gathering" in the form of non-US (read: EM inspired) weakness, but the US economy remains highly robust, as exemplified by the blow-out GDP report last week.
This week marked the most stark bifurcation among the data in a long time. Consumer-related indicators - mortgages, oil and gas, jobless claims, and consumer spending - all remain positive. But those portions of the US economy most exposed to global forces, including the US$, commodities, and industrial production and transportation, have all turned firmly negative. Two out of the three employment metrics have now also turned either firmly negative or neutral. I remain focused on housing and cars. Although the forces of darkness are gathering, so long as those two most leading sectors of the US economy remain positive, so do I.
The US economy shows no signs of rolling over into recession, which would be a bull market killer. That's one key reason why I remain constructive on equities longer term.

As well, an optimistic note can be found by waning market anxiety. The St. Louis Fed Financial Stress Index has fallen three weeks in a row and it remains below zero, which is considered to be a "normal" level of stress.

Most of the stress reduction comes from falling rates of financial volatility, both in the form of bond and stock market volatility.

The source of the most recent market angst is said to come from the risk of a emerging market meltdown because of a Chinese slowdown. However, a glance at the relative performance of EM bonds show that they are outperforming US high-yield.

Bottom line, the fear of financial contagion is falling.

An uncertain Earnings Season
There is, however, a blemish starting to appear in the bull case. The latest update from Factset shows that forward EPS ticked down by -0.15% in the week after climbing steadily for the last few weeks (annotations in red and estimates are mine).

Factset also shows that the negative pre-announcements are slightly below historical norms, which could indicate that the weakness in forward EPS is part of the the warnings season game. We all know how that game is played by now. Companies guide downwards in order to lower the bar when they actually report earnings so that they can beat expectations.
At this point in time, 108 companies in the index have issued EPS guidance for Q3 2015. Of these 108 companies, 76 have issued negative EPS guidance and 32 have issued positive EPS guidance. Thus, the percentage of companies issuing negative EPS guidance to date for the third quarter is 70% (76 out of 108). This percentage is below the 5-year average of 72%.
Is falling forward EPS just statistical noise, pre-Earnings Seasons guidance or the start of a negative trend? A one week pause is no reason to panic, but it is something to keep an eye on as Earnings Season progresses.

My inner trader: A seriously choppy market
As my inner investor looks ahead bullishly to year-end and 2016, my inner trader is conflicted about short-term market direction. He believes that the market is in the process of making a bottom, much like it did in 1998 and 2011. Here are the SPX charts of that period (via Chris Ciovacco):

The patterns are similar - the stock market made an initial bottom and then chopped around for a few weeks before falling back to test the old lows. Once the second test was complete, stocks resumed their uptrend.

Given the kind of recent volatility that we have seen in the stock market, the chart of weekly prices that I usually show of my Trend Model trading signals does not come anywhere near to capturing the daily ups and downs of the market and the signal. The Trend Model was designed for trending markets, but any recent market trends has instead been replaced by a choppy market in the past few weeks in the manner of the market bottom of 2011.

The current environment has been more favorable to an approach of fading strength and weakness. I have come to rely more on the excellent charts at IndexIndicators. Short-term indicators (1-3 day horizon) such as % of stocks above their 10 dma have recently shown an oversold reading. Regardless of any signs of short-term momentum, I would be wary about pressing short positions.

Longer term (1-2 week time horizon) indicators such as net 20-day highs-lows also flashed an intra-day short-term oversold reading on Thursday.

A better representation of the choppiness of the current environment is to zoom in from a weekly price chart above with an hourly chart that pinpoints the recent trading signals of the last few days.
  • September 17: I tweeted that I was flipping from long to short on the reaction to the FOMC decision (red down arrow). 
  • September 22: I tweeted that I was scaling back my short positions as the market was getting oversold on short-term indicators (first blue up arrow).
  • September 23: I tweeted that I was taking a modest long position, as the market had become oversold on a 1-2 week view (second blue up arrow).

At the end of the week, price momentum is tilted to the downside as rally attempts failed but the market is oversold. My inner trader is in a low conviction long trade and he is watching a couple of unfilled gaps that have the potential to fill very quickly next week. If both get filled, then we could easily see a test of the SPX 2000 level. Otherwise, there is decent support at the 1900-1915 zone.

The market remains range-bound short-term and mildly oversold right now, but declines have been on high volume and advances have been on weak volume. This conditions are highly indicative that a test of the August lows is still ahead in the days to come.

The current market pattern is consistent with past market "crashes" and bottoms. If history is any guide, then we still have a few weeks of choppiness ahead before the stock market can stage an enduring rally into year-end.

Next week will feature a number of potentially high volatility events with binary outcomes. First, the Catalan elections this Sunday have been positioned by the governing party as a referendum on independence and early results indicate that the secessionists are close to a majority. In addition, John Boehner's surprise resignation as the Speaker of the US House of Representatives is a wildcard in the uncertainty leading to a possible government shutdown. Current consensus thinking suggests that Boehner will cobble together a coalition of House Republicans and Democrats to continue to funding the government, but the debt ceiling fight will be a much tougher fight later. Finally, the market will be on edge Friday as the Employment Report gets released - a much watched indicator in light of the Fed`s close decision not to hike interest rates in September.

Volatility is here to stay, at least for the next few weeks.

Disclosure: Long SPXL