Below is a round-up of Longview related views/research & trade ideas – the intention is to publish this most Fridays, updating key themes and highlighting key pieces of (often contrarian) research. Feedback, as always, is appreciated. Equally just ‘unsubscribe’ at the bottom if you don’t want to receive the email.
Brewing for a Bounce
Two weeks ago, there was a ‘palpable’ sense of relief in markets (with major indices having retraced a large portion of their October losses). That ‘relief’ was showing up across a number of metrics: Put protection in portfolios, for example, had unwound, buying of US equity ETFs had picked up rapidly and, technically, markets had (once again) become overbought. Equities, as we noted at the time, were following the classic ‘3 wave’ pattern* that is typical during stock market SELL-offs (for detail see 9th November Longview on Friday “Beware of the palpable relief”, available HERE).
In the past two weeks, equities have continued to follow that script and have worked their way lower, and in the case of the main US market, the S&P500, they are now (close to) retesting their October lows. Overall therefore it’s clear that equity markets are now in ‘wave 3’ of this SELL-off. As such the key question is: How much lower will equity markets fall before making a major local low?
Of note, in that respect, the wave three pullback typically doesn’t make new lows significantly below the wave one lows (especially after the S&P500 has fallen 10% or more in wave one). As we illustrated in this analysis (see HERE), in eighteen out of the nineteen 10%+ ‘wave 1’ SELL-offs, the ‘wave 3’ low was close to the wave one low (i.e. within a few percent). Indeed, at times, the lows from wave 1 are not broken at all (e.g. the summer 2015 SELL-off, see FIG A).
FIG A: S&P500 – this SELL-off mapped against the 2015 (and early 2016) SELL-offs
*Historically, equity market SELL-offs follow a three wave pattern: An initial pullback (wave 1), a relief rally (wave 2); and a final leg of selling (wave 3).
In addition to that price action analysis, it’s notable that a number of our medium term indicators have been working their way back to ‘BUY’ levels. Our ‘combined’ short and medium term scoring system, for example, is (effectively) back on ‘BUY’ (FIG 1)….
FIG 1: Longview combined short & medium term risk appetite scoring systems vs. S&P500
…while our aggregated scoring system is also at low/BUY levels (FIG 2) – although not quite at the negative two standard deviations level which is typical at the end of a wave three (e.g. see early 2017 & early 2016 SELL-offs).
FIG 2: Aggregated four scoring system vs. S&P500
Given those two factors, i.e. (i) the history of price action in SELL-offs; and (ii) the emerging BUY signals from our proprietary models, markets are now ‘brewing for a bounce’. In particular, given how oversold markets have become (e.g. see FIG 3 below), they are vulnerable to positive news flow.
FIG 3: S&P500 medium term technical scoring system vs. S&P500 index
That ‘positive’ news may take the shape of further dovish language by key Fed Presidents. Last week’s commentary by Clarida (on Friday), Powell (Wednesday) and Bostic (Thursday) was potentially a key turning point in that respect – with all of them casting doubts on how much further the Fed should tighten in 2019. In particular it’s likely that their focus is shifting towards the deflationary forces in the US economy, including US$ strength, a sharply weaker oil price, and a loss of credit impulse (e.g. see weak M1 growth and tighter financial conditions**), as well as the signs of slowing growth.
It’s also possible that next weekend’s G20 meeting offers some positive surprises (potentially with conciliatory discussions on trade between Trump and Xi Jinping). Even a neutral outcome on this front would probably be positive for markets, given how much ‘bad news’ is in the price***.
In addition, December is a seasonally strong month for US equity markets (as is well known). On average, the S&P500 delivers a return of 1.9% (and is the strongest month of the year – i.e. since 1987), see FIG 4. In the past 20 years, outside of bear markets, there have only been 4 December months in which the equity market return was not positive (1996, 2005, 2014 & 2015).
FIG 4: Average S&P500 returns by month (%)
Source: Longview Economics, Macrobond
**Albeit tighter financial conditions are not clear across all measures.
***i.e. after recent plans for trade talks in Washington fell through – and given warnings by Larry Kudlow (and others) of a ‘direct confrontation’ between the US & China at the G20 meeting.
Brewing Rotation
Our central view, as highlighted above, is that the Fed will pause its hiking cycle in 2019 (as we’ve discussed before – see HERE). If that’s correct, then we would expect that, over the coming months, there will be significant shifts in portfolio positioning back towards classic reflationary/cyclical assets. Whilst we are not yet at that position, the evidence for that forthcoming shift is brewing.
Key to it occurring will be; (i) more convincing evidence that a local high in the US dollar is in place (and, with that, more evidence that the Fed is embarking on an extended pause); and (ii) a sharp shift by the other major global central banks in their policy outlook (i.e. towards an easing bias). Added to which a more widespread easing of Chinese policy (fiscal & monetary), would also add to that case. Over and above those factors, positioning has become increasingly defensive amongst some global asset classes which in turn could provide fuel for outperformance.
Of note, some models have already shifted meaