Thursday, October 29, 2015

More evidence of China re-balancing

The big news out of China is its decision to end its one-child policy. For investors, however, the news is that the process of re-balancing from financial driven infrastructure growth to household and consumer led growth continues.

A couple of data points came across my desk that confirms this view. First, Capital Economics noted that the Chinese job market remains tight, which reinforces political stability and takes pressure off the urgency for economic growth at any price (via Ambrose Evans-Prichard):

In addition, I had referenced a couple of pairs trades which bought baskets of Chinese consumer oriented stocks and shorted Chinese financials (see Two better ways to play Chinese growth). Both of these pairs indicate the ascendancy of consumer sector.

As we await China's PMI release on Sunday, keep these points in mind should the data come in below consensus. Even if the growth outlook were to disappoint, growth is shifting from "bad" value-destroying growth to "good" consumer led sustainable growth. Don't freak out.

Tuesday, October 27, 2015

How I differ from Jim Paulsen

I received a query from an eagle-eyed reader in response to my bullish commodity call (see The weak USD scenario for equity bulls) in which I quoted Jim Paulsen's analysis on commodities. The reader questioned my bullishness (also see A "What's the credit limit on my VISA card" buy signal and Momentum = Risk on!) by pointing out that Jim Paulsen's latest essay shows that he is actually quite cautious on both stock and bonds. What gives?

To answer that question, let`s review Paulsen`s calls for 2015 to show how I have agreed or differed from his analysis.

Paulsen's 2015 record
Jim Paulsen of Wells Capital Management was spot on in his bearish call early this year. In an important April letter, he wrote that he was seeing signs of excessive complacency. He identified the current environment as market adherence to the long-term trend as overbought (my words, not his). Paulsen did the rolling 36-month regressions of stock prices and charted the R-squared of the regressions (the higher the R-squared, the tighter the fit). He found that current levels of R-squared is in the top decile of fit, which is consistent with the straight up stock market without a 10% correction that has been observed.

He interpreted these conditions as excessive complacency and suggested that stocks are due for a tumble. I expanded on Paulsen's work and found that the market has a tendency to weaken when the long-term price trend shows complacency and the short-term trend starts to roll over (see Why I am bearish (and what would change my mind)).

Explained more simply, an examination of the past 20 years shows when the monthly MACD histogram has gone negative, the stock market is either already in a corrective episode or about to weaken.

I am grateful to Jim Paulsen for that insight. In a September letter, he became more constructive on commodity prices. He believes that the recent period of commodity weakness is not a sign of impending recession, but a mid-cycle pause. In fact, falling commodity prices can provide a "second wind" boost to growth (my words, not his).
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.
In other words, when commodity prices fall during a mid-cycle pause, ensuing economic growth spurs demand, which lifts commodities into the final peak in the economic cycle. That`s where we are today.

I would tend to agree with that analysis, with the caveat that as commodity prices are inversely correlated to the US Dollar, we need to monitor the differential in monetary policy between the Federal Reserve and other major global central banks. That`s why I cautiously turned bullish on commodities (see The weak USD scenario for equity bulls).

Paulsen turns cautious
In his most recent letter, Paulsen has turned more cautious on the economic outlook, citing a US economy that is approaching full employment. Under these circumstances, stock and bond markets simply don`t behave well.
Historically, the stock and bond markets have done much better when the labor unemployment rate is above 5% (i.e., above full employment). Indeed, since 1948, annualized stock returns have been nearly twice as strong and long-term government bond returns have been almost four times greater compared to their respective returns when the unemployment rate is at or below 5%. Moreover, both stocks and bonds have tended to suffer more frequent monthly declines in fully employed economies. Finally, on average during the post-war era, once the unemployment rate reaches 5%, a recession has been less than two years away.
Here are the historical instances when the unemployment rate has been at or below 5%:

The bond market will not be a place to hide either, as the efficient frontier has historically shifted downward when unemployment falls this far.

In an earlier letter, he attributed the equity headwinds to rising wages, which puts pressure on operating margins. Even though companies may experience sales growth, earnings growth will be a more difficult task to accomplish.
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/earning multiples. Is a relatively modest earnings growth against a backdrop of rising inflation and higher interest rates sufficient to support the current 18 to 19 times price/earnings multiple?
Indeed, the wage pressure issue is becoming a more prevalent as an investment theme. The latest Earnings Season update from John Butters of Factset indicates that some companies are starting to discuss this issue in their earnings calls:
A number of companies have commented on the impact of higher wages on earnings and revenues as well.

