Sunday, August 20, 2017

Imagining the next bear market

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.



The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Neutral*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


What will the next bear market look like?
Recently, Lawrence Hamtil of Fortune Financial wrote an article entitled "Imagining the next bear market (with examples from the last two)". He analyzed the effects of sector performance, large and small cap returns, asset correlations, and other characteristics of the last two two equity bears.

While that kind of analysis represents a good starting point, we know that history doesn't repeat, but rhymes. With that in mind, here is an examination of the stress points of the next bear market, based on the assumption that it is sparked by a recession.

My main focus estimating equity downside risk. What will the next bear market look like (chart bars =annual returns, dots=annual drawdowns)? Will the recession be mild (1990), or long and protracted (1980-82, 2000-02)? Will the market crash? If so, will it be accompanied by a recession (2008) or not (1987)?


Recessions are periods when the excesses of the past expansions are unwound. Arguably, there have been few excesses in the current expansion except for the proliferation of Silicon Valley unicorns. That argues for a shallow bear market with a drawdown in the order of 20%, such as 1990. On the other hand, the excesses have occurred outside the US (see Looking for froth in the wrong places), which makes the case for higher losses if the economic downturn is global.

The answer can be found by analyzing the fault lines of the economy today for clues of how the next recession might develop.

The full post can be found at our new site here.

Thursday, August 17, 2017

A summer reading list

I will be off for a few days in Oregon, where I will (hopefully) observe the Great American Eclipse of 2017. The regular weekend commentary will continue to be published, but posting will be lighter than usual as internet access is expected to be spotty.

Before I leave, I leave you with a summer reading list. I have been asked in the past to suggest books on how to invest and trade. My answers are a bit more offbeat than the usual recommendations to read Market WizardsThe New Market Wizards, or Fidelity Low-Price Stock PM Joel Tillinghast's book, Big Money Thinks Small (see Barron's interview).

The purpose of this site is to teach readers how to fish. No book is going to make you the next Warren Buffett or Paul Tudor Jones. I am going to make you work and expend some effort to catch your fish in your reading.


The basics
Let`s start with the basics. Even before thinking about investing, consider the basics of financial literacy and why you need a financial plan. Here are some blog posts of value, including some old posts of my own.

Freakonomics: Everything you wanted to know about money (but were afraid to ask). Can you correctly answer three basic financial literacy questions? If not, you should start with the 10 things you need to know about investing that fit on an index card.

Humble Student of the Markets: The ABCs of financial planning. Do you have an Investment Policy Statement? If not, how will you know where you are going if you don't have an objective? Put simply, if the term investment plan sounds overly intimidating, think of it as a savings plan.

Humble Student of the MarketsInvestment policy: Not just for pension funds. Once you have figured out where you are going, here is an example from CALPERS on how to create an investment road map.

A Wealth of Common Sense: Thinking through a change in asset allocation. Once you have an investment plan, Ben Carlson goes through on how to create a process on thinking through changes.

A Wealth of Common Sense: Reframing the concept of risk. Risk is everywhere. Carlson puts it very simply, "Don't over-react to events."


Corporate strategy and fundamental analysis
For a primer on corporate strategy, there is no better place to start than with Michael Porter. Porter is known as the guru of corporate strategy. His books Competitive Advantage and Competitive Strategy are must-reads and taught in virtually all B-School programs. However, Porter acknowledged that his list of competitive advantages, however, are static advantages and shifts can occur. He evolved by detailing how the shifts occur at a macro level in The Competitive Advantage of Nations.

For investors interested in how disruptions happens, Blue Ocean Strategy represents a newer line of thinking in corporate strategy. Authors W. Chan Kim and RenĂ©e Mauborgne argue that companies can succeed by creating "blue oceans" of uncontested market space, as opposed to "red oceans" where competitors fight for dominance, the analogy being that an ocean full of vicious competition turns red with blood. They assert that these strategic moves create a leap in value for the company, its buyers, and its employees while unlocking new demand and making the competition irrelevant. The book presents analytical frameworks and tools to foster an organization's ability to systematically create and capture blue oceans (via Wikipedia).

Do you want to find undervalued companies and takeover candidates? Try this useful handbook of how companies work financially: Best-Practice EVA: The Definitive Guide to Measuring and Maximizing Shareholder Value. The book is an eye opener and details how companies add shareholder value. More importantly, the Economic Value-Added (EVA) framework details where the cash flow goes in a company. In turn, it lends to an understanding of corporate restructuring process by private equity investors. In the process, investors can discover hidden gems and takeover candidates where private market value exceeds publicly listed value.


