Safe Haven Bid: Ahead of Itself?

 

Marilyn: Thank you for coming over, Mr. Baer. Welcome back and forgive me if I wade right in, but forgetting for a second your bureaucratic checklist, I’m trying to get undigested information, so if you could give me a reading of the temperature over there?

India is now our ally. Russia is our ally. Even China will be an ally. Everybody between Morocco and Pakistan is the problem. Failed states and failed economies, but Iran is a natural cultural ally of the U.S. The Persians do not want to roll back the clock to the 8th century.

I see students marching in the streets. I hear Khatami making the right sounds. And what I’d like to know is if we keep embargoing them on energy, then someday soon are we going to get a nice, secular, pro-Western, pro-business government?

Bob: It’s possible. It’s complicated.

Marilyn: Of course it is, Mr. Baer. Thank you for your time.

Intelligence is the misnomer of the century.

Bob: They let young people march in the street and then the next day shut down fifty newspapers. They have a few satellite dishes up on roofs, let ’em have My Two Dads, but that doesn’t mean the Ayatollahs have relinquished one iota of control over that nation.

Distinguished Gentlemen: Mr. Baer, the reform movement in Iran is one of the President’s great hopes for the region and crucial to the petroleum security of the United States.

Terry George: These gentlemen are with the CLI.

Distinguished Gentlemen: The Committee for the Liberation of Iran, Mr. Baer

Bob: We’ve had Iran in embargo for almost thirty years, we backed their neighbor, a neighbor we invaded twice, in a ten year war against them, we’re hanging on by a thread with a massive occupation force, so I got news for you… Thomas Jefferson just ain’t that popular over there right now.

― Syriana (2005)

 

Iranian foreign minister, Javad Zarif, made a surprise visit Sunday to the the Group of Seven summit, meeting with a delegation including French President, Emmanuel Macron, as leaders grappled with how to defuse tensions and salvage the landmark nuclear deal after a US pullout.

 

Mr Javad Zarif did not meet with the US delegation in Biarritz, France, although President Trump has indicated that he is open to meeting Iranian officials without preconditions.

 

The narrative in the noughties when oil was rallying and the spectre of peak oil (supply not demand) was of popular concern ― the BBC even produced a film titled The Crude Awakening: The Oil Crash in 2007 to warn of the end of life as we know it because the world was running out of oil ― was that of the US’s need to ensure hydrocarbon security. Today, the narrative is that the world is awash with oil and the US is energy independent, affording President Trump the luxury to scrap the deal with Iran and to re-impose economic sanctions.

 

As it relates to oil, the truth lies somewhere in between the fears over peak demand and peak supply but almost never, barring a energy paradigm changing supply- or demand-shock, at the extremes.

 

As it relates to geopolitics, should oil prices rise sufficiently, driven by a flurry of  bankruptcies in the US shale patch or US shale production plateauing, it would be of no surprise to see the US either return to the negotiating table with Iran or to ease sanctions.

 

The overarching consensus for oil appears to be that of lower oil prices. With some even calling for a crash to below the US dollars 30 per barrel level, that would lead to global deflationary bust. In our opinion, these calls seem premature. Rather, if anything, we see the greater risk being to the upside.

 

We often use the 48-month moving average, for commodities and major currency crosses, to guide our trading strategy. For now, WTI crude prices remain above the moving average, albeit just barely. Given the proximity of the current price to the moving average, the best course of action may be to be on the sidelines. That being said, as long as prices do not meaningfully breach the 48-month moving average, our bias is to be long in expectation of prices climbing the ‘Wall of Worry’ over the next 6 to 12 months.

 

USCRWTIC Index (US Crude Oil WTI 2019-08-26.png

 

Has the Safe Haven Bid Got Ahead of Itself?

 

In the below chart, the magenta line is the ratio of the price of gold to the Merrill Lynch 10-year Treasury Total Return Index. The orange line is that of core price index.

 

XAU Curncy (Gold Spot $_Oz) GL 2019-08-26 11-47-07

 

The US dollar price of gold, loosely an inflation hedge, rising relative to the 10-year Treasury index generally coincides with rising core inflation. There, of course, are periods that the ratio over- or under-shoots core inflation but over time the roughly coincident movement of core inflation and the gold-to-ten-year Treasury index tends to reassert itself.

 

In recent months we have seen safe haven assets, government bonds and precious metals, get bid up. Notably, gold has outperformed 10-year Treasury bonds in 2019 even as core inflation has witnessed a sharp drop. Between early 2017 and early 2018 we saw a similar dynamic play out, when long-term bond yields rallied (long bonds sold off) and gold remained steady while at the same time core inflation moved sharply lower.

 

In 2018, core inflation  eventually moved higher and caught up with the gold-to-Treasuries ratio. Suggesting that markets had correctly anticipated the move higher in core inflation.

 

We will know in time if the markets have got it right again or not. If core inflation does not move higher, it is likely that the safe haven bid, specifically in gold and other precious metals, has gotten ahead of itself and investors are better off owning government bonds over precious metals.

 

With long-term bond yields near all-time lows, it is difficult to make a strong case for bonds, however.

 

 

The below chart is that of WTI crude (magenta) and gold (orange). The two commodity prices tend to, over the long-term, have the same directional move. Oil does not have the safe haven characteristics of gold and therefore has stronger moves than gold both to the up and down sides.

 

USCRWTIC Index XAU (US Crude Oil WTI 2019-08-26.png

 

Much like the relation between the gold-to-Treasuries ratio and core inflation, a gap has opened up between the price of gold and that of oil, much like it did in 2017. In 2018, the gap was closed with oil moving higher. Will that also be the case this time around?

 

Finally, the last chart in this week’s piece. This one compares the price of oil to core inflation.

 

USCRWTIC Index PCE.png

 

The price of oil is one of the primary drivers of core inflation, albeit with a lag. Should oil prices move higher from here, core inflation will be higher 6 to 12 months down-the-line; justifying the move higher in gold and likely proving the current rally in government bonds to be a bull trap.

 

On the other hand, if oil prices make new lows, gold should be sold in favour of government bonds.

 

The price of oil is probably the most important price in capital markets today. The next move in oil will drive many of key tactical decisions for asset allocators.

 

If oil moves higher, portfolios will be found to be lacking allocations to assets that do well in periods of rising inflation ― resource and mining companies, resource rich emerging markets, high yield credit and precious metals ―and over exposed to high duration assets such as loss-making technology companies as well as utilities and long-terms bonds.

 

If oil moves lower, the stampede into developed market government bonds, technology stocks and utilities is likely to continue unabated.

 

We will be following the oil price ever so closely hereon out.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

Shifts in US Capital Flows and Positioning for a Steepening Yield Curve

 

A chart heavy piece this week in which we dig into the underlying shifts in the capital flows into the United States.

 

We had aimed to issue this piece last week but it took more work and longer to draw out coherent conclusions than we had anticipated.

 

The key takeaways we draw out from the analysis in this week’s piece are (1) the structural shifts in capital flows into the US since the Global Financial Crisis and (2) a flows based framework for charting the path of the US dollar.

 

“Total return has three elements: the interest rate differential, the exchange rate differential, and the capital appreciation in local currency. Since the third element varies from case to case we can propose the following general rule: speculative capital is attracted by rising exchange rates and rising interest rates.

 

Of the two, exchange rates are by far the more important. It does not take much of a decline in the currency to render the total return negative. By the same token, when an appreciating currency also offers an interest rate advantage, the total return exceeds anything that a holder of financial assets could expect in the normal course of events.