“Yeah, we don't have any plans right now for any kind of a national price increase to deal with wage pressure, but we do have a number of isolated markets, a number of which are coming up in January....We had a couple of markets that had pretty significant increases in minimum wage. Generally, we're not affected by minimum wage, but in some cases, the minimum wages are being increased to $10, $11, $12 per hour, and those will have some impact.” –Chipotle Mexican Grill (Oct. 20)

“Fiscal year 2017 will represent our heaviest investment period. Operating income is expected to be impacted by approximately $1.5 billion from the second phase of our previously announced investments in wages and training as well as our commitment to further developing a seamless customer experience. As a result of these investments, we expect earnings per share to decline between 6 and 12 percent in fiscal year 2017, however by fiscal year 2019 we would expect earnings per share to increase by approximately 5 to 10 percent compared to the prior year.” –Wal-Mart Stores (Oct.14)

“Looking ahead to the December quarter, we expect non-fuel CASM to be up about 2%. Expenses related to the pay increases that go into effect on December 1 are creating about a point of pressure, while international capacity reductions are also creating a temporary headwind for CASM, as the cost takeout associated with these changes comes at a lag.” –Delta Air Lines (Oct. 13)

“Wage pressure continues to be a problem. We'll continue to monitor it as we monitor the different states and the different cities and what they're doing with minimum wage.” –Darden Restaurants (Sep.22)
Ben Carlson also identified this problem as a headwind for equity prices (via Business Insider):

I tend to agree. In fact, I highlighted this risk in a recent post (see Margin pressures = Subdued L-T equity returns).

A matter of "sequencing"
The difference between my bullishness and Paulsen`s more cautious outlook is, as Mario Draghi is fond of saying, "Sequencing." My bullish equity call is based on a combination of friendly central bankers, powerful price momentum, positive seasonality and a mildly crowded short sentiment reading into year-end and 1Q 2016. These are conditions that are suggestive of a tradeable rally for the next 3-6 months.

Looking further into 2016, however, concerns over the aging profit cycle, wage pressures and other factors, such as Hillary Clinton`s capital gains tax proposals which would likely induce some early selling in 2016 to lock in capital gains, are going to pose headwinds for equity prices.

In conclusion, I have no major disagreements with Jim Paulsen's analysis and I continue to have enormous respect for his work. Tactically, my outlook for year-end and 2016 calls for a rally into year-end and possibly 1Q, with the SPX range-bound with an upper bound of 2200-2300 on the upside and possibly 1900-2000 on the downside.

It's all a matter of sequencing.

Sunday, October 25, 2015

Momentum = Risk-on!

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

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

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

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

Central bankers throw a party
The Trend Model is designed to spot global trends in risk appetite. As shown by the above chart of past signals, the model was fortunate to have caught the risk-on trend a few weeks ago. Now the central bankers have decided to join the party.

Last week, we saw the PBoC cut rates, which sparked a rally in commodity prices and troubled miner Glencore melted up by 10% on the news. In addition, ECB head Mario Draghi hinted at further QE in December (via The Guardian):
Speaking after the ECB’s latest policy meeting in Malta, Draghi revealed that some members of the governing council had favoured taking more action to stimulate the economy immediately. He blamed the slowdown in emerging markets, including China, for renewed weakness in the eurozone.

“While euro area domestic demand remains resilient, concerns over growth prospects in emerging markets and possible repercussions for the economy from developments in financial and commodity markets continue to signal downside risks to the outlook for growth and inflation,” he said in his opening statement.

Draghi said the ECB could also step up the scale of QE. A decision is likely to be made at the December meeting of its governing council, when its latest economic forecasts will be available. As Draghi spoke, the euro dropped by 1.5 cents against the dollar, to $1.117.

“The governing council is willing and able to act by using all the instruments available within its mandate, if warranted, in order to maintain an appropriate degree of monetary accommodation,” Draghi said.
Less noticed was the Federal Reserve, but it wasn't left out of the festivities either. Vasco Cúrdia of the San Franciso Fed recently published research indicating that the "natural rate" of interest is -2.1%, which gives cover for the doves to argue that with interest rates at the zero bound, Fed policy is actually quite tight (emphasis added):
Figure 1 shows that the natural rate declined substantially during the recession and did not start to recover until the end of 2014. Currently, the median estimate is –2.1%, far below its long-run level of about 2.1%. The fall in the natural rate during the recession is explained by low expected productivity growth. With projected low growth, the economy would need less saving and more spending to use resources fully, hence the lower natural rate of interest. During the economic recovery, the natural rate was kept low by weak demand due to a larger propensity to save in the aftermath of the financial crisis.