Top down analysis
Regular readers know that I have a global big picture macro focus. Here are some important books that have formed my views of how societies develop. Unless you understand the development process, you won't be able to construct an analytical framework and react properly when shocks like the Great Financial Crisis, or the Asian Crisis occur.

The Competitive Advantage of Nations. Michael Porter lays out how countries go through the stages of development, and the kinds of policies that work at each stage of growth.

The Economy of Cities and Cities and the Wealth of Nations: Principles of Economic Life. Jane Jacobs was a leading researcher in how cities develop. Jacobs' views on development are very similar to Porter's, except that her unit of development is the city-state, instead of country, which is Porter's framework.



Personal journeys in technical analysis
Finally, we get to the good stuff (for traders)! I am going to disappoint many readers here. There is no magic black box to trading. Everyone has to develop their own style. Books like Market Wizards will not instantly make anyone a better trader. Instead, I have suggested to readers that they enroll in the Charter Market Technician program. Start by learning the basic body of knowledge, then develop your own style.

That said, here are some examples of books written by a couple of readers that undertaken their own journey of market analysis.

Mind, Money and Markets: A guide for every investor, trader, and business
Authors Dave Harder, portfolio manager, and Janice Dorn, a psychologist, have put together a book that combines human psychology with market analysis. The book has received positive reviews from the likes of James P. O’Shaughnessy, money manager and author of What Works on Wall Street, Predicting the Markets of Tomorrow, How to Retire Rich, and Invest Like the Best; Robert McTamaney, Former Partner and Head of Trading, Goldman Sachs Asia; Robert Sluymer, Technical Analyst, RBC Capital Markets; and John Gray, Editor, Investors Intelligence.

The Pathway
Author and portfolio manager Ken MacNeal uses a unique technique that uses price momentum for his clients. While I don't always agree with his conclusions, I respect his approach and insights. Ken describes his book this way:

'The Pathway - Your money ... in a changing world' tells why Momentum-style investing is the best strategy to navigate the new factors, with unknowable outcomes, affecting financial markets today: the digital revolution, globalization, new Central Bank policies like negative interest rates, Middle East politics, Donald Trump, to name a few. Momentum points you mathematically to the winning sectors and companies while as importantly, avoiding the casualties. You are also given the tools to invest; customized momentum charts of over 500 industry ETFs and the largest companies in them. These are dynamically linked to the internet and update automatically when viewed.

These are just some samples of journeys that others have taken. The CMT program as a good way of learning the basics, and then you can find your own path.



Regular programming will resume next week. Please keep everything together while I step out (and, please, don't shoot any Archdukes while I am gone).

Wednesday, August 16, 2017

Bought for a good time, but not a long time

Mid-week market update: Last Friday, subscribers received an email alert indicating that the trading model had flipped from short to long. In my weekend commentary (see "Fire and Fury" is hard) that my inner trader expected "the time horizon of that trade to be not much more than a week."

I am reminded of the Trooper song, "We're here for a good time, not a long time" when referring to this trade. On one hand, the relief rally has been impressive. Both my VIX model and Zweig Breadth Thrust Indicator had flashed deeply oversold conditions (see Three bottom spotting techniques for traders). If history is any guide, the duration of the rally should last, at a minimum, until Friday or Monday.

On the other hand, breadth indicators are not showing the bulls any love. The chart below shows negative divergences in credit market risk appetite, % bullish, % above 50 and 200 dma, In particular, the latter three indicators are exhibiting bearish patterns of lower lows and lower highs.



Looking into September, the stock market faces a number of macro headwinds that could serve to further depress prices.

The full post can be found at our new site here.

Sunday, August 13, 2017

"Fire and Fury" is hard

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.



The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bearish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


War is hard
President Donald Trump has achieved few major legislative victories in his six month presidency, despite the Republican majority in both the Senate and House. One disappointment was the failure of the Republicans to repeal Obamacare because of disagreements between different wings of the GOP. Trump has learned that "healthcare is hard". Similarly, "tax reform is hard".

By design, American government was built on a system of checks and balances. While Trump's legislative initiatives may be held up by Congressional dissension, the President has far fewer constraints in the conduct of trade policy, foreign policy, and military affairs. In particular, he can do more or less what he wants without Congressional oversight when it comes to his role as Commander-in-Chief of the American military.

As the markets are gone risk-off in light of Trump's "fire and fury" comment about North Korea, I am going to depart from the usual economic and market analysis this week and focus on the question of the constraints on President Trump in a conflict with North Korea. To be sure, the markets are showing a high degree of fear that war could break out on the Korean peninsula. Past scares has seen little reaction from the Korean Won (KRW) or Korean equities. This time, South Korean stocks are tanking, both on an absolute basis and relative to global stocks.



