Green Shoots and Market Bottoms - A rationally derived contrarian perspective

Green Shoots and Market Bottoms - A rationally derived contrarian perspective

The Global Financial Markets are a real-time barometer by which the health of the economy can be assessed and even predicted. Just as high volatility tells you that something is very wrong, in the same way low volatility and rising or stable equity prices with broad market participation tell you that things are robust no matter what the gloom-and-doomers may be saying, or that seemingly stable prices but with narrow market participation tell you that the tide may be ripening for a turn.  Macroeconomic data of course is crucial even though it can be lagging, to inform and re-inforce the story derived from the markets.

Many economists and watchers would probably agree that the high market volatility since August is a reflection of the following major problems

  • A significant strengthening of the US Dollar from late 2014 through 2015 against most currencies, especially against Emerging Market Commodity producers along with additional deflationary impacts of US, Japanese, and European Central Bank Quantitative Easing (QE) Policies, have crashed Commodity prices. This has in turn fractured the credit worthiness of commodity producers, increasing their borrowing costs, and has forced them to keep pumping out the commodity to stay solvent, which exacerbates the supply glut further pressuring the price of the commodity, and keeping commodities in a vicious downwards cycle. The very tight correlation between the global equity markets and the price of Crude Oil is telling us how important this problem has become.
  • China’s growth and export slowdown, growing non-performing investments, and resulting Capital Outflows have created a tremendous amount of instability in China’s domestic financial markets and pressure on the Renminbi. China’s massive foreign currency reserves have dropped by 20% in the last 15 months as their Central Bank uses them to minimize the slide in the RMB. The term thrown around by the media has been “China sneezes and the world catches a cold”, to explain the roiling of the US and global equity markets since the problems with China came front-and-center.

What adds to the bearish sentiment is the divergent path the US Central Bank has taken by beginning to increase short-term interest rates in this very uncertain global growth environment relative to the easing policy stance of Japanese and European Central Banks. This threatens to worsen two of the above drivers of instability … i.e.  to further strengthen the US Dollar and in turn to further drop Crude Oil/Commodity Prices.  The tightening stance of the Federal Reserve also makes China’s job, of stabilizing its growth decline and of setting it on a sustainable longer term trend, more difficult.  To do so, China must find a balance between making their exports more competitive with their trading partners to support its own middle class, while encouraging domestic consumption to wean it off of its dependence on exports, and in the process of both make a smooth transition to becoming a major international currency.

In addition, market volatility itself adds to bearish sentiment which can breed additional volatility by seeping into consumer and businesses spending decisions.

So will things continue getting worse, start to get better, or stay the same?

We believe each of the underlying issues above have actually started to stabilize.

Our summary prognosis for equities is as follows. 

  1. The US Equity markets have bottomed, though the problems in the global economy have not yet stabilized
  2. We expect the US Equity Markets to continue moving sideways (i.e. up and down) in a broad price band until the healing process is further along
  3. China’s equity market has also likely bottomed
  4. We should see a broader bottoming of other Commodity exporting Emerging Markets as the year progresses

The clarity and conviction in our view comes first and foremost from our proprietary predictive models of the markets.   These models have been refined, improved, and tested meaningfully through real-time use during the 2007-2009 Recession and over the course of the subsequent Bull market, including the correction from last August.  But there are three other lenses which we use, that are easier to communicate, and that are also indicating these “green shoots”.

#1 The Markets’ Tale

  1. US Equity Markets have demonstrated a very strong support level around 15,000 for the Dow since 2013 when the level first acted as resistance for the post-“fiscal cliff” rally, and then as very strong support repelling 5 different declines from causes ranging from the “Taper tantrum” in 2013, and the Ebola Virus in 2014, to the Chinese currency devaluation/growth slowdown related decline last August. The two recent tests on Jan 20th and Feb 11th that correlated with the crash in Oil prices into the mid-$20/barrel range, and the increasing strength of the two subsequent bounces from this support level, indicate how formidable the support is. What we can conclude is that whatever the reasons, the macro problems described in the paragraphs above have not yet been substantial enough to break the back of the markets (by breaking this support) and the underlying economy.
  2. We have found Gold to be an excellent indicator for market liquidity and fear. Gold’s very strong rally in February could initially have been attributed to the high levels of fear in the markets back in February, however the continuation of the rally late last week, even after the equity markets had stabilized somewhat, indicates there now could be enough liquidity in the markets to support a broader based stabilization in “risk-on” markets like US and Emerging Market Equities, and Commodities at least for the near future. Again, I am not saying there is a new uptrend that would start here, but that there are signs of stabilization.