Blue shaded areas represent the range of possible estimates with 70% (darker) and 90% (lighter) probability. Gray bar indicates NBER recession dates.
Cúrdia concluded:
This Letter suggests that the natural rate of interest is expected to remain below its long-run level for some time. This implies that low interest rates over the next few years are consistent with the most efficient use of resources and stable inflation. The analysis also finds that the output gap is expected to remain negative even after the natural rate is close to its long-run level. Additionally, there is considerable uncertainty about both the short-run dynamics as well as what level should be expected in the longer run. All these considerations reinforce the possibility that interest rate normalization will be very gradual.
This research may be more than just a trial balloon. CNBC reports that Cúrdia has worked closely with Michael Woodford, who made a big splash at Jackson Hole in 2012 with his paper entitled Methods of Policy Accommodation at the Interest-Rate Lower Bound, which had a profound influence on central banker thinking.
Neil Azous of Rareview Macro points out that Curdia has worked closely with Michael Woodford, "who is widely considered to be the strongest consultant to the Federal Reserve for quite some time, and he's sort of the backbone to modern monetary policy." Further, the San Francisco Fed is "the academic arm of the entire system, and Janet Yellen came from the San Francisco Fed, so it's given additional credence."
When you combine the Cúrdia paper with the extraordinarily dovish speech by Fed Governor Lael Brainiard, which Tim Duy characterized as a "direct challenge to Chair Janet Yellen and Vice Chair Stanley Fischer", you have the potential for lots of fireworks at the next couple of FOMC meetings, particularly if Yellen wants to form a consensus about interest rate policy. We will have better clarity of this issue resolves itself as the FOMC meets this week. Stay tuned!

Momentum, momentum!
As well, equity price momentum is manifesting itself in a big way. Mark Hulbert pointed out that stocks are entering a period of positive seasonality, when the "sell in May" six months is expiring. Further, his found that momentum enhances returns. Stocks tend to do much better when they rise during September-October period (emphasis added):
These already-impressive statistical odds become even better when the stock market is able to buck the seasonal odds and eke out a gain over the September-October period — the last two months of the seasonally unfavorable summer period. That’s exactly what’s happened this year, with the Dow currently 5% higher than where it stood at the end of August.

For example, according to a Hulbert Financial Digest analysis of the Dow back to its creation in the late 1800s, the Dow produced an average Halloween-through-May-Day gain of 4.0% whenever the market was a loser over the two months prior to Halloween.

When it was a gainer, in contrast, the Dow’s subsequent Halloween-through-May-Day gain was 6.8%. This difference of 2.8 percentage points is significant at the 95% confidence level that statisticians often use to determine if a pattern is genuine.
David Lutz also pointed out that share buybacks tend to be especially heavy in November and December, which creates a tailwind for stock prices (via Business Insider):

The Zweig Breadth Thrust off the bottom set in August is a also confirmation of the positive price momentum effect on stock prices (see my previous posts Bingo! We have a buy signal! and The Zweig Breadth Thrust as a case study in quantitative analysis). Consider what has happened in recent ZBH signals in the last 20 years, though the sample size is small at three. Here is 2009, when the stock market melted up after the March 2009 bottom and never looked back.

The 2011 ZBT saw a minor pullback after the ZBT, but any bull will take that if the 2011 experience is the worst case scenario:

We also saw a ZBH in 2013. The market saw a period of minor consolidation and pullback and then experienced a small correction a couple months later, but the main trend was up.

I want to address the issue of poor small cap performance during this rally. Several readers have voiced concerns about how small caps have lagged during this period of strength. The chart below of the relative performance of the Russell 2000 during past ZBT is somewhat inconclusive. True, small caps led the way up in 2009 and 2011, but they initially tanked, on a relative basis, in 2013 but later recovered. Could the current episode parallel 2013? This is a situation that needs to be monitored, but there is no need to hit the panic button.

An examination of breadth behavior during past ZBTs is also instructive. The chart below shows the NYSE Common stock only Summation Index (middle panel) and the more commonly used NYSI in the bottom panel. I have also overlaid a stochastic on the former indicator. Currently, the stochastic shows that this indicator is overbought, but the record on past overbought conditions has been mixed. The Summation Index became overbought in 2009 but did not pause; it became overbought in 2011 and did pause and consolidate; but this index did not even get overbought in 2013. One theme that did show up in all of this analysis is that breadth continued to trend upwards after ZBTs, which is better shown in NYSI (bottom panel), though that condition was also evident in the common stock only Summation Index as well.

If history is any guide, it shows that the path of least resistance for stock prices is up, at least into year-end.