Investors should relax. As Donald Trump is about to find out, "War is hard too".

The full post can be found at our new site here.

Wednesday, August 9, 2017

Correction ahead:

Mid-week market update: Narrow trading ranges are often technical signs of sideways consolidation, followed by further upside. In this case, bulls are likely to be disappointed, as market internals point to a correction ahead.



I am reiterating my tactically cautious view that has been in place for the last two weeks (see Curb your (bullish) enthusiasm) for the following reasons:
  • All sectors are overbought, indicating an extended condition
  • Negative seasonality
  • Overbought breadth
  • Negative momentum
The full post can be found at our new site here.

Tuesday, August 8, 2017

Can China save the world again?

Japan saved the world in the aftermath of the Crash of 1987. When the panic selling of stocks cascaded around the world, the Nikkei Index bent, but did not break (via the FT):
The Nikkei tumbled 15 per cent on its “Black Tuesday” in the wake of Wall Street’s violent collapse and lost a further 5 per cent before global markets regained their feet in mid-November.

Yet, even though the crash knocked $500bn off corporate Japan’s market value, Tokyo’s fall was mild compared with those in the US, Europe and elsewhere in Asia – where some bourses plunged as much as 40 per cent. By the spring of 1988 the Nikkei was back up to a 15-year high, from which it would continue soaring for another 20 months.

“I don’t remember anybody in the office panicking,” Soichiro Monji says of the turbulent weeks that followed the October crash. Mr Monji, then a dealer at Daiwa Securities, Japan’s second-biggest brokerage house, now plans equity strategy at the group’s asset management arm.

“The economy was in good shape and the stock market had momentum. We thought, ‘There must be days like this sometimes’.”

Daiwa and Japan’s other big brokers were in any case sitting tight, having been ordered by their regulators in the Finance Ministry not to sell into the panic – an act of intervention that “would be inconceivable today”, notes Mr Monji.

Kiichi Miyazawa, the finance minister and later prime minister, who died earlier this year, told all who would listen that calm would soon return.

The government’s tactics helped stem the Nikkei’s fall, although a rosy growth outlook, low interest rates and a rising yen probably played a bigger role. The market’s structure helped: two-thirds of all company shares were held not by profit-seeking investors but by allied companies seeking to cement business ties.
In many ways, the panic was arrested in Japan and saved the world, but it paid a price later in that decade when the Japanese market collapsed and began the Lost Decades.

Fast forward to the Great Financial Crisis of 2008. The Chinese authorities ordered the banks to lend, and local authorities to spend. In many ways, China saved the world. As the American economy starts to show evidence of late cycle behavior, a recession is sure to follow some time in the future. Can China save the world again?

The full post can be found at our new site here.

Sunday, August 6, 2017

Will overheating spoil the market rally?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.


The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bearish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


A late cycle market
Bloomberg recently published an article, Why a little economic overheating won't spoil the market rally, that featured the views of Nomura strategist Kevin Gaynor:
The “Goldilocks” rally still has juice.

That perfect environment to sustain broad market gains -- when global growth is fast enough to lift corporate profits, but tame enough to keep inflation muted -- should be in effect for at least another 12 months, according to Kevin Gaynor, the head of international economics at Nomura Holdings Inc.

As the business cycle reaches its climax, European stocks, high-yield bonds and emerging-market credit have the potential to catch up with valuations notched in the halcyon days before the 2008 financial crisis, he said.

“We could get a more extended market rally,” Gaynor said in an interview. “When labor markets are tight and economic growth operates above trend, you see corporate profitability dropping, and that’s one reason to get bearish. For now, we aren’t seeing that type of margin pressure.”
I agree 100%. The nowcast shows that initial jobless claims, which has shown a remarkable inverse correlation with stock prices, is pointing to a robust economy.


For investors and traders, the trick is to spot the turning point. Here are the bull and bear cases for stock prices.

The full post can be found at our new site here.

Thursday, August 3, 2017

Things you don't see at market bottoms: No fear edition

It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.

I have stated that while I don't believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just another post in a series of "things you don't see at market bottoms". Past editions of this series include:
Numerous readings indicate that any semblance of investor fear has gone out the window. An update of the Euphoriameter.from Callum Thomas shows that it has reached a new recovery high for this market cycle.



There are plenty of other examples of fearlessness. The full post can be found at our new site here.