 

That is not to say that interest rate differentials are unimportant; but much of their importance lies in their effect on exchange rates and that depends on the participants’ perceptions. There are times when relative interest rates seem to be a major influence; at other times they are totally disregarded. For instance, from 1982 to 1986 capital was attracted to the currency with the highest interest rate, namely, the dollar, but in the late 1970s Switzerland could not arrest the influx of capital even by imposing negative interest rates. Moreover, perceptions about the importance of interest rates are often wrong.”

 

― The Alchemy of Finance, George Soros (emphasis added)

 

For those of you not wanting to run through the lengthy discussion, jump to the ‘Putting It Altogether’ section at the end of the piece.

 

One Quick Detour

 

Before going on to this week’s piece, a brief comment on bitcoin (or cryptocurrencies, in general).

 

We do not discuss cryptocurrencies or blockchain often and write about them even less. Even so, in our occasional discussions about cryptocurrencies we regularly come across statements along the lines of: “I am bullish on blockchain, not bitcoin,” or “The use case for blockchain technology far exceeds that of cryptocurrencies.” You too might have heard similar such statements from investors, venture capitalists, or other “authoritative sources” in discussions or interviews.

 

This line of thinking, we suspect, has driven capital and resources into developing private blockchains or proprietary databases that are based on blockchain technology. For example, banking behemoths of the likes of JP Morgan and UBS are spearheading efforts to use blockchain technology for settling cross-border trades worldwide with their own “Bitcoin-like” tokens.

 

The arguments in favour of private blockchains over public cryptocurrencies may yet prove prescient and the development of private database-like structures turns out to be the optimal use case for blockchain technology. The below passage from The Hard Thing About Hard Things written by Ben Horowitz, of Andreesen Horowitz fame, about the Internet and competing proprietary networks, is a reminder, however, that the public versus private implementation debate is not new. And a technology that appears to be inferior, insecure or volatile can evolve and supersede a seemingly superior competing solution.

 

“In retrospect, it’s easy to think both the Web browser and the Internet were inevitable, but without Marc’s work, it is likely that we would be living in a very different world. At the time most people believed only scientists and researchers would use the Internet. The Internet was thought to be too arcane, insecure, and slow to meet real business needs. Even after the introduction of Mosaic, the world’s first browser, almost nobody thought the Internet would be significant beyond the scientific community-least of all the most important technology industry leaders, who were busy building proprietary alternatives. The overwhelming favorites to dominate the race to become the so-called Information Superhighway were competing proprietary technologies from industry powerhouses such as Oracle and Microsoft. Their stories captures the imagination of the business press. This was not illogical, since most companies didn’t even run TCP/IP (the software foundation for the Internet)―they ran proprietary networking protocols such as AppleTalk, NetBIOS, and SNA. As late as November 1995, Bill Gates write a book titled The Road Ahead, in which he predicted that the Information Superhighway―a network connecting all businesses and consumers in a world of frictionless commerce―would be the logical successor to the Internet and would rule the future. Gates later went back and changed references from the Information Superhighway to the Internet, but that was not his original vision.

 

The implications of this proprietary vision were not good for business or for consumers. In the minds of visionaries like Bill Gates and Larry Ellison, the corporations that owned the Information Superhighway would tax every transaction by charging a “vigorish”, as Microsoft’s then―chief technology officer, Nathan Myhrvold, referred to it.

 

It’s difficult to overstate the momentum that the proprietary Information Superhighway carried. After Mosaic, even Marc and his cofounder, Jim Clark, originally planned a business for video distribution to run on top of the proprietary Information Superhighway, not the Internet. It wasn’t until deep into the planning process that they decided that by improving the browser to make it secure, more functional, and easier to use, they could make the Internet the network of the future. And that became the mission of Netscape―a mission that they would gloriously accomplish.”

 

A parting thought, consider the oft-cited explanation for the superiority of open-source solutions: “Given enough eyeballs, all bugs are shallow.”

 

US Trade Balance and Foreign Portfolio Investment

 

The below chart consists of the de-trended US trade balance (magenta bars), presented in reverse order and defined as the quarterly trade balance minus the three-year moving average of the trade balance,  and the quarterly foreign portfolio investments into the US on a net basis (orange line).

 

US Trade Balance De-Trended vs Net Foreign Portfolio InvestmentNPI vs TB.pngSources: US Census Bureau, US Department of the Treasury

 

The US, over the last twenty-five years, has, more often than not, run a trade deficit with the rest of the world. That is, Americans have consumed more than they have produced. During the 1990’s and the first five years of the current millennium, a growing trade deficit coincided with increasing foreign portfolio flows into the US.

 

Ahead of the financial crisis, the US trade deficit shrank and was duly followed by a sharp drop in foreign portfolio inflows. During and a few quarters following the Global Financial Crisis, the trade balance and foreign portfolio flows relation was flipped on its head. The US started to run a trade surplus, more on that anon, yet foreign portfolio flows increased rather than retrenching. The safe-haven bid for US assets, specifically US Treasury securities, was sufficiently large to overrun the impulse for foreign capital to retreat as the US went from running a trade deficit to running a trade surplus.

 

In the chart below, international flows into US Treasury securities are plotted against the US trade balance.  The international bid for Treasury securities was strong during the Global Financial Crisis and, following a brief pause, remained strong all the way through 2011.

 

US Trade Balance De-Trended vs US Treasury International Capital FlowsTrade Balance vs Treasury InflowsSources: US Census Bureau, US Department of the Treasury

 

Following the Global Financial Crisis and up until the election of President Trump, the US no longer ran consistent trade deficits and even when it did, they were not as large as they were prior to the crisis. As a corollary, foreign portfolio investments, too, waxed and waned between positive and negative during the time period.

 

The Diminished Role of Oil in Dictating Foreign Flows

 

Prior to the crisis, US oil imports were on a steady uptrend, going from below 5 million barrels per day at the end of 1990 to a peak of more than 10 million barrels in 2006/07. Imports dropped sharply to below 8.5 million barrels per day during the crisis, spiked in 2010, then continued declining through 2015, picked up in 2016 and 2017, and once again started falling from the second quarter of 2018. In February 2019, US oil imports averaged less than 7 million barrels per day for an entire month for the first time since February 1996.

 

US Trade Balance De-Trended vs Price of Brent Crude Oil De-TrendedTrade Balance vs BrentSources: US Census Bureau, Bloomberg

 

The rise of shale and the sharp drop in oil prices in the second half of 2014 has shifted the source and structure of net foreign portfolio investments into the US. The US trade balance, particularly during the commodity super-cycle witnessed during the first decade of the new millennium, was strongly correlated with the fluctuations in the price of oil. Since 2012, however, the correlation has broken down.

 

US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedPPI vs BrentSources: US Census Bureau, Bloomberg

 

The US trade balance being less correlated with the fluctuations in the price of oil also coincided with the correlation between foreign portfolio flows and the price of oil declining.

 

The breakdown in the correlation can be understood through the shifting structure of foreign portfolio flows. From the 1990’s  through 2006, the growth in portfolio flows was predominantly driven by increasing international flows into US Treasury securities. Oil exporting nations, particularly those operating US dollar pegged currency regimes, and China, were recycling their US dollar windfalls back into Treasury securities.

 

The rise of shale and subsequent drop in the price of oil has meant oil exporting nations no longer have the kind of excess capital to re-direct into Treasury securities as they once used to. China’s dollar-shortage challenges are, of course, well documented. Consequently, foreign flows into US government bonds have become more sporadic and the relative share of foreign flows into other securities has increased. The relative share of US foreign portfolio flows from other pools of capital, specifically pension funds and insurance companies in Europe and Japan, has also increased.

 

Structure of US Net Foreign Portfolio InvestmentNPISource: US Department of the Treasury

 

The shift, however, in the correlation between the fluctuations in the price of oil and foreign flows into US Treasury securities has not been as dramatic. Suggesting that oil exporters continue to prefer parking excess capital into US government bonds and are not going out on the risk curve.