Poised for a FOMO rally
The combination of positive price momentum and what was a crowded short is also setting the stage for a short-covering FOMO (Fear of Missing Out) rally. The latest data from Rydex show that retail traders and investors moving off a crowded short position, but readings are nowhere near neutral yet. This indicates a high potential for more panicked buying should momentum continue to carry the day.

In addition, the NAAIM Exposure Index shows that RIAs actually increased their bearishness even as stocks rallied last week. With year-end coming up, there will be a lot of advisors with a lot of explaining to do should stocks continue rising. If and when they throw in the towel, the market will see more melt-up stampedes.

Key risk: Earnings
To be sure, this is not a universal picture of rainbows and unicorns for the bull camp. The latest update from John Butters of Factset show that Street forward EPS estimates continue to fall.

Analyzing the internals further, figures from Ed Yardeni showed that most of the declines came from cyclical sectors, namely Energy and Materials, with a minor contribution from Industrials.

Here is a closeup of the evolution of forward EPS of the three sectors in question:

However, the relative performance of cyclical sectors indicate that Mr. Market appears to be discounting a scenario of global reflation (see above comment about central bankers throwing a party). I would therefore temporarily discount any concerns about falling EPS and give the bull case the benefit of the doubt (for now).

The week ahead
As I look to the week ahead, the SPX rallied through its 200 day moving average (dma) on Friday on a show of strength. RSI(5) is showing a series of "good" overbought readings, where overbought conditions beget more overbought conditions, and RSI(14) is trending upwards but not overbought yet.

Visually, the market appears to be extended, but breadth readings are not showing extreme overbought conditions. This chart of stocks above their 10 dma from IndexIndicators is not especially overbought on for an indicator with a 1-3 day time horizon.

Using the net 20 day highs-low indicator, which is useful for a 1-2 week time frame, the market doesn't appear to be very overbought when viewed in the context of a rally off a corrective bottom like 2011.

In conclusion, the combination of friendly central bankers, powerful price momentum, positive seasonality and a mildly crowded short sentiment reading all suggests that the path of least resistance for stock prices is up. Even in the short-term, the market doesn't appear to be especially overbought in the context of the momentum rally. Should the market pause and consolidate, pullbacks are likely to be shallow and mild.

Both my inner investor and inner trader therefore remain bullish on equities, with a particular emphasis in beaten down cyclical sectors and industries.

Disclosure: Long SPXL, ERX

Saturday, October 24, 2015

A growth plan for Canada

I try to remain apolitical on this blog, but for your weekend reading, here is my analysis of the challenges for the new government and my thoughts on the way forward.

On Monday, Canada elected a centre-left Liberal government, with Justin Trudeau as the new Prime Minister. Expectations are high and they are likely to come down to earth in the next few years. Bloomberg recently highlighted analysis by HSBC Canada David Watt of the challenges facing the Trudeau government:
"Until Canada overcomes its productivity and competitiveness hurdles, it will continue to feature cyclical behaviors similar to those of emerging-market economies," Watt wrote.
Watt had the same reservations about productivity that I did (see my past post, Uh-oh, Canada!):
In his report, Watt joins some of his peers in arguing that an economic acceleration south of the Canadian border doesn't pack the same punch it once did. Bank of America Merrill Lynch Canada and U.S. Economist Emanuella Enenajor has detailed how Canada's sensitivity to U.S. domestic demand has been on the decline, while Steven Englander, Citibank's global head of G-10 currency strategy, has connected the subdued performance of Canada's non-energy exports to the ascendance of Mexico in U.S. manufacturing. Mexico now benefits handsomely from its proximity to the U.S. and enjoys its position as an integral part of many supply chains.

Canada's weakened currency has helped the nation increase its cost competitiveness with the U.S., Watt acknowledges, but hasn't significantly shifted the calculus.

Generally speaking, HSBC economists have found little evidence of exchange rate depreciation fueling export growth since the financial crisis. And some contend the weak exchange rate actually impedes productivity growth. The increase in competitiveness through lower labor costs masks productivity shortcomings, while the soft domestic currency makes importing such materials more expensive, the thinking goes.
As an investor, I would like to see the government, any government, take steps to boost Canadian competitiveness. The "old" ideas of the former Conservative government of "get government out of the way of business" only goes so far.

The Harper-led Conservative government cut taxes and shrank services in the last 10 years, but the market did not show the desired response. A BCG study showed that Canadian manufacturing costs becoming uncompetitive with its NAFTA partners, the US and Mexico. Let's call the Harper small government plan Growth Plan 1.0.

Indeed, Macquarie recently called for a minimum target on the CADUSD exchange rate of 69c in order for Canada to be competitive:

The Liberals campaigned on a plan of running modest deficits to invest in infrastructure and stimulate growth. Call that Growth Plan 2.0. (Incidentally, I believe that one of the failures of the Tory campaign is to properly explain why deficits matter. The Trudeau plan of borrowing when the market will lend you money at 2% or less to invest in growth producing infrastructure is arguably sound.) While Growth Plan 2.0 is certainly an improvement over 1.0, the Liberal approach is very Keynesian. Though it will undoubtedly provide a short-term boost, it doesn't address long-term productivity issues facing Canada.

Growth Plan 3.0
What we need a Growth Plan 3.0 that focuses on improving productivity and innovation, which leads to sustainable quality growth. We don`t need the same-old-same-old innovation solutions of research and development tax credits, nor will the tired approach of squeezing labour costs in export industries like autos be sustainable in the long-run. It only leads to playing the game of competing with Emerging Market economies, where Canadian workers get paid at EM wages scales.

We need to think outside the box. As an example, Michael Porter showed back in the early 1990`s that Germany was able to remain a high wage country but enjoyed good growth. The secret was to create higher value-added jobs, rather than to compete with low-wage countries engaged in low value-added manufacturing.

A cheap but effective method might be to adopt the American model of the DARPA challenge to jump-start innovation. A senior DARPA official explained it this way:
DARPA’s role is to spur innovation. And we do it by focused, short term efforts. We pick things that are not impossible, but also not very low risk. So we take very high risk gambles, and those risks have tremendous payoffs. So if we’re successful it means that these robots are actually going to be able to make a difference. In particular, in disaster scenarios making society more resilient. The lesson of the original challenge [DARPA Grand Challenge - driverless cars] is that persistence pays. It’s important if you know the technology is almost there and you can sort of see the light at the end of the tunnel, a little bit of persistence will pay off. What I’m hoping for in the trials is that some of the teams will score some points. I don’t think that any team is going to score all the points that there are. Maybe no teams will even score half the points that there are. But I think some teams will do moderately well. My expectation is that the robots are going to be slow. What we’re looking for right now is for the teams to just do as well as roughly that one year old child. If we can get there, then we think that we have good reason to believe that some of these teams with continued persistence for another year will actually be able to demonstrate robots that show the utility that these things might have in a real disaster scenario. DARPA is in the innovation business, not in the development business. So, what we do is we wait for technology to be almost ready for something big to happen, and then we add a focused effort to catalyze the something. It doesn’t mean that we take it all the way into a system that’s deployed or to the marketplace. We rely on the commercial sector to do that. But we provide the impetus, the extra push the technology needs to do that.
Using a Michael Porter framework of development economics, the intent of a DARPA challenge is to create clusters of expertise. There is no point in trying to re-create Silicon Valley in your own back yard, but you can focus on specific industries that are already clusters of expertise in your regions. Examples include autos in southern Ontario, aerospace in Quebec, oil service and exploration in Calgary, mining in British Columbia and so on.

The federal government could create Canada Council administered DARPA challenge-like prizes aimed at specific problems in targeted industries, e.g. nano materials technology for the auto or aerospace industry, to encourage universities to take the lead in research. If a breakthrough were to occur, then the existing private-public partnership structures already in place at the universities can do the rest. Such an approach would be a low-cost way of encouraging innovation that highlight Canadian expertise.

Imagine, for example, if UBC became a global leader in earthquake-proofing buildings. It would create an engineering industry and expertise in the region that would be second to none. It would mean good jobs that would have no worries about competing with low labour cost countries like Mexico. What would that kind of growth be worth?

Is there anybody listening?

Wednesday, October 21, 2015

How Valeant revealed the dirty little secret of fund management

How would you feel if your equity fund manager lagged the index by 5% in a year? Supposing that you hired the manager, or bought his fund, as part of the diversified equity portion of your portfolio and he missed by 5% in a year. Let's say that you be patient, then he underperforms by another 5% in the next six months. Would you fire someone who lags the market by 10% in 18 months?

Returns vs. business risk
I have met people who say that they love managers who hit the home run and loathe benchmark huggers, but investors get very nervous when their managers lag the market by as little as 5-10% in a relatively short (1-3 years) time frame. From the perspective of the manager, this level of risk tolerance brings up the issue of business risk. How do you maximize performance using your process, or "secret sauce", without taking on excessive business risk that sinks the entire firm?