Wednesday, August 2, 2017

Bullish exhaustion

Mid-week market update: You can tell a lot about the tone of the tape by how it reacts to news. There is growing evidence that the stock market is becoming immune to good news, which is a signal of bullish exhaustion. In all likelihood, the near-term path of least resistance for stock prices is down.

The results from Q2 Earnings Season has been stellar. Experienced investors know that corporate management is plays the "beat the earnings" game well. According to FactSet, the average 5-year EPS beat rate is 68%. On the other hand, it's harder to play accounting game with sales, as the average 5-year sales beat rate is only 53%. This quarter, sales beat rates are off the charts when compared to their historical experience.


FactSet's update of earnings from last Friday shows that forward EPS is being revised upwards as well. That should be good news for stock prices.


Instead, the SPX has been mired in a narrow trading range and it has been unable to stage an upside breakout to new highs.



The lack of a bullish impulse in response to positive news is a warning for the bulls.

The full post can be found at our new site here.

Monday, July 31, 2017

How Covel inadvertently exposed the chasm between investors and traders

As a rule, I don't do book reviews. However, regular readers know that I am a big fan of trend following models and I use them extensively in my asset allocation work. When a publicist offered a free review copy of Michael Covel's Trend Following, 5th Edition: How to Make a Fortune in Bull, Bear and Black Swan Markets, I jumped at the chance.



The book also featured a forward by Barry Ritholz. Ritholz's partner Josh Brown recently wrote that they use trend following techniques for tactical asset allocation, which is a sensible decision that I wholeheartedly agree with:
At my firm, we use trend for tactical asset management. It takes everything above into account- not only the things, but people’s actual reaction to the things, a sort of realpolitik for markets. Will it always work? Doubtful. What is the downside when it doesn’t work? What is the expected benefit when it does? Is there a behavioral aspect to why it makes sense to include tactical in client portfolios? We think so. Not everyone would agree that this is worthwhile.
After all that buildup, the book left me vaguely disappointed. Covel's approach has been to be a cheerleader for traders who use trend following techniques without digging into the deeper issues that face investors. He treats trend following almost as a magic black box that everyone should use. He doesn't take the next step to discuss the characteristics of this class of strategies, which sophisticated investors think about when they consider the use of such techniques have a place in their portfolio.

The full post can be found at our new site here.

Sunday, July 30, 2017

No one rings a bell at the top, but...

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.


The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


The message from sector leadership
It is said that no one rings a bell at the market top, but a review of sector leadership shows that late cycle inflation hedge sectors are poised to assume the mantle of market leadership (see Nearing the terminal phase of this equity bull), which would be the signal for a blow-off in inflationary expectations. Such an event would be the trigger for the Fed to become more aggressive in its rate normalization policy, and raises the risk of a policy mistake that could push the economy into recession.

If investors are looking for a bell to ring at the top, then there are signs that someone is slowly ascending the bell tower.

Consider the Relative Rotation Graphs, or RRG chart, of the market today. As an explanation, RRG charts are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.


Wayne Gretzky famously said that his secret was to skate where the puck is going to be. Using that principle, the top left hand quadrant shows the sectors that are the likely emerging market leadership. These groups, with the exception of Financial stocks, are all in the inflation hedge and resource extraction industries, namely Energy, Metals and Mining, and Materials.

In short, the message from the evolution of sector leadership indicates that the market is poised for a blow-off in inflationary expectations, which will likely prompt a response from the Fed.

The full post can be found at our new site here.

Wednesday, July 26, 2017

Curb your (bullish) enthusiasm

Mid-week market update: Subscribers received an email update of the tactically fragile environment for US equities on Monday. There are plenty of reasons to be cautious.

Trade Followers observed that the Twitter breadth of all sectors are bullish, and such conditions are reflective of overbought market conditions:
Last week, sector sentiment gleaned from the Twitter stream had every sector positive. When this occurs a short term market top materializes usually within the following week. Once in a while, the sectors will paint another week with all of them in positive territory, then the top comes. Basically, when every sector is being bought aggressively it signals that the market is overbought.

That`s the just first warning. There are more.

The full post can be found at our new site here.

Tuesday, July 25, 2017

Why the labor market is tighter than you think

As the FOMC meets this week, one key question for Fed policy makers is, "How tight is the labor market?" A related question is, "In the face of tame inflation statistics, when are we going to see evidence of rising wage growth?"

Both questions are important for monetary policy. The New York Times had an article that lamented the lack of inflation. The WSJ reported late last week that, in effect, the Fed has no idea of what is going on with inflation:
The Federal Reserve is likely to stand pat on policy when it concludes a two-day meeting next week, but it faces a debate about the future path of interest-rate increases because of a deepening puzzle over inflation.