 

US Net Foreign Portfolio Investment vs Price of Brent Crude Oil De-TrendedTreasury Inflows vs BrentSources: US Department of the Treasury, Bloomberg

 

Putting It Altogether

 

We have gone through some of the high level dynamics of the US trade balance and foreign portfolio flows. To round off the discussion, we outline a framework that can be helpful in thinking about the US dollar and demand for US dollar assets in general.

 

US Trade Balance + Net Foreign Portfolio Investment De-Trended vs YoY Change in US Dollar IndexTB NPI vs DXY (1).pngSources: US Census Bureau, US Department of the Treasury, Bloomberg

 

The magenta line in the above is the sum of the de-trended trade balance and the de-trended net foreign portfolio investment. The line being above zero implies foreign demand for US dollars exceeding the supply of US dollars. For example, the demand for US dollars emanating from portfolio flows exceeds the supply of US dollars being created by the US running a trade deficit.

 

Demand outstripping supply, to state the obvious, places upward pressure on the US dollar.

 

Outside of periods of insatiable demand for safe-haven assets, this flows based framework works well as a tool to chart out a path for the US dollar.

 

Based on this framework, let us consider the scenario of the US undertaking a large fiscal spending programme following the presidential election. If such a fiscal spending programme greatly increases the US trade deficit, supply of US dollars should also increase substantially. This increase in the supply of US dollars will place tremendous downward pressure on the greenback unless accompanied by a commensurate increase in foreign portfolio flows into American financial assets.

 

An increase in foreign demand for American financial assets, in all likelihood, requires higher long-term interest rates. The optimal way for investors to position for it in the current environment, in our opinion, is to be long yield curve steepeners.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

 

 

An Unconventional Inflation Gauge | What Have We Learnt?

 

“The first lesson of economics is scarcity: There is never enough of anything to satisfy all those who want it. The first lesson of politics is to disregard the first lesson of economics.” ― Thomas Sowell

 

An Unconventional Inflation Gauge

 

In the below monthly chart the magenta line is the ratio of silver to the S&P 500 Index. A rising magenta line means that silver is rising relative to the S&P 500 Index.

 

The black line is the 5-year (or 60 month) moving average of the silver-to-S&P 500 Index ratio.

 

The orange line is core consumer price inflation in the US.

 

Ideally the impact of geopolitical events, such as the spike in the oil price following Sadaam Hussain’s invasion of Kuwait, and the sharp swings in inflation in the immediate aftermath of the Global Financial Crisis due to base effects should be ironed out of the core inflation series.

 

XAG Curncy (Silver Spot $_Oz) S 2019-08-09 18-01-00

 

The silver-to-S&P 500 Index ratio has led the disinflation / deflation curve in the US over the course of the last 30+ years. As a general rule, the periods during which the ratio has been below its 60-month moving average, inflation has receded. When the ratio has moved above its 60-month moving average and remains above it for some time, inflation has tended to pick-up on a cyclical basis.

 

The silver-to-S&P 500 ratio is approaching its 60-month moving average and it just maybe that a breach of the moving average coincides with cyclical inflationary pressures picking up in the US once again. Mathematically, barring very sharp moves in either silver (up) or the S&P 500 (down), the series will take some months yet to crossover, if at all. Therefore, it might well pay to monitor the series and its moving average for any signal for a pick up in core inflation.

 

Notably, the Atlanta Fed’s Wage Growth Tracker has shown an uptick during the past several months. The 12-month average reached 3.7 per cent in June, up from 3.2 percent last year. If wage inflation continues to remain for 3 per cent, its only a matter of time that we see core inflation pick up.

 

Trade Wars: What Have We Learnt?

 

With an additional US dollars 300 billion of Chinese exports to the US to incur tariffs and the proverbial line in the sand of 7 on the USDCNY cross having been breached, what have we learnt?

 

First, the battle lines have been drawn and Beijing has clearly decided that it is not willing to make a deal on purely US terms. If a ‘beautiful deal’ is to be struck, it will now require some concessions from the Trump Administration ― the tough talking China hawks will need to back off, even if a little. Otherwise, China will tough it out and hope that the 2020 election will deliver an adversary other than Trump.

 

Second, President Trump has run out of Chinese imports to tariff. He could ratchet up tariffs to 25 per cent from the proposed 10 per cent but such a move risks a severe loss of business confidence; and gives China added impetus to let the renminbi depreciate further and stabilise its own economy, at the expense of everyone else’s.

 

What is seemingly working in President Trump’s favour is the half-life of the impact of his tariff tweets on the US equity market is declining. This may have more to do with liquidity than investor apathy.

 

The below chart is the year-over-year increase in commercial bank deposits in the US.

 

ALNLDEPO Index (US Commercial Ba 2019-08-09 18-51-12.jpg

 

Using commercial deposits as a proxy for US system-wide liquidity, liquidity has been in a cyclical contraction since 2013. Since November last year, system-wide liquidity has been picking up. If US commercial bank deposits can continue expanding, the US economy and equity market are likely to remain resilient for the time being.

 

Given this resilience, President Trump could continue to ratchet up tariffs and assume economic and market damage can be contained, especially if he can bully the Federal Reserve into loosening the purse string. If the Fed plays hardball, however, and markets and the economy have an almighty wobble, President Trump will have a ready scapegoat.

 

This might or might not be a successful strategy to get re-elected. It will not, however, bring China back to the negotiating table. Instead, Beijing is likely to let the renminbi depreciate gradually in an effort to shore up its economy. And central banks of nations with close economic ties with China are likely to respond by cutting rates to stabilise their respective currencies to the renminbi, much like what we saw happen in New Zealand this week.

 

It is worth noting that since the breakdown of the trade talks in early May, the Chinese negotiating position has been quite clear, and unaffected by the pressure tactics applied by the Trump Administration. Statements in May by senior Chinese officials, including chief negotiator and vice-premier Liu He, demanded that any trade deal meet three conditions: the list of US goods to be purchased by China to cut the trade deficit must be reasonable and not subject to capricious change; existing tariffs must be substantially reduced or eliminated; and the text of the agreement must “respect China’s dignity”.

 

The latest tariff threat by President Trump, despite virtually all his advisors objecting to it, achieved very little except giving China an excuse to let the renminbi depreciate. For now, the US-China negotiations are a stalemate. The choice President Trump makes will determine whether China returns to the negotiating table or not.

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

 

 

Dislocation

“Neutrality is at times a graver sin than belligerence.” – Louis D. Brandeis

In May, an escalation in the US-China trade dispute and President Trump’s reversal on the trade pact with Mexico, albeit short-lived, damaged business confidence and sufficiently raised uncertainty to cause corporations to re-think their investment plans.

No surprise then that business investment in the US fell by four-fifths of a percentage point, on a quarter-over-quarter basis, during the second quarter and was a major drag on US GDP growth.

President Trump, having raised hopes of an amicable solution to the trade dispute following the G20 meeting in Osaka, once again threw a spanner in the works yesterday. He tweeted that the US will be imposing, starting 1 September, a 10 per cent tariff on the remaining US dollars 300 billion of Chinese imports that hitherto had not been subject to tariffs.

President Trump’s tweets sent Twittersphere into a frenzy and caused stocks to sell off, oil to crater and gold to, well, behave like a safe-haven. And probably delayed corporate investment plans further.

Given the context, may be everyone should be long bonds and it makes sense that:

  • Over US dollars 13 trillion of global bonds trading with negative yields;
  • Bonds of sub-investment grade issuers in Europe trading with negative yields;
  • The German and Swiss yield curves are negative out to more than 20- and 30-years, respectively; and that
  • Austria sold a century bond with a yield of just 1.2 per cent.