Risk comes in all shapes and sizes. For an equity portfolio, common sources of risk are sector and industry risk, market cap risk and stock specific risk. To illustrate my example, consider the lowly issue of stock specific risk, which should be diversifiable (at least according to theory).

The recent case of price volatility in Valeant Pharmaceuticals (VRX) is an instructive example in risk control. In the past few weeks, I have spoken to a number of Canadian portfolio managers whose performance was blindsided by specific risk from that one single stock, The outlook for VRX is highly divisive and talking about it is the equivalent of bringing up touchy topics like religion or gun control in polite company. (Incidentally, I have no opinion on the stock.) The chart below depicts the price of VRX in the top panel and the TSX-VRX ratio in the bottom panel, which shows what would have happened to relative performance had a manager had no position in VRX for the past few years.

Despite the fact that the stock got hit today, VRX has shown remarkable returns in the past few years. In the space of about 5 years, the stock has become a 10-bagger and anyone who didn't own it would have underperformed the index (bottom panel). Consider the following effects for a manager who did not hold VRX:
  • If he didn't own it at the end of 2013, relative return shortfall would be over 8% when VRX hit its peak this year. For some investment organizations, that kind of shortfall could be a near-death experience.
  • Even with the pullback, relative performance shortfall would only be back to 2013 levels and he have not made up for the shortfalls in the previous years.

The art of business risk management
The analysis brings up a key question for the business risk for investment management operations. Yes, we would all like to have the courage to bet our investment convictions, but how much business risk is the practice willing to take? Supposing that an operation were to lose half its clients because of a single decision on a stock, what does that do to the bottom line? Revenues would go down by about 50%, but there are fixed costs such as rent, salaries, systems, legals, etc. Profitability would plunge in such an instance, is the investment management business willing to take that kind of risk?

If not, then there are a couple of steps a manager can do. First, he has to decide the appropriate level of stock specific risk he is willing to take against the benchmark. Supposing a stock has a 3.5% weight in the benchmark, would you hold a 0% if you ranked it a "sell" (-3.5% bet), a non-zero weight, such as 2.5% (+/- 1% vs, benchmark) or 1.5% (+/- 2% vs. benchmark)? On the other hand, if your ranked it a "buy", would a 5.5% weight (+/- 2% vs. benchmark) be appropriate? What about 8.5% (+/- 5% vs. benchmark)?

Another way of approaching the problem would be to try and determine the median competitor weight in the stock (with techniques that I have written about before). Then set benchmark weight to be the median competitor weight instead of the index weight.

I show this example as just how a simple decision on a single stock can crash an entire investment management practice. I haven't even gone into all the other ways that risk can rear its ugly head, such as macro factor, sector, size and so on.

Asking too much of managers?
This post also illustrates the dirty little secret of fund management. Investors are asking too much of managers and managers are consequently reacting rationally by closet indexing.

Investors have to ask themselves: How much rope are you willing to give a manager to succeed? Is John Hussman flaming out, or is he a brilliant thinker going through a bad patch? Other well-known managers like Bill Miller and Ken Heebner have had their ups and downs, how patient are you willing to be? If you have a low level of patience, then you are forcing managers to become benchmark huggers because you are not giving them enough room to win.

For managers: Given the realities of the market, how much risk are you willing to take so you don't crash your firm?

Tuesday, October 20, 2015

Two better ways to play Chinese growth

The WSJ recently featured an article about the silver lining in Chinese growth. Even though the GDP growth rate had fallen below 7% to 6.9%, there was evidence of rebalancing away from the same-old-same-old lending based model of infrastructure spending to the household sector (emphasis added):
There is robust growth in China if you know where to look, some contrarian investors believe.

Monday’s gross-domestic-product report offered the latest sign that the world’s second-largest economy is slowing. But the gloom is overdone, said some portfolio managers who are focusing on the nation’s booming service sector.

Their purchases amount to a bet on Beijing’s efforts to engineer an economic rebalancing, toward a consumer-led, service-driven economy from one dominated by manufacturing and trade. While slowing Chinese economic growth and declines in the country’s use of materials such as copper, nickel and cement have rippled through financial markets, some traders say some less-publicized metrics paint a more upbeat picture.

To name a few, box-office sales are up more than 50% this year, Internet traffic through mobile devices has nearly doubled and railway passenger traffic and civil aviation are increasing steadily, government data show.

The most recent numbers highlighted the Chinese economy’s increasingly dual nature. China reported its economy expanded at a 6.9% annual rate in the third quarter, its slowest pace since the global financial crisis. At the same time, the services sector expanded 8.4%, accounting for more than half of China’s GDP growth for the first time, according to official statistics.
For years, US investors have either bought FXI or commodity related vehicles as a way to play Chinese growth. Now that there is growing evidence of growth rebalancing, those vehicles may not be the most appropriate anymore.