Officials will likely leave short-term rates unchanged and wait until September before announcing plans to slowly shrink their $4.5 trillion portfolio of bonds and other assets.

They face a dilemma, however, because the two sets of economic indicators they most closely monitor are sending conflicting signals about the urgency of additional rate increases.

The unemployment rate, which hit a 16-year low in May, shows labor markets are tightening. That argues for the Fed to keep lifting interest rates to prevent the economy from overheating. But inflation is drifting away from the central bank’s 2% target, suggesting borrowing costs should stay low to strengthen price pressures.
I recently highlighted analysis from Adam Ozimek of Moody's Analytics showing that there is no wage growth mystery. Ozimek found that the Phillips Curve, which postulates a trade-off between unemployment and inflation, is alive and well once he substituted the prime age non-employment rate for the unemployment rate (also see my recent post In search of the elusive inflation surge).

Using this analytical framework, the Fed is on the right track in normalizing monetary policy. Additional data indicates that the labor market is tighter than the market consensus, and a rise in inflation is just around the corner.

The full post can be found at our new site here.

Sunday, July 23, 2017

What would a contrarian do?

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.


The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


What's the contrarian class?
Being a contrarian is a lonely life. You don't hang out with the popular kids. You are probably the nerd in the class. You get picked last in team sports. You don't get invited to any of the parties. And even if you do, everyone laughs at you.

Over at Macro Man, he put us in a contrarian state of mind by asking, "What's the unloved asset class?"

The question was not in the context of a trade, such as short FAANG, but an asset class that you buy and hold for the next few years. Going down the list, he rejected US equities for the reasons of high valuation.


He also rejected developed market fixed income, as well as all forms of credit. The cap rates on commercial real estate isn't offering great value either.


Private equity? Just look at the cash on the sidelines waiting for deals.


At the end, he concluded, "Hmm, cash and gold seem to check a lot of boxes." No wonder contrarians don't get invited to parties.

Cash? Gold? While I believe that it's still a little early to get overly bearish on equities, but here is how a scenario that favors cash, gold and other commodities may develop.

The full post can be found at our new site here.

Thursday, July 20, 2017

Things you don't see at market bottoms: Wild claims edition

It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.

I have stated that while I don't believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top. This is just one post in a series of "thing you don't see at market bottoms". Past editions of this series include:
It is said that one of the signs of a market top is when participants (and scam artists) start making wild claims for the future. Here are some examples:
  • USA Today: Millennials fear of stocks could cost them $3.3 million
  • Chinese offshore property stampede: Start of a trend?
  • A sucker born every minute, or more signs of unbridled greed
The full post can be found at our new site here.

Wednesday, July 19, 2017

What's the upside target in this rally?

Mid-week market update: As the major US equity indices reach fresh all-time highs, it is time to ponder the question of how far the current upleg is likely to carry us. While technical analysts have several techniques available at their fingertips, I rely mostly on the venerable point and figure charting system (click link for primer), which was first used in the late 19th Century, to determine upside targets.

Using the point and figure charting tool at stockcharts, I get an upside target of 2549 for the SPX with a traditional box size and 3 point reversal.



If I vary the parameters to a 1% box size and a 3 point reversal, the upside target is 2524. The difference seems to be the width of the consolidation pattern and the site of the upside breakout.


Is the target 2524 or 2549? What gives?

The full post can be found at our new site here.

Monday, July 17, 2017

In search of the elusive inflation surge

US bond yields began to settle down last week when Fed Chair Janet Yellen stated in her Congressional testimony that the neutral rate for Fed Funds is roughly the inflation rate, which is much lower than market expectations. In addition, she allowed that the Fed is likely to re-evaluate its tightening path in light of tame inflation figures.

Even Fed Governor Lael Brainard, whose Fedspeak had recently taken on a more hawkish tone lately, sounded dovish in a speech last week:
Once that [normalization] process begins, I will want to assess the inflation process closely before making a determination on further adjustments to the federal funds rate in light of the recent softness in core PCE (personal consumption expenditures) inflation...I will want to monitor inflation developments carefully, and to move cautiously on further increases in the federal funds rate, so as to help guide inflation back up around our symmetric target.
The June CPI print came in below expectations, which reinforced the view that low inflation releases may prompt a shallower path for rate hikes in 2017 and 2018. Brainard stated on Thursday, before the CPI release, "I don’t think anybody can give a fully satisfactory answer to why we’re seeing the inflation trajectory that we see today."