Or it might be that global bonds trading at record low yields is a signal that either a global recession is underway, which the data will confirm sooner rather than later, or that the world will enter a recession sometime between now and late 2020. An imminent global recession appears to be the consensus view.

In our humble opinion, global bonds trading at record low yields are just as much a signal that a recession is imminent and that inflation is dead as technology stocks trading at market capitalisations of  double- and triple-digital multiples of their hypothetical five-year revenues at the height of the tech bubble were of the internet ushering in a new business paradigm.

Sometimes the price is just wrong. Often because of a technicality.

A Digression

Up until  18 March 2005 the S&P 500 Index was a market capitalisation weighted index. That is, the weight of a stock in the index was equal to its market capitalisation divided by the sum of the market capitalisation of all stocks in the index. After 18 March 2005, the S&P 500 Index became a float adjusted capitalisation weighted index. That is, a stock’s weight in the index is equal to its free float market capitalisation – the stock price multiplied by the number of its shares freely available to trade, i.e., all shares excluding those held by insiders, locked-in as part of incentive programmes, held by the government or the promoters – divided by the sum of the free float market capitalisation of all stocks in the index.

The S&P 500 Index weighting calculation being agnostic to the free float and being based purely on a market capitalisation had an unintended consequence. That unintended consequence was the tech bubble.

All else being equal, a stock with fewer freely available shares to trade is less liquid, or illiquid, relative to a stock with more freely available shares to trade. Illiquid stocks tend to have more exaggerated price moves, up or down, than a liquid stock for the same value of buy or sell orders.

During the tech bubble, the market direction was just one way – up. So the upward price moves in illiquid stocks, in general, were greater than those of liquid stocks. And with each passing day, as a result, illiquid stocks started comprising a greater and greater portion of the S&P 500 Index. As their weight in the index grew, the demand for these illiquid stocks grew from (i) passive strategies that allocate based on index weightings and (ii) active managers reducing their tracking error and benchmark risk. The growth in demand for these illiquid stocks was not met with a commensurate increase in the quantity of stock freely available to trade. Rather, the opposite occurred. Those that held the illiquid stocks became averse to trading them. Setting off a vicious spiral that required bubble-like prices for the market to clear. Of course, when the market was ready to clear, nobody wanted the illiquid stocks anymore.

The Bond Technicality

Rather than go through an exhaustive list of technicalities that force bond buying, the below are examples of rules and regulations that have created price insensitive buyers of bonds:

  • OECD countries, such as Japan, France, Belgium, Portugal and Denmark, impose a minimum allocation to public sector bonds on their respective pensions plans. The minimum allocations range from 15 to 50 per cent of pension assets.
  • Basel III, a set of banking regulations developed by the Bank for International Settlements, increased the ‘Tier 1’ capital ratio – roughly the amount of ‘equity’ banks need to hold as a percentage of risk-weighted assets – and put a zero risk-weight on government bonds. To comply with the more stringent  requirements banks have a choice to maintain risk-weight by increasing capital or reduce risk-weight by investing more in government bonds. Most banks chose the latter.
  • Quantitative easing. Just as an example, the European Central Bank bought over euros 1.9 trillion of government bonds, roughly 90 per cent of the bonds issued by European governments, over the 45-month period the quantitative easing programme was running.

The global bond prices are not right. It is a technicality. That does not mean you bonds should be shorted, either.

What Does Trump Want?

President Trump is nothing if not belligerent. He will try to get what he wants by any means necessary. But what is it that he wants other than being re-elected for a second term?

Lower Interest Rates, More Spending

The last four US presidents not to be re-elected all oversaw struggling domestic economies going into their re-election campaign. President Trump is undoubtedly aware of this and does not want a tight monetary policy or higher, than needed, interest rates to derail his campaign.

Lower interest rates, moreover, may make it easier for the Trump Administration to continue playing hardball with China. After all, the US economy is far less reliant on trade than most and it is the health of the consumer that tends to determine to fate of the US economy. Lower rates are simply put better for the US consumer.

In this instance investors should be long short-term interest rates. Equity investors should be long  high quality consumer packaged companies with a decent yield such as Campbell Soup $CPB.

A Weaker Dollar

A weaker US dollar is generally stimulative for the global economy but also reduces China’s ability to meaningfully weaken its currency to offset any tariffs. Getting a weaker US dollar, at a time when most central banks are cutting rates and easing monetary policy, is not easy. The Fed, of course, is the one central bank that has the capacity to manufacture a weaker US dollar.

In this instance, investors should be long gold and other precious metals.

In neither instance do we think is buying long-term bonds the answer because a world with a weaker US dollar and / or lower interest rates is unlikely to enter a recession.

More importantly, businesses will eventually have to invest and they are most likely to invest in the US – the trade uncertainty is not going to go away anytime soon whether President Trump gets re-elected or not. The US has tight production capacities and low unemployment. Save a new immigration drive, a meaningful increase in business investment in the US or a large government led fiscal spending programme  is likely to kindle inflationary forces and precipitate a sell-off in long-term bonds.

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

China Gold & Equities | Silver Update | Yield Curve

“An open, competitive, and liberalised financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention.”  ― Henry Paulson

 

The irony of the above quote is rather obvious: Henry Paulson was a driving force behind  the Troubled Asset Relief Program (TARP), which freed the United States government to purchase toxic assets and equity from financial institutions to strengthen its financial sector. That does not, however, mean the message is incorrect.

 

XAUCNY and the Chinese Equity Market

 

Earlier this year and late last year there was much debate around an implicit peg that seem to have formed between the renminbi and gold.  More recently, the seven handle on the USDCNY cross has gathered much intrigue as the line in the sand for China.

 

We, too, have been following the price of gold in renminbi terms.  Rather than signaling an impending currency devaluation, however, we think the pair can signal potential dislocations between the Chinese equity market and the economic realities on the ground.

Gold / CNY vs. CSI 300 Index (Inverted)

XAUCNY CSI300

Source: Bloomberg

The chart above plots the price of gold in renminbi versus the Shanghai Shenzhen CSI 300 Index (inverted).

 

Gold strengthened between 2010 and 2012 as the equity market faltered. Then weakened well ahead of the sharp Chinese market rally of 2014/15. Notably, the bottom in gold in renminbi terms almost coincided with the peak in the Chinese equity market.

 

More recently, the draw down in Chinese stocks following the sharp rally at the start of the year has coincided with strengthening gold. Gold has since continued to strengthen while stocks have traded sideways, portending more bad news for equity investors.

 

According to a paper authored by researchers at the Japan Center of Economics Research “(1) the gold return rises significantly if stock returns fall sharply; (2) it rises as the stock market volatility increases; (3) it also rises when general financial market conditions tighten”. The quoted study focuses on the US equity market. Assuming, however, that the findings are just as applicable in China, the continued rise in gold in renminbi terms may be signalling a sharp tightening of financial conditions on the mainland.

 

The below chart plots the Citi Early Warning Index for China (magenta) versus the XAUCNY cross.

 

CEWSCNY Index (Citi Early Warnin 2019-07-26 12-12-46.jpg

 

The above too suggests that the renminbi price of gold can act as a less volatile signal for the stresses building up in China.

 

Silver Updates

 

The below are updated versions of charts we have shared previously.

 

XAG Curncy (Silver Spot $_Oz) 4 2019-07-24

Silver has moved above its 48-month moving average. If it can continue to stay above the moving average, silver could sharply move higher.

 

SPX Index (S&P 500 Index) spx si 2019-07-24 10-00-21

 

The S&P 500 Index in silver terms in struggling around key levels. Making a silver a suitbable hedge for any US equity market weakness henceforth.