Consider this chart of two "New China" vs. "Old China" pairs.

The first is a long position in PGJ (NASDAQ Golden Dragons Index) vs. short position FXI (FTSE China 50), which is depicted in black. The Golden Dragons Index is far more heavily weighted in consumer services and technology, which are also consumer e-commerce oriented (think Baidu, etc.), while the FTSE China 50 Index is tilted towards financials, which represent "Old China" finance and infrastructure plays.

The second pair is a long position in CHIQ, Global X China Consumer ETF, and a short position in CHIX, Global X China Financials ETF, depicted in green.

In both cases, these pairs tell the story of progress of growth rebalancing towards the consumer sector of the economy. Even if you don't want exposure to China, monitoring these pairs is a useful way of seeing how rebalancing is progressing in real-time.

Sunday, October 18, 2015

The weak USD scenario for equity bulls

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

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

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

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

Climbing a Wall of Worry
The news doesn't look good from Earnings Season, according to John Butters of Factset . While the preliminary earnings beat rate is 81%, well above the five-year average of 72%, the revenue beat rate stands at 50%, which is below the historical average of 57%. More importantly, forward EPS estimates are falling, yet stock prices are rising. What gives?

I believe that equity prices are rising for two reasons:
  • Positive trend and momentum, which is technical; and
  • The market discounting the positive effects of a weaker USD.

Is the bad news in the market?
The bad news is starting to accumulate. New Deal democrat's weekly review of high frequency economic data shows that the US economy is feeling the effects of a shallow industrial recession, though his long leading indicators are not forecasting any weakness in 2016:
There are two developments going in opposite directions. While industrial production is still in a shallow recession, inventory is no longer being accumulated, although it is not being disposed of yet. This suggests weakness is not getting worse, although the weakness will continue. That, presumably, will include near term weakening of employment.

And employment is really coming into focus. Tax withholding has gotten much more mixed since the beginning of August. Temporary staffing has gotten worse. Monthly payrolls have been weak for the last two months. At the same time, new jobless claims are at historic lows. Typically hiring slows down or stops before layoffs increase, and it seems that's where we are. So I expect the weakness in employment to continue and maybe intensify until the inventory correction is worked through.
The latest Factset forward EPS data shows that forward 12 month EPS is still falling, which is another bearish sign (annotations in red are mine):

Momentum to the rescue
In my post last week, I suggested that the recent risk-on rally is an indication that Mr. Market telling us that he is looking over the valley of temporary weakness. Indeed, volatility has dropped like a rock. Remember those dark days of September when we couldn't go 2-3 days without an overnight swing of 1% or more? Those days are gone.

Charlie Bilello recently presented analysis indicating that stock prices have a positive bias after a precipitous drop in the VIX Index:
Over the past 10 trading days, the VIX Index has fallen over 41% (from 27.6 to 16.2), one of the steepest 10-day drops in history. Only the collapse in volatility last October saw a larger decline.

I believe that the current rally is likely to continue on an intermediate term basis. As regular readers are aware, my Trend Model uses inter-market analysis to determine stock market trends - and the trend is turning up. The chart below shows that market strength has not just been isolated to the US. Global stocks, US stocks, eurozone and British equities have all recovered to regain their 50 day moving average (dma).

What about China? Remember how spooked everyone was about Chinese weakness in September? The equity markets of China and her Asian trading partners have also rallied and regained their 50 dma.

In addition, commodities have started to turn up as well, aided by a softer tone in the USD, which is inversely correlated to commodity prices:

As the above chart shows, the USD Index violated an uptrend and underwent a "death cross" last week. There is a decent support zone in the 93-94 area. If that is breached, then we are likely to see further greenback weakness. From a macro perspective, near-term USD weakness is likely due to a dovish Fed (see the latest Hilsenrath article) and emerging strength in China and Europe.

Watch the USD!
The near-term behavior of the USD represents the key to further stock market strength. As we progress through Earnings Season, one of the refrains that investors will hear again and again is how a strong USD posed headwinds to earnings and margins.

For a slightly different perspective on the underlying fundamentals of Earnings Season, I turn to Jonathan Golub of RBC (via Business Insider):
RBC Capital Markets' Jonathan Golub illustrates this tweak and goes one step further noting that companies historically beat expectations for earnings growth by about 4 percentage points.