In the past, we have seen inflationary surges whenever the unemployment rate falls substantially below 5%. The graph below depicts the unemployment rate (blue line, with the zero level set at 5%), with CPI (red line). The rise in inflation has been quite tame by historical standards, which is creating a dilemma for policy makers.


The Fed's underlying model of inflation is the Phillips Curve, which posits a trade-off between inflation and unemployment. As the chart from this Money and Banking primer shows, the inverse relationship between inflation and unemployment has been flattening since 2000. Falling unemployment should drive up wages, which is the price of labor, and put upward pressure on inflation. This time, the wage and inflation response has been muted.



Questions are being asked at the Fed. Is the Phillips Curve broken? Why aren't wages rising?

The full post can be found at our new site here.

Sunday, July 16, 2017

Looking for froth in the wrong places

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.


The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Where's the Bubble?
Ben Carlson at A Wealth of Common Sense recently detailed the four criteria for a market bubble:
In a recent conversation with Meb Faber, William Bernstein discussed how his criteria for seeing a bubble has more to do with sociological factors than econometric indicators. Here are his four signs of a financial market bubble:

(1) Everyone around you is talking about stocks (or real estate or whatever the fad asset of the day is). And you should really start worrying when the people talking about getting rich in certain areas of the market don’t have a background in finance.

(2) When people begin quitting their jobs to day trade or become a mortgage broker.

(3) When someone exhibits skepticism about the prospects for stocks and people don’t just disagree with them, but they do so vehemently and tell them they’re an idiot for not understanding things.

(4) When you start to see extreme predictions. The example Bernstein gives is how the best-selling investment book in 1999 was Dow 36,000.

He said he’s not worried about a bubble at the moment but seeing 3 out of these 4 conditions being met would be a warning sign.
Despite my series on investor sentiment, Things you don't see at see at market bottoms (which had four editions that were published 13-Jul-2017, 7-Jul-2017, 29-Jun-2017, and 23-Jun-2017), market psychology has not reached the "OMG I have to quit my job/mortgage the house to buy/trade the hot asset of the day". While there are some excesses, such low levels of institutional cash (chart via Business Insider), the lack of over-the-top froth suggests that the next stock market downturn from a recession may be relatively mild in the manner of a 10-20% decline seen in the 1990 bear market.



While I am somewhat sympathetic to that view, investors who are looking for signs of froth are looking in the wrong places. One of the processes that occur in recessions the correction of excesses in the past expansion. Most of the real excesses are not to be found within US borders, but abroad.

The full post can be found at our new site here.

Thursday, July 13, 2017

Things you don't see at market bottoms, Retailphoria edition

It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.

I have stated that while I don't believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top.

As a result, this is another post in an occasional series of lists of "things you don't see at market bottoms". This week, I focus on more signs of retail giddiness.

  • The TD-Ameritrade Investor Movement Index hits an all-time high
  • E-Trade parties like it`s 1999
  • If the market is chasing yield, corporations can get away with murder
The full post can be found at our new site here.

Wednesday, July 12, 2017

U-S-A! U-S-A!

Mid-week market update: Having reviewed sector rotation last week (see More evidence of an emerging reflationary rebound), it is time to apply the same analysis to countries and regions.

First, let's start with a primer of our analytic tool. Relative Rotation Graphs, or RRG charts, are a way of depicting the changes in leadership in different groups, such as sectors, countries or regions, or market factors. The charts are organized into four quadrants. The typical group rotation pattern occurs in a clockwise fashion. Leading groups (top right) deteriorate to weakening groups (bottom right), which then rotates to lagging groups (bottom left), which changes to improving groups (top left), and finally completes the cycle by improving to leading groups (top right) again.

Here is the RRG chart of the major countries and regions of the world. All ETFs are priced in USD and therefore all currency effects are already part of the returns. The rotation analysis was performed relative to MSCI All-Country World Index (ACWI).



My interpretation of the RRG chart indicates that US stocks are poised to take the leadership position again, after a brief hiatus. Emerging leadership can also be found in the resource producing countries of the world, such as Australia, Canada, Latin America, and Russia. European and Asian stocks, which had been the leaders, are starting to consolidate and they are likely to begin to weaken on a relative basis. These patterns are consistent with my thesis of a developing reflationary blow-off equity market top.

The full post can be found at our new site here.

Tuesday, July 11, 2017

Are stocks being stalked by a silent Zombie Apocalypse?