 

Reading Too Much into the Treasury Yield Curve

 

The below is a chart of the yield differential between US 10 year and 3 month Treasury securities.

USGG10YR Index (US Generic Govt 2019-07-25

Starting July, US yield curve is no longer inverted. A sharp steepening of the yield curve over following an inversion caused by a series of Federal Reserve interest rate hikes has been characteristic of the early stages of the last four US recessions. We think, however, commentators and investors may be reading too much into it. In the prior instances, a recession was signaled by a bull steepening, with the short end of the curve falling faster than the long end. This time, though, long end has been rising faster than the short end ― a bear steepening

 

Several factors have contributed to the reversal of the US yield curve’s inversion over the last couple of weeks. On one hand, Fed chairman Jay Powell confirmed market expectations of a near term rate cut in his testimony to Congress last week. On the other, both the New York Fed’s survey of one-year ahead consumer inflation expectations and the 10-year breakeven inflation rate signaled a pick-up in inflation expectations. As a result, the bond market has begun to price in the possible effects of firmer future inflation on future Fed policy. With the short end of the yield curve anchored by the Fed’s current dovishness and the labour market tight, any liquidity-driven improvement in the US growth outlook is likely to feed through into a further steepening of the US yield curve over the second half of this year.

 

The current iteration of an inversion followed by steepening resembles 1998 and not the last four recessions. In 1998, the Fed cut interest rates in response to global economic weakness following the Asian Financial Crisis and the collapse of Long Term Capital Management, resulting in a bear steepening. Between 1998 and 2000, US equities, specifically tech stocks, went parabolic.

 

Now is not the time to sell US equities in fear of a recession. It is the time to wait and see if we get a parabolic move higher and to gradually reduce equity exposure as markets move higher.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

A Fear & Greed Gauge

 

“I listened very, very carefully to the world around me to pick up the signals of when trouble was coming. Not that I could stop it. But it made me observant. That was helpful when I became a lawyer, because I knew how to read people’s signals.” ― Sonia Sotomayor, Associate Justice of the Supreme Court of the United States

 

“Remember always that everything you know, and everything everyone knows, is only a model. Get your model out there where it can be viewed. Invite others to challenge your assumptions and add their own.” ―Donella H. Meadows, lead author of The Limits to Growth and Thinking in Systems: a Primer

 

As the US stock market has rallied and reached new heights, we have been trying to develop a framework that can provide a timely signal to reduce exposure. At the same time, we also want said framework to provide a timely signal to increase exposure following a draw down in the market.

 

In today’s piece we share one tool that we hope will, eventually, form part of a larger market timing framework. This piece is word light, chart heavy with the same tool being applied to major indices, select sector ETFs, and individual securities to provide indicative buy and sell levels can help us preempt sharp draw downs and avoid missing out on  sharp rallies.

 

If you would like us to apply the tool to any additional securities just email us and we would be happy to do so.

 

Greed & Fear Gauge

 

The tool is really quite simple. It is a leading indicator created by deducting the 100-week moving average from weekly close prices and then identifying key buy and sell levels  based on the indicator.

 

The key buy and sell levels are meant to act as guide, allowing some room for discretionary judgement if one prefers, rather than exact levels to trigger decisions. While there is some friction from whipsawing around key levels, a non-discretionary approach to the key levels can work well too, in our opinion.

 

In each of the charts presented below, there are twenty-five, the magenta line is the indicator and the orange line is the weekly close prices of the index / ETF / security in question.

 

Major Indices

 

S&P 500 Index

SPX Index (S&P 500 Index) Fear a 2019-07-22 09-57-22

 

The key levels are indicated using the black horizontal lines on the chart above.

The upper bound should be used as follows:

 

  • If the index has a weekly close at or more than 350 points above the 100-week moving average for the index, the sell trigger is a weekly close that is less than 350 points above the 100-week moving average.

 

  • If the index recovers the 350 points threshold on a weekly close at a later day, long positions should be re-established.

 

The lower bound should be used as follows:

 

  • If the index has a weekly close below the 100-week moving average of the index, any remaining long positions should be closed out.

 

  • If the index moves back above the 100-week moving average, new long positions should be initiated.

 

For the remaining charts we will identify the upper and lower bound levels and the same explanation as above will apply but replacing the respective upper and lower bounds for the ones for the S&P 500 Index.

 

Nasdaq 100 Index

NDX Index (NASDAQ 100 Stock Inde 2019-07-22 10-33-15

 

Upper bound: A weekly close 1,000 points above the 100-week moving average.

 

Lower bound: A weekly close below the 100-week moving average.

 

Nasdaq Index (Broader)

CCMP Index (NASDAQ Composite Ind 2019-07-22 09-57-45

 

Upper bound: A weekly close 1,000 points above the 100-week moving average.

 

Lower bound: A weekly close below the 100-week moving average.

 

MSCI ACWI

MXWD Index (MSCI ACWI Index) Fea 2019-07-22 14-41-28.png

 

Upper bound: A weekly close 50 points above the 100-week moving average.

 

Lower bound: A weekly close 25 points below the 100-week moving average.

 

Emerging Markets  $EEM

EEM US Equity (iShares MSCI Emer 2019-07-22 10-59-31

 

Upper bound: A weekly close $10 above the 100-week moving average.

 

Lower bound: A weekly close $5 below the 100-week moving average.

 

Nikkei 225

NKY Index (Nikkei 225) Fear and 2019-07-22 11-19-22

 

Upper bound: A weekly close 3,000 points above the 100-week moving average.

 

Lower bound: A weekly close 150 points below the 100-week moving average.

 

MOEX Russia Index

INDEXCF Index (MOEX Russia Index 2019-07-22 11-19-50

 

Upper bound: A weekly close 400 points above the 100-week moving average.

 

Lower bound: A weekly close below 100 points above the 100-week moving average.

 

Sectors

 

PHLX Semiconductor Sector  $SOX

SOX Index (Philadelphia Stock Ex 2019-07-22 10-24-22

 

Upper bound: A weekly close 100 points above the 100-week moving average.

 

Lower bound: A weekly close 35 points below the 100-week moving average.

Energy  $XLE

XLE US Equity (Energy Select Sec 2019-07-22 11-49-30

 

Upper bound: A weekly close $5 above the 100-week moving average.

 

Lower bound: A weekly close $10 below the 100-week moving average.

 

Utilities  $XLU

XLU US Equity (Utilities Select 2019-07-22 12-03-59

 

Upper bound: A weekly close $5 above the 100-week moving average.

 

Lower bound: A weekly close below the 100-week moving average.

 

Pharmaceuticals  $XPH

XPH US Equity (SPDR S&P Pharmace 2019-07-22 12-10-28

 

Upper bound: A weekly close $5 above the 100-week moving average.

 

Lower bound: A weekly close $5 below the 100-week moving average.

 

Retail  $XRT

XRT US Equity (SPDR S&P Retail E 2019-07-22 12-12-39

 

Upper bound: A weekly close $3 above the 100-week moving average.

 

Lower bound: A weekly close $1.25 below the 100-week moving average.

 

Consumer Staples  $XLP

XLP US Equity (Consumer Staples 2019-07-22 13-24-22

 

Upper bound: A weekly close $5 above the 100-week moving average.

 

Lower bound: A weekly close below the 100-week moving average.

 

Healthcare  $XLV

XLV US Equity (Health Care Selec 2019-07-22 13-26-42

 

Upper bound: A weekly close $12 above the 100-week moving average.

 

Lower bound: A weekly close below the 100-week moving average.

 

Biotech  $IBB

IBB US Equity (iShares Nasdaq Bi 2019-07-22 13-29-00

 

Upper bound: A weekly close $10 above the 100-week moving average.

 

Lower bound: A weekly close $5 below the 100-week moving average.