 

#2 The Macro View

The two most likely mechanisms in the current environment that could actually cause liquidity to increase in the system are

  1. The underlying problems that were drying up the liquidity in the first place, and hence creating the market volatility (i.e. the problems listed in previous paragraphs), have hit an inflexion and have started to moderate. Two examples here -
    • For the problems related to Commodity/Commodity Producing Emerging Markets, the most important indicators to look at are the spreads between High Yield Bonds of different risk tranches versus the 10-Year Treasury Note. There has been a remarkable shrinking in these spreads over the last 2.5 weeks with a technical strength that has not been seen since early 2015.
    • For China, its M2 Money Supply YoY % growth is a leading indicator of inflation, which we believe has to begin to increase if China’s growth slow-down is to stabilize. The M2 growth rate has been clawing its way back from its low in April 2015 which has coincided with an acceleration of the Chinese Central Bank efforts to turn the growth situation around. The YoY growth in M2 hit 14%, its highest level since July 2014. This has been the only positive surprise this year among a host of negative growth related indicators for China. The probability that China has successfully arrested and is turning around its export and growth doldrums increases significantly If this growth rate keeps giving upside surprises over the next few months.
  2. The Fed is kick-starting “Carry Trades” again to support Commodity Prices and solve the China growth issue in one fell swoop. Given negative Interest Rates in Europe and Japan, such a “Risk-on” trade could be quite profitable. The mechanics could be for the entity to borrow money (and get paid to borrow money) from Japan or the Eurozone due to Negative Interest Rates, and then park the money in a higher interest yielding currency like the Australian Dollar (currently offering a 3 month interest rate of 2.25%) or in the future in the USD (after the Fed raises rates a few times) and/or purchases commodities, High Yield Bonds, or Equities, i.e. “Risk-on” financial instruments with the USD or AUD obtained from the borrowed money. However, given the downside risk from the declining end-markets, it takes someone with very deep pockets (like the Fed) to try and actually turn the tide (so to speak) and then hopefully attract other market participants to this trade once the new trend is established. We can hypothesize that this party is actually the Fed if, from here on, subsequent rises in US equities are accompanied by a declining USD, at least for the remainder of the current rally.   In other words, if this mechanism was actually happening in conjunction with Chinese Central Bank activities, we would see a declining USD co-incident with 3 things … rising US equities, rising Commodity prices including Oil, and a dropping RMB against its (China’s) trading Partners. More on this in our next letter if this hypothesis can actually be backed by a month’s (versus just a week’s) worth of data.

 

#3 Fundamentals

The Infrastructure sector is the first derivative of the economy, i.e. if the pace of the global economic growth decline is indeed slowing, the infrastructure spending decline would be arrested first and will be one of the first sectors to recover. Since High Tech is pretty healthy and one of the least impacted by the problems causing the current slump, we would expect Tech Infrastructure to be one of the first sectors to reflect a turn-around.  Two bellwether companies in the High Tech infrastructure space are Cisco Systems and Applied Materials.  Both companies blew away analyst estimates in their last earnings calls on Feb 9th and Feb 18th respectively and their stocks rose by ~10% each, overnight after their earnings calls.

 

Our Medium-Term Forecast

Like I forecasted in an interim update to my Linked-in connections on Feb 12th, the day after the Dow hit 15,412, “The US Equity markets decline from December (originally from last July) may have been arrested for good at the 1800 level for the S&P500 and 15,400 level for the Dow. However we don't think a new uptrend is on the cards until all the negativity has been absorbed, i.e. the markets should continue to bounce and go sideways for the next many months. In other words, this is no time for panic selling”, the US equity markets have bounced substantially from that low with the Dow closing on Friday above 17,000.  We think there is more life left in this bounce for the reasons described above, maybe all the way up to the 18,000 level.  However, the problems have not gone away, only faded, and more healing is needed before there is an end to the correction from last July.  We think another strong bout of pessimism and volatility with an accompanying test of the Feb 2016 lows is likely as a result, before we finally enter the next phase of the rally from 2009.

That phase should have a very different, inflationary nature, and hence provide a very different profile of returns compared to the dis-inflationary nature of the previous phases of this astounding and historic rally. But that again like most of this letter is a contrarian view, though I would like to think, a rational one.

Indian Summer

Indian Summer

This equity market rally has been a lot like an Indian Summer, the weather phenomenon where spells of unseasonably warm, gorgeous weather bring fall cheer before the merciless grip of winter takes hold. The markets have timed this rally perfectly for October, though if this were really a weather pattern it would already be an uncharacteristically long one.

Even though it seems like a lot has happened since the precipitous market drop in August, I cannot identify any tangible changes from our thesis in “All is (not) Well” that would drive a fundamental trend reversal in the market from the downtrend that it asserted in August and September.   Every piece of economic information below questions the sustainability of this “Melt-up” of the markets.