There was some minor buzz on the internet when Jonathan Tepper tweeted the following BIS chart and rhetorically asked if zombie firms was the cause of falling productivity during this expansion. BIS defines a "zombie" firm as a company that has been listed for 10 years or more and has an EBIT interest coverage of less than 1. As the charts show, the number of "zombie" companies have been rising steadily, while advanced economy (AE) productivity and CapEx has been muted during this expansion.


While the zombie hypothesis has much intuitive appeal, especially to the permabear and doomster set, a deeper examination reveals some unanswered questions that casts doubt about this explanation for the muted productivity gains of this cycle.

The full post can be found at our new site here.

Sunday, July 9, 2017

A mid-year review of 2018 recession risk

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.



The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bullish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


What is the risk of recession?
Over at A Dash of Insight, Jeff Miller criticized WSJ reporter Greg Ip for writing what Miller consider to be a doomster-like article about rising recession market risk. He went on to accuse Ip of cherry picking data to make his point about a heightened risk environment, and concluded:
The entire article reads like a laundry list of points that would make sense to investors with limited knowledge of economics. That is why I am disappointed. My hope is that top journalists would help explain reality rather than feed fears stoked by so many others. This article will frighten investors. Is that what the author intends?
The issue of recession risk is important to investors because every recession has been accompanied by an equity bear market. So let me put in my two cents worth in my own assessment of recession risk for the American economy.


Some time ago, I created a Recession Watch page on my website. The recession risk criteria on the page was based on the framework specified by New Deal democrat. NDD used the work of Geoffrey Moore, the founder of ECRI, to create seven long leading indicators designed to spot recessions a year in advance (click on links for the latest FRED charts):
  • Corporate bond yields (Corporate bond yields have always made their most recent low over 1 year before the onset of the next recession)
  • Housing starts (Housing starts peaked at least one year before the next recession)
  • Real private residential fixed investment (Aside from the 1981 "double-dip," and 1948, it has always peaked at least one year before the next recession)
  • Money supply (In addition to the 1981 "double dip," on only 2 other occasions have these failed to turn negative at least 1 year before a recession)
  • Corporate profits and Proprietors` income, which can be a more timely proxy for corporate profits (Corporate profits have peaked at least one year before the next recession 8 of the last 11 times, one of the misses being the 1981 "double-dip.")
  • Yield curve, which may not be relevant in the current interest rate environment (The yield curve inverted more than one year before the next recession about half the time)
  • Real retail sales (It has peaked 1 year or more before the next recession about half of the time)
A review of the seven indicators revealed both good news and bad news. Here are the details of each indicator, along with a discussion of the internals behind each indicator,

The full post can be found at our new site here.

Friday, July 7, 2017

The things you don`t see at market bottoms, bullish bandwagon edition

It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.

I have stated that while I don't believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead and Nearing the terminal phase of this equity bull). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top.

As a result, this is another post in an occasional series of lists of "things you don't see at market bottoms". This week, I focus on the theme of further signs of the bullish bandwagon.

To summarize, Callum Thomas of Topdown Charts constructed a Euphoriameter, consisting of forward P/E, VIX (inverted), and bullish sentiment. Readings are highly elevated, though they have not reached the highs seen at the last cycle top.



The full post can be found at our new site here.

Wednesday, July 5, 2017

More evidence of an emerging reflationary rebound

Mid-week market update: Further to my last post (see Nearing the terminal phase of this equity bull), There are numerous signs that the market's animal spirits are getting set for a reflationary stock market rally. First of all, the BAML Fund Manager Survey shows that a predominant majority of institutional managers believe that we are in the late cycle phase of an expansion.



The full post can be found at our new site here.

Sunday, July 2, 2017

Nearing the terminal phase of this equity bull

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.



The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bearish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


Charting the pain trade
Even as the recent SPX stays in a narrow trading range, there was plenty of pain to go around beneath the surface. The drubbing taken by NASDAQ stocks were largely offset by rallies in Financials and Healthcare.

So what are the next pain trades, and what are the implications?

Hedgopia documented how large speculators (read: hedge funds) have moved from a crowded short in the 10-year Treasury Note to a crowded long.



Similarly, large speculators are also in a crowded long in the T-Bond futures.



Bond yields began to rise, and the yield curve steepened dramatically.


Those are the first major pain points for traders. These dramatic reversals have further implications for the equity market.

The full post can be found at our new site here.

Thursday, June 29, 2017

Things you don't see at market bottoms, 29-Jun-2017

It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.

I have stated that while I don't believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top.