 

Individual Stocks

 

$AAPL

AAPL US Equity (Apple Inc) Fear 2019-07-22 10-16-02

 

Upper bound: A weekly close $30 above the 100-week moving average.

 

Lower bound: A weekly close below the 100-week moving average.

 

$MSFT

MSFT US Equity (Microsoft Corp) 2019-07-22 10-45-46

 

Upper bound: A weekly close $30 above the 100-week moving average.

 

Lower bound: A weekly close below $10 above the 100-week moving average.

 

$SBUX

SBUX US Equity (Starbucks Corp) 2019-07-22 10-43-16

 

Upper bound: A weekly close $10 above the 100-week moving average. Given the strongly rally recently, however, we add $20 above the moving average as a profit-taking trigger.

 

Lower bound: A weekly close below the 100-week moving average.

 

$GOOG

GOOG US Equity (Alphabet Inc) Fe 2019-07-22 09-59-49

 

Upper bound: A weekly close $225 above the 100-week moving average.

 

Lower bound: A weekly close below $50 above the 100-week moving average.

 

$NKE

NKE US Equity (NIKE Inc) Fear an 2019-07-22 10-48-10

 

Upper bound: A weekly close $18 above the 100-week moving average.

 

Lower bound: A weekly close below $5 above the 100-week moving average.

 

$AMZN

AMZN US Equity (Amazon.com Inc) 2019-07-22 10-05-05

 

This is a difficult one given the strength of the rally in the last three years and probably provides a weak signal.

 

Upper bound: A weekly close $600 above the 100-week moving average.

 

Lower bound: A weekly close below $200 above the 100-week moving average.

 

Micron  $MU

MU US Equity (Micron Technology 2019-07-22 10-55-54

 

Upper bound: A weekly close $15 above the 100-week moving average.

 

Lower bound: A weekly close $5 below the 100-week moving average.

 

Precious Metals

 

Gold

XAU Curncy (Gold Spot $_Oz) Fe 2019-07-22 11-22-35

 

Upper bound: A weekly close $250 above the 100-week moving average.

 

Lower bound: A weekly close below the 100-week moving average.

 

Silver

XAG Curncy (Silver Spot $_Oz) F 2019-07-22 11-27-11

 

Upper bound: A weekly close $5 above the 100-week moving average.

 

Lower bound: A weekly close $1 below the 100-week moving average.

 

Bitcoin

XBTUSD Curncy (XBT-USD Cross Rat 2019-07-22 11-31-24

 

Upper bound: A weekly close $5,000 above the 100-week moving average.

 

Lower bound: A weekly close below $1,000 above the 100-week moving average.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

 

 

 

 

 

Cheap vs. Expensive | The Threat to Incumbents

 

“Business is the systematic playing of games.” ― Reid Hoffman

 

We gathered some data on the changes in the make up of S&P 500 Index over time and did some good old fashioned number crunching in MS Excel. In this week’s piece we share some of the analysis and insights from this number crunching, which covers the following:

 

  • Price-to-earnings spread between ‘expensive’ and ‘cheap’ constituents of the S&P 500 Index;
  • Return profile of stocks added to the S&P 500 Index between 31 August 2017 and 30 April 2019; and
  • How the largest US companies, in a rush to return cash to shareholders, may be unwittingly setting themselves up to be disrupted.

 

As a disclaimer, the analysis presented below is neither meant to paint a bullish nor bearish picture. We have, however, on a number of occasions in the last year expressed our constructive view on the market, most recently here and prior to that here.

 

Price-to-Earnings Differential

 

The below chart presents the trailing price-to-earnings ratio spread between the 25th and 75th percentiles for the constituents of the S&P 500 Index ranked by their trailing twelve month price-to-earnings ratio.

 

A rising line implies that the spread between the upper and lower quartiles is expanding or simply put expensive stocks, in terms of trailing price-to-earnings, are getting even more expensive relative to cheaper stocks.

 

Differential Between 25th & 75th Percentiles TTM P/E Ratio of S&P 500 Constituents

PE Differential.png

Source: Bloomberg, S&P Global

 

The dashed lines in the above chart are the levels marking +/- 1 and +/- 2 standard deviations from the average TTM P/E ratio differential between the 25th and 75th percentiles.

 

As can be seen in the above, this is yet another market metric reaching levels last seen during the tech bubble.

 

S&P 500 Index Inclusion: Return Metrics

 

For a stock to be added to the S&P 500 Index is quite a big deal. The sheer amount of passive and non-discretionary assets tracking the S&P 500 Index means that any stock included into the index should see an uptick in its trading volumes and a near perpetual bid from S&P 500 trackers and ETFs.

 

What, however, does inclusion mean in terms of returns for investors holding stocks included in the S&P 500 Index? We try to answer that question by looking at a relatively small sample: stocks included into the index between 31 August 2017 and 30 April 2019. We are aiming, in the next two weeks, to extend the sample set to as far back as 1 January 1990 and also to include the impact on stocks dropped from the index.

 

Post Inclusion Alpha
1 Month 3 Months 6 months 1 Year
Average 0.73% -3.46% -3.12% -7.32%
Median 2.54% -1.42% -5.91% -6.39%

 

Based on the analysis of the limited sample, it suggests that one would be better off, one average, selling a stock that has been included into the S&P 500 Index immediately after its inclusion and buying the S&P 500 Index instead.

 

The data set used for the above calculations can be found here.

 

Research & Development

 

According to alternative assets data provider Preqin, at the end of 2018 the amount of dry powder committed to private capital funds and investment programmes stood at US dollars 2 trillion, of which approximately US dollars 400 to 450 billion was committed to angel investing and venture capital funds. To put that in context, the amount dry powder available to angel and venture capital investors as recently as 2014 was estimated to be in the range of US dollars 100 to 150 billion dollars.

 

An estimated three-fold increase in the amount of capital gives venture capitals a lot of money to throw at a lot of problems.

 

We recently listened to a podcast featuring famed venture capitalist Bill Gurley in which he passingly mentioned something along the lines of incumbents being more at risk of being disrupted today than ever before.

 

This got us to thinking that what if US corporations were prioritising returning capital, through buybacks and dividends, to investors to such a degree that it was coming the expense of the future profitability of the respective businesses?

 

While we do not have an answer to our question, we do have some interesting data to shares.

 

R&D Expense as a Percentage of Net Sales (Average) for S&P 500 Constituents 

RD Exp Sales.png

Source: Bloomberg

 

There appears to have been a structural step down in the amount of money, as a percentage of net sales, that has been invested in research and development following the Global Financial Crisis. There was a spike up recently, we suspect that is due to US tax reform and the repatriation of non-US profits.

 

Year-over-Year Growth in R&D Expenses (Average) of S&P 500 Constituents 

RD Exp Growth.png

Source: Bloomberg

 

Similarly, even in terms of absolute dollar amounts, there has been a slowdown in growth of absolute dollars being invested in research and development by the constituents of the S&P 500 Index. This is all the more surprising given the makeup of the S&P 500 has shifted in favour of healthcare and technology companies over the last decade. Healthcare and technology companies are generally known to be heavy investors in research and development. Businesses operating in the more “old economy” sectors are, it seems, investing even less in research and development.

 

Average Cash and Marketable Securities Balances for S&P 500 Constituents

Cash.png

Lastly, the above chart is of the average cash and marketable securities balances of S&P 500 constituents, excluding major financial services businesses.

 

The largest corporations in the United States are draining their cash in financialisation at a record pace just as their predators in the venture capital industry have been building up their war chests. The picture gets even worse once you exclude the major technology companies with large piles of cash ready to be invested in acquiring and developing up and coming technologies.