  • “more of the same” Central Bank maneuvers - the 6th Chinese interest rate drop in 12 months or the strong ECB hints at further easing
  • our Fed’s back-pedaling from their September statement and instead attempting to convince the markets that they still intend to increase rates (which we think is a charade)
  • Shrinking revenues in many Sectors of the economy (see WSJ article “US Companies warn of slowing economy”)
  • Continuing Dollar Strength and corresponding macro weakness in Emerging Markets and Commodities
  • China has been quiet in its disposal of US Treasuries in October, and the Renminbi has actually risen against both the Dollar and the Euro. This can’t be good for the Chinese economy.

However, one bright spot has been Technology revenues, which though under significant pressure from Dollar Strength, are still hanging in there because of secular growth trends like Cloud adoption (Amazon, Microsoft, Intel), growth of Internet retailing at the expense of Brick & mortar retail (e.g. Amazon vs Walmart), or simply just organic growth in adoption and penetration (Google and Apple).

So what are the markets telling us? The Nasdaq 100 Index (represents the best of Technology) has poked through the last of its important technical resistance levels, i.e. its July peak, and has made a brand-new intraday high yesterday. So at first glance it seems like this rally may no longer be just a technical reversal but an actual trend change. However, our fractal models and intermarket and macro analysis is indicating the opposite. Specifically -

  • About 45% of the Nasdaq’s rally from the September lows came through Fed injected liquidity at various junctures in October, and from a significant surge in European inflows into both US Equities and Treasury Bonds corresponding to the date of ECB Chair Mario Draghi’s hint of further easing. Thus violations of these resistance levels are nominal and not meaningful.
  • US Small Caps have behaved more rationally, and have been immune to these liquidity injections and surges even though these firms are the least impacted by global and currency factors. Hence, Small Caps may reflect the true effect of the same key resistance levels that were violated on the larger indices like the Nasdaq and S&P500 or the Dow. In other words, the other indices should reverse the same time as the Russell 2000 Small Cap Index does when it runs into its resistance zone (see Fig 1 below).

Figure 1: Russell 2000 Index Futures Chart showing the Resistance Band where strong selling pressure is expected to stop and repel the current rally from early October

  • Structurally we appear to be near the mid-point of the rally from early October, and it could continue through much of November and even possibly December before volatility returns.
  • Gold’s response during the remainder of this rally should be interesting to watch. It has risen, co-incident with the Equity Markets since late September, indicating that it is benefiting finally from the same liquidity flows that have lifted up US Treasuries and US/Global Equities in October. However, if this liquidity surge is limited and temporary (which we believe it is), Gold’s performance should be relatively weaker, and it should clearly top and reverse before equities do since it is much more sensitive to such flows.

In conclusion, we are in for an unusually long Indian Summer in the markets that may last for the remainder of 2015. “Winter” should reassert itself by the first part of 2016 if not earlier, with significant downside to the Equity Markets as the global macro-economic slowdown becomes impossible to ignore, even for the Technology sector. We believe that the risk is high of a severe decline that could retrace this entire rally, with a test or even a temporary breach of the all-important 15,000 resistance level for the Dow, which is a good 15% lower than current levels.

I hope you don’t find yourself in the wrong clothes when the long-due Winter finally arrives.

ALL IS (NOT) WELL

ALL IS (NOT) WELL

In 3 Idiots, one of my favorite (Bollywood) movies which is about the power of free thinking and true friendship to break lifelong dogmas and elevate lives out of an oppressive rat race, a central mantra is “ALL IS WELL!”. This forms the philosophical basis for the protagonists shutting out challenging reality and its diminishing emotional impact in order to launch themselves out of numerous, and sometimes hilariously sticky situations. This week, our own Federal Reserve has done a very uncharacteristic thing and signaled the opposite when they decided not to raise short-term interest rates off the zero level because of “recent global economic and financial developments“.

In my last post “The Dow is back at 2013 levels … now what?” in August, I opined that the Chinese (competitive currency devaluation) wildcard would change the fundamental nature of the economic pseudo-stability we have gotten used to in the last many years of well-coordinated Quantitative-easing between the US, Japanese, and European Central Banks as they have re-inflated their respective economies (and equity markets) out of the depths of the Great Recession of 2008/2009. This QE has resulted in the unintended consequence of an emerging market slowdown starting with commodity exporting countries like Brazil and Russia, and is now affecting export-oriented China (now the 2nd largest economy in the world) whose currency has (until recently) been pegged to the US Dollar. Since the time of that post, we have seen some strong indications about the mechanism of China’s response and some likely economic outcomes if such a response continues.