As a result, this is another post in an occasional series of lists of "things you don't see at market bottoms". This week, I focus on the theme of "subprime is the new black":
  • How cov-lite loans have become the norm
  • The popularity of subprime auto loan ABS
  • A start-up for customers with no money but want to buy things

The full post can be found at our new site here.

Wednesday, June 28, 2017

All eyes on policy makers

Mid-week market update: As we wait to see if the stock market can break either up or down out of this narrow trading range, this week has been a light week for major market moving economic data, However, there are a number of political and non-economic developments to keep an eye on.



The full post can be found at our new site here.

Sunday, June 25, 2017

Long live the reflation trade!

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The "Ultimate Market Timing Model" is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. 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 component of the Trend Model to look for changes in the direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading "sell" signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading "buy" signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.


The latest signals of each model are as follows:
  • Ultimate market timing model: Buy equities*
  • Trend Model signal: Risk-on*
  • Trading model: Bearish*
* The performance chart and model readings have been delayed by a week out of respect to our paying subscribers.

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.


The global bull keeps on charging
Despite my recent negativity (see Risks are rising, but THE TOP is still ahead and Things you don't see at market bottoms, 23-Jun-2017 edition), I am not ready to throw in the towel on this equity bull market.

From a long-term perspective, the reflation trade is still alive, and growth is global in scope. As the 20-year monthly chart below of the Dow Jones Global Index (DJW) shows, the last two tops were preceded by negative RSI divergences. So far, DJW is barely overbought and has not even had the opportunity to exhibit a negative RSI divergence. This suggests that global equities can continue to grind higher, and the ultimate top is, at a minimum, several months away.


The tactical outlooks suggests that there may be some near-term weakness ahead. Drilling down to the weekly chart, DJW has shown a pattern of flashing double RSI overbought sell signals. In the past, the index has achieved a first RSI peak overbought reading (dark vertical line) which was followed by a second RSI peak (red vertical line). DJW has recently shown the same double overbought peak pattern, and, if history is any guide, the market is likely to stage a minor pullback.


I interpret these technical conditions as being in favor of the global reflation trade, though some minor pause may be necessary. This scenario is consistent with current macro and fundamental readings that are supportive of a reflationary driven equity advance..

The full post can be found at our new site here.

Friday, June 23, 2017

Things you don't see at market bottoms, 23-Jun-2017 edition

It is said that while bottoms are events, but tops are processes. Translated, markets bottom out when panic sets in, and therefore they can be more easily identifiable. By contrast, market tops form when a series of conditions come together, but not necessarily all at the same time.

I have stated that while I don't believe that the stock market has made its final cyclical top, we are in the late stages of a bull market (see Risks are rising, but THE TOP is still ahead). Nevertheless, psychology is getting a little frothy, which represent the pre-condition for a major top.

As a result, I am starting a one in an occasional series of lists of "things you don't see at market bottoms":
  • Argentina's 100-year bond offering
  • Irrational Exuberance Indicator at fresh highs
  • The E*Trade Indicator flashes a warning
  • More signs of excesses from the Chinese debt time bomb
The full post can be found at our new site here.

Wednesday, June 21, 2017

A market breadth model that works

Mid-week market update: Technical analysts monitor market breadth, as the theory goes, to see the underlying tone of the market. If the major market averages are rising, but breadth indicators are not confirming the advance, this can be described as the generals leading the charge, but the troops are not following. Such negative divergences are signs of technical weakness that may be a precursor to future market weakness.

That’s the theory.

I have been highly skeptical of breadth indicators as a technical analysis tool because breadth divergences can take a long time for the market to resolve, if at all. The chart below shows the SPX, the “generals”, along with several indicators of how the “troops” are behaving, namely the mid-cap and small cap indices, as well as the the NYSE Advance-Decline Line.


The behaviour of these indicators during and after the Tech Bubble was problematical. During the advance from 1998 to 2000, the NYSE A-D Line fell and flashed a negative divergence sell signal. At the same time, both the mid- and small-cap indices continued to rise and confirmed the market advance. Which divergence should investors believe?

After the market peaked in 2000, the mid and small caps traded sideways, which represented a non-confirmation of the bear market. Investors who followed this buy signal would have seen significant drawdowns during this bear market.

To be sure, there were periods when breadth indicators worked. The NYSE A-D Line traded sideways during the market decline of 2011, which was a buy signal. As well, it correctly warned of market weakness in 2015.

Putting it all together, the report card for these indicators can best be described as inconsistent and the timing of the signal uncertain. At a minimum, no investor would use breadth indicators in a trading system.

I believe that I discovered a solution to the problems that technicians struggle with when they use breadth indicators.

The full post can be found at our new site here.