"Current projections indicate a 4.2% decline in 3Q SP 500 EPS, largely the result of Energy weakness (EPS -64% YoY)," Golub wrote on Monday. "Assuming an historical 4.0% beat rate and excluding Energy, trend growth should come in between 7-8%, shown below."

In other words, 3Q earnings growth won`t be that bad if we apply a historical beat rate to the ex-energy component of the market. New Deal democrat more or less said the same thing when he analyzed industrial production ex-energy:
Manufacturing (blue) continues to be in an uptrend, although it is slightly off (-0.3) of its high two months ago, which is actually pretty darned good considering the strong dollar.

Yes the US is in a shallow industrial recession. But it is focused and limited, and hasn't translated into any downdraft in the consumer economy (see: real retail sales) which is 70% of the total.

The bullish implications of USD weakness
So what would happen if the USD weakened and energy prices turned up? To put some numbers on that scenario, a Bloomberg interview with strategist Tom Lee indicated that USD strength subtracted about $10 from SPX earnings and the drop in oil prices subtracted about $7. So let's do some back of the envelope calculations. Supposing that USD weakness and commodity strength reverses about half of the $17 earnings shortfall in the next 3-6 months. Applying a 16x multiple to those recovered earnings, we get an SPX target price of 2170, or a gain of about 7%.

Wow! An SPX all-time high is well within reach.

Jim Paulsen of Wells Capital Management has been recently spot-on on market direction. I cited his work when I turned equity bearish in the spring (see Why I am bearish (what would change my mind)). Paulsen has called for a commodity rally. He believes that the recent period of commodity weakness is not a sign of impending recession, but a mid-cycle pause. In fact, falling commodity prices can provide a "second wind" boost to growth (my words, not his).
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.

From a technical perspective, the recent bout of commodity weakness appears to be overdone and they are due for a bounce. The chart below of the 20-year relative performance of the CRB-SPX ratio shows that commodities are in a relative downtrend when compared to stocks, but the ratio recently saw a positive RSI divergence indicating that they are poised for a relative rally. While I am not postulating the start of a new commodity bull, the CRB-SPX can rally up to test the downtrend line (see red arrow).

Emerging market equities, which are correlated to commodities, are displaying a similar pattern, though the EM-SPX ratio did not show a positive RSI divergence.

The biggest upside potential comes from the energy sector, as shown by this crude oil-SPX relative performance chart, largely because oil prices have cratered badly:

The oil stock-SPX ratio chart also tells the same story:

A change in leadership
Indeed, we are starting to see a change in market leadership. The old market leaders of Financials and Healthcare stocks have started to falter, as shown by this relative return chart. Only Consumer Discretionary stocks remain in a relative uptrend.

The emerging leadership are cyclical stocks that are sensitive to USD weakness, such as Industrials, Technology, Materials and Energy.

I do want to make one point clear. My call for USD weakness and commodity price rally is a tactical one with a time horizon of one or two quarters. It is definitely not a forecast of a revival of a secular commodity bull, especially in oil. As this analysis from FT Alphaville shows, oil extraction technology has improved dramatically as any sustained rise in oil prices will be met by a tsunami of new supply coming onto the market.

In the meantime, stock prices can grind higher. As this chart shows, the weight of the old leadership in the SPX is 44.0%, while the weight of the new leadership is 40.2%. If the American consumer can continue to spend and Consumer Discretionary stocks hold up, then there is no reason why the SPX cannot rise to further highs as over half of the sectors by weight will be in relative uptrends.

Watching for the "good" overbought readings
Last week, I postulated that stocks would continue to rise, but may see some short-term consolidation and pullback early in the week (see A "What's the credit limit on my VISA card" buy signal). That scenario has played out well so far. I also suggested that market rallies off Zweig Breadth Thrusts are often accompanied by a series of "good" overbought readings, where the market gets overbought and stays overbought.

At the end of the week, this chart from IndexIndicators shows that the market has pulled back slightly off its near-term overbought readings. If the theme of price momentum were to prevail, then the temporary consolidation early last week could propel stocks higher.

The SPX is approaching overhead resistance at the 2040 (past support now turned into resistance) to 2060 level (the 200 dma). RSI(5) is starting to show those "good" overbought conditions, though RSI(14) is not yet overbought. Last week was option expiry week, which tends to have a bullish bias, but weeks following OpEx have a tendency to mean revert and weaken.

My inner trader averaged into long positions in SPX and energy stocks early last week. He expects that any pullbacks will be shallow and he is betting on momentum to carry the day.

My inner investor is also long and expects that this is a start of a rally into year-end.

Disclosure: Long SPXL, ERX