 

Low interest rates did not encourage large US corporations to invest, rather they encouraged financialisation. The unintended consequence of which may be the death of the incumbents.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. 

 

Osaka: From Trade to Tech

 

“Decisions in a modern state tend to be made by the interaction, not of Congress and the executive, but of public opinion and the executive.” ―Walter Lippman, The Basic Problem of Democracy, 1919

 

 

Before going on to this week’s commentary, we wanted to share a passage from These Truths: A History of the United States by Jill Lepore:

 

Progressivism had roots in late nineteenth-century populism; Progressivism was the middle-class version: indoors, quiet, passionless. Populists raised hell; Progressives read pamphlets. Populists had argued that the federal government’s complicity in the consolidation of power in the hands of big banks, big railroads, and big businesses had betrayed both the nation’s founding principles and the will of the people, and that the government itself was riddled with corruption. “The People’s Party in the protest of the plundered against the plunderers―of the victim against the robbers,” said one organizer at the founding of the People’s Party in 1892. “A vast conspiracy against mankind has been organized on two continents and is rapidly taking possession of the world,” said another. Progressives championed the same causes as Populists, and took their side in railing against big business, but while Populists generally wanted less government, Progressives wanted more, seeking solutions in reform legislation and in the establishment of bureaucracies, especially government agencies.

 

Populists believed that the system was broken; Progressives believed that the government could fix it. Conservatives who happened to dominate the Supreme Court, didn’t believe that there was anything to fix but believed that, if there was, the market would fix it. Notwithstanding conservatives’ influence in the judiciary, Progressivism spanned both parties.

 

The United States of America has been here before.

 

We will be sharing passages from Jill Lepore’s magnum opus over the coming weeks and months in the run up to the Democratic primary battle for 2020 Presidential Election.

 

Osaka: From Trade to Tech

 

From The Wall Street Journal:

 

Some money managers are bracing for a potential resurgence in trade tensions after President Trump’s meeting with Chinese President Xi Jinping this weekend by hedging their bets with currencies and options.

Strategies include a short on the Australian dollar and other currencies as well as bearish put options on the iShares China Large-Cap exchange-traded fund. Money managers including Russell Investments have pared their exposure to U.S. stocks, favoring more-attractively-valued shares of emerging-market companies.

How those moves pan out largely depends on what happens in Osaka, Japan, this weekend, when Messrs. Trump and Xi meet Saturday on the sidelines of the Group of 20 summit. There is no clear consensus among investors on whether the U.S. and China can reach a deal. Trade-policy uncertainty remains at elevated levels, according to data compiled by Wells Fargo Investment Institute.

Rather than being left flat-footed, investors are taking precautions in case talks lead to an impasse or, worse, a full-blown escalation in tensions. The S&P 500 slumped 6.6% in May following the unexpected implementation of additional tariffs on China’s products.

 

With one trading day remaining before President Trump and President Xi are expected to meet at the sidelines of the G-20 summit in Osaka, the S&P 500 Index is down 69 basis points while the Philadelphia Stock Exchange Semiconductor Index is up 317 basis points. Huawei is likely to be part of any potential trade deal, the recent strength in semiconductors could well reflect some optimism for trade negotiations taking a turn for the better following the meeting between Messrs. Trump and Xi.

 

While we are somewhat optimistic with progress being made on trade negotiations, more on that anon, we are concerned the economic hostilities between the US and China gradually shifting from being centered around trade to being increasingly focused on enabling technologies, such as semiconductors, and core technology infrastructure, such as telecommunication  networks. For that reason, we would use any trade optimism related rallies in semiconductor stocks to further reduce exposure or add short positions.

 

Trade Optimism

 

The noise out of Washington suggests that there is a more than even chance that the talks between the leaders of the largest economies in the world will result in a deal in the next few months. It may well also be that the US and China negotiate a truce on Huawei, although any deal relating to the Chinese telecommunication changed could be torpedoes by Congress.

 

Our view is predicated on President Trump, not the trade hawks in his administration, wanting a deal rather than applying further tariffs on US dollar 325 billion of Chinese imports that he threatened to impose as early as next month.

 

We expect the two leaders to announce, following their meeting, that trade talks will resume and they expect a deal to be hammered out before the end of the year. The hawks on the Chinese side are likely to agitate for all tariffs to be eliminated with immediate effect. While the hawks in the Trump Administration will continue to insist that China enshrine its commitments in law.

 

Beijing has already made changes to its laws by passing a new Foreign Investment Law in March, and making amendments to its intellectual property-related laws and regulations. Changes to the intellectual property laws and regulations offer, accord to experts we have spoken to, significantly stronger protection for foreign intellectual property rights and limit Chinese corporations ability to coerce technology transfer.  More action is likely to be required China, but at least there appears to be meaningful progress on this front.

 

Putting China’s Technological Progress in Check

 

Among the preconditions for a trade agreement put forth by China is the requirement for the US to remove its ban on the sale of US technology Huawei. This will be a tricky matter to resolve. The Trump Administration has for months been drumming up anti-Huawei sentiment in Washington that any attempt to compromise will be seen as selling out national security for monetary gains. Senator Mitt Romney is already working on legislation that would prevent the President from removing Huawei from the export ban list.

 

Of the few bipartisan issues in Washington is the desire to put China’s technological progress in check, particularly its development of semiconductor and defense industries. Therefore, in our opinion, any trade deal is likely to skirt around the Huawei and technology transfer issues. These issues are then likely to manifest through alternative channels after a trade deal has been struck. One possibility is for a compromise allowing Huawei to resume buying components from US suppliers, in exchange for some restrictions on Huawei building out telecommunication networks US-friendly jurisdictions.

 

The technology-led US equity bull market might not die of old age but may die because the power players in Washington decide that the no amount of lost revenue is worth salvaging in its bid to slow the rise of China.

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

 

 

 

 

 

 

 

Trading the Thin Zone | Healthcare Follow Through

 

“If history repeats itself, and the unexpected always happens, how incapable must Man be of learning from experience.” ― George Bernard Shaw

 

 

Goldbugs are gloating. Dollar bulls are hurting. Ellioticians are cursing. This, we hope, is not one of those pieces.

 

Trading in the Thin Zone

 

Actions speak louder than words. Well, except for the Federal Reserve. They talked a big game, did very little yet markets popped. None more so than precious metals.

 

Rather than discussing the what and why of the latest Fed meeting, we discuss our thoughts about trading strategies for the US dollar, gold and silver.

 

Before we explain, the summary:

 

  • The critical level for US dollar bears is around 92 on the $DXY or US dollars 24 for the Invesco DB US Dollar Index Bullish Fund $UUP;

 

  • Above US dollars 1,375 per ounce for gold; and

 

  • Around US dollars 17.50 per ounce for silver.

 

In the price charts below, we overlay the volume around each price level to identify what may be called “thin zones”  ― areas where prices can move quickly and where positioning should be biased in favour of the shorter-term trend. The investment instruments we chart are ones we deem suitable proxies for the US dollar, gold and silver.

 

Thin zones are price levels where there has been relatively little buying or selling. Making them areas where there should be little to no support or resistance and so prices can move quickly through them.

 

These thin zones are typically preceded by, from above or below, price levels where there has been a lot of volume both on the way up and on the way down. These price levels are likely where institutional buying or selling has been heaviest in the past and where there are been a lot of push and pull between bulls and bears. And therefore the breach of such price levels can cause one set of market participants immense amount of pain while reap handsome rewards for the other set of participants.

 

Winners are unlikely to suppress a favourable move and instead may add fuel to the fire by increasing their positions and heaping yet more pain on those on the other side. The losers, except the most stubborn, are likely to cover adding yet more fuel to the move.  With demand being almost unidirectional, prices can spike on very little volume ― making it profitable to position at the edges of thin zones.