  • Marketwatch reported this week that China’s US Treasury Bond holdings dropped $30B in August with an additional $55B sale out of associated dealers in Belgium. We believe that selling these US Treasury holdings was the primary mechanism used by China to devalue the Renminbi against the US Dollar and the Euro.   For reference, the Fed was purchasing $85B a month in long-dated Treasury Bonds at the peak of past periods of Quantitative Easing, so it is interesting that this salvo totaled about that amount.
  • We believe that despite official rhetoric of this being a one-time move, China has no option but to continue down the path to competitive devaluation relative to its primary export markets in order to stimulate growth. This is not only due to the extent of instability in the Chinese financial markets (Chinese “A” shares trading on the Shanghai Stock exchanged dropped almost 20% the night (US time) before the Fed announcement on Thursday while the US equity market was enjoying a 600 point rally). More importantly, continuing devaluation of the Renminbi is required to address the root cause of this instability, which is the Chinese growth and export slowdown, and the resulting exit of capital from the China’s financial market and Emerging Markets in general.
  • It is not clear if the Fed actually intervened in the Bond Markets by absorbing the supply with fiat Dollars at the time of the Chinese sale, but the fact that the US Dollar actually dropped during the period of and shortly following the Renminbi devaluation indicated that is what may have happened, since we should normally have seen a rise in the US Dollar from such a sale.
  • We believe the Fed has started to actively stabilize and even reflate the US equity markets. This same 600 point rise in the Dow leading up to the Fed announcement at a time of low trading volume, carries a signature pattern which we identified in 2011 as the manner in which QE injected liquidity enters the US equity market (see “Signature of the Stimulus”). This is one of the macro reasons we think there is a floor of around 15,000 for the Dow for the current round of equity market volatility, in addition to there being strong technical support at that level based on our fractal inter-market models.

Putting all this together, a realistic scenario that emerges is of the Chinese continuing to competitively devalue the Renminbi against the US Dollar and Euro, the Fed intervening through an absorption of this Treasury demand in a manner similar to QE, the Dollar reversing its up-trend and starting to weaken in consequence, and global growth continuing to flounder until the Chinese export engine resumes and the demand for commodities and Emerging market exports starts to increase again. How much demand can this cheaper supply of goods stimulate in this new world of suppressed aggregate demand is anyone’s guess. Our view is that this increase would be measurable, but not sustainable, since it would be accompanied by inflationary forces.

I am glad that the Fed is signaling “ALL IS (NOT) WELL” by recognizing the very real risks posed by this emerging market slowdown. They will need to intervene a lot more than to simply not raise short-term interest rates to prevent this risk from getting contagious (bellwether US Treasury Bond and US Equity markets could crash and hence start to affect the US economy, which is one of the few relatively healthy demand growth engines left remaining in the world).

But there is no free lunch, and such intervention, if pursued, will have future unintended consequences. Connect with me on Linked-in to get our viewpoint on this story as it unfolds.

The Dow is back at 2013 levels … now what?

The Dow is back at 2013 levels … now what?

The zero-sum (at best) character of Quantitative Easing (QE), especially Japanese or European QE, is staring us in the face of the rout Global Equities are experiencing.  The Dow is back at its 2013 levels (the Dow Jones Industrials closed below 16,000 today) while emerging markets, especially countries that rely on exports, are reeling from fleeing liquidity.  China, because of the resulting export and growth slowdown, is left with only one viable option which is to join Japan and Europe in a de-facto competitive devaluation of its currency.

So does this signal the end of the 6 year global equities rally and mark the beginning of a new economic ice age? Or is this a normal correction with a return to the “new normal” of QE driven asset inflation and sluggish but steady economic growth?

Our baseline picture at The Absolute Return, which is built on our global macro informed, inter-market correlated fractal models, has been anticipating this weakness and suggests that there is no need to panic but to carefully understand the economic shifts taking place and re-align investments over the coming months with a new and very different phase of the economic recovery from 2009.

In summary

  • The upheaval is the sign of a significant shift that is starting to take shape in response to the deflationary impact of global quantitative easing on Emerging Markets.  China is no longer a passive victim of quantitative easing policies in the US, Japan, and Europe, but has begun an unprecedented liquidity drive that has already untethered the Yuan from the USD and, we believe, should ultimately reverse this emerging market deflation. The sign that this is happening would be a top and a reversal in the US Dollar, but that top could take many more months to form.
  • Practically, this could mean a floor for the Dow in the 15,000 range with sideways looking price action into 2016. But a repeat of 2008 appears to be unlikely.
  • US and developed world economic growth should stall during this period of sideways equity market prices.
  • Any pickup from current levels would be inflationary in the US and in most Emerging Markets, a very significant change from the nature of economic growth we have seen since 2011.
  • The current market rout and the sideways market of the coming months could provide some exceptional medium-term buying opportunities in many categories of investments that have performed poorly in the QE driven, dis-inflationary economy of the past few years.