 

Using $GLD as a proxy, gold given the recent sharp move higher is right at the very edge of the thin zone and any continuation of the move higher should be used to add to longs.

 

GLD.png

 

Based on $UUP, the US dollar is still someway from getting to the thin zone on the downside but is close to one on the upside. It is still too early to have a full short position in the US dollar and if the current move down is a head fake, shorts should close out positions and even look to go long.

 

We suspect, 92 on the $DXY is close to the pain threshold for foreign pools of capital holding US Treasury securities without hedging foreign currency risk. If the US dollar breaks 92, it will be time to put on a full short position in the greenback.

 

UUP

 

Silver has a lot of work to do before it too can get closer to the thin zone. Gold is probably the better instrument to trade if you want to be long precious metals at present. If, however, silver moves through US dollars 17.50 per ounce, all bets are off and gold longs should be rotated into silver.

 

slv

Another proxy for silver is to watch for a sustained move above its 48 month moving average.

 

XAG Curncy (Silver Spot $_Oz) 4 2019-06-20 12-54-14.png

 

 

Healthcare Follow Through

 

A few weeks ago we highlighted the sharp recovery in healthcare stocks and started thinking about the sector as hunting ground for new long ideas. Since then we have witnessed a follow through with the SPDR Health Care Select Sector ETF $XLV continuing to push higher, particularly on the back of mergers and acquisitions activity in the biotechnology space.

 

The sector has been a laggard year-to-date but a leader in the last month. If the current iteration of the US bull market still has legs, we expect healthcare to continue going from strength-to-strength.

 

XLV US Equity (Health Care Selec 2019-06-20 11-27-42.png

 

We remain long Repligen Corp $RGEN and Novocure $NVCR and identify two additional names as long ideas in the healthcare sector. (A long in $AbbVie has still not been triggered.)

 

RGEN US Equity (Repligen Corp) H 2019-06-20 12-07-54.png

 

Medtronic $MEDT

 

Medtronic is the world’s largest medical devices company that infamously acquired Ireland-based Covidien to enable Medtronic to shift its legal headquarters from the US to Ireland to benefit from the favourable tax-regime in Ireland.

 

We will look to enter a long position should the stock close above US dollars 100.

 

MDT US Equity (Medtronic PLC) He 2019-06-20 12-10-26

 

 

Edwards Lifesciences Corp  $EW

 

Edwards Lifesciences is another medical equipment company. It specialises in artificial heart valves and hemodynamic monitoring.

We are long here.

 

EW US Equity (Edwards Lifescienc 2019-06-20 13-12-18.png

 

 

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This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

 

 

 

 

Durability of the US Bull Market

 

“Having insurance doesn’t guarantee good health outcomes, but it is a critical factor.” ― Irwin Redlener

“Seeing the bigger picture opens your eyes to what is the truth.” ― Wadada Leo Smith

As the key indices in US equity market are once again approaching all-time highs, we look to assess the durability of the bull market in the face of a plethora of negative headlines and rising valuations. We also identify a few leaders in the retail sector as long ideas.

 

Technology Leadership

 

When a bull market is turning over, the tell tale signs can usually be found in the segment that has led the bull charge. And as we all know, technology has been the clear leader in the most recent incarnation of the US equity bull market.

 

The below monthly chart is a ratio of the NASDAQ 100 Index to S&P 500 Index. The ratio is now in territory witnessed during the tail-end of the tech bubble. The difference this time ― ominous last words ― being the steady, as opposed to parabolic, rise in the ratio.

 

 

NDX Index (NASDAQ 100 Stock Inde 2019-06-13 09-39-55

 

The quarterly rate-of-change of the above ratio, shown in the chart below,  is another way to see the stark difference in the relative rise of the NASDAQ 100 over the last ten years as compared to the relative rise during the tech bubble.

 

NDX Index (NASDAQ 100 Stock Inde 2019-06-13 10-22-11.png

 

What the rate-of-change, or momentum, chart does suggest is that the recent waxing-and-waning in technology stocks, be it due to slowing earnings or fears over antitrust action against the mega-capitalisation technology companies, is still within the normal bounds of volatility.

 

If the NASDAQ 100-to-S&P 500 ratio fails to make new highs in the coming weeks and months or there is a marked deterioration in the ratio’s momentum, we would become concerned about the durability of technology’s market leadership.

 

Growth and Value

 

Other ratios in tech bubble territory are those of the S&P Growth Index-to-S&P 500 Index and the S&P Growth Index-to-S&P Value Index.

 

SGX Index (S&P 500 Growth Index) 2019-06-13 10-17-07

 

 

SGX Index (S&P 500 Growth Index) 2019-06-13 10-16-27

 

We are increasingly convinced that a barbell strategy should be applied today in managing equity exposures. With tech and other growth names on one side and value names and precious metals on the other. And if tech and growth continue to rally, investors should re-balance  regularly to avoid any lopsidedness in their portfolios.

 

Heavy Truck Sales

 

The below chart compares the S&P500 Index (magenta) to heavy truck sales in the US (orange). Heavy trucks sales are a barometer for economic activity in the US. Heavy truck sales rolled over in 2000 and in 2006 ahead of the cyclical peaks in the US equity market. Heavy trucks sales have thus far remained strong.

 

USASHVTK Index (United States He 2019-06-14 14-46-20.jpg

 

Cyclical to Defensive Stocks

 

The below chart is a ratio of the MSCI USA Cyclical Stocks Index to the MSCI USA Defensive Stocks. We see this ratio as a gauge of ‘animal spirits’. A rising line suggests a preference for profit over preservation.

 

The ratio has recently broken out to fifteen year highs. This is a but surprising given that Treasury yields have come in quite a bit in recent months, which should have benefited defensive sectors such as consumer staples and utilities.

 

MU704866 Index (MSCI USA Cyclica 2019-06-13 15-24-54.png

 

We would avoid or reduce allocations to bond-proxies such as utilities and REITs for now and search for alternative sources of diversification for portfolios with growth and technology heavy allocations.

 

The Smart Money Flow Index

 

The technology led rally from the lows recorded in February last year was not accompanied by a recovery in the Smart Money Flow Index. Rather, the index was hitting new lows just as the NASDAQ 100 was approaching new highs.

 

The rally in 2019, however, has coincided with a rebound in the Smart Money Flow Index. If the index starts retreating again we would be concerned.

 

SMART Index (Smart Money Flow In 2019-06-13 14-03-59.png

 

Corporate Yield Spreads

 

The below chart is the yield spread of Corporate BBB bonds to the US 10 Year Treasury.

 

Corporate yield spreads remain below the levels reached during the “volmageddon”on 2018 despite the sharp drop in oil prices in recent weeks. If yield spread breach the 1.65 per cent level in the below time series, we would think about scaling back equity exposures. Moreover, if we see exuberance take yield spreads below 2018 lows, we would worry that we are entering the “melt-up” phase in the bull market and also look to sell into strength.

 

CSI BBB Index (US Corp BBB_Baa - 2019-06-13 13-10-40.png

 

Consumer Leaders

 

If the Federal Reserve cuts interests rates, the US consumer will benefit from lower debt servicing costs on its mortgages and other debt. This should boost consumer spending, at least at the margin. We identify retail leaders that we add to our ideas on the long side.

 

ETSY  $ETSY

 

(The bottom panel is the relative strength to the SPDR Retail ETF $XRT.)

 

ETSY US Equity (Etsy Inc) Retail 2019-06-14 14-59-54

 

Five Below  $FIVE

 

FIVE US Equity (Five Below Inc) 2019-06-14 15-00-53

 

Under Armour $UAA

 

UAA US Equity (Under Armour Inc) 2019-06-14 15-00-22

 

 

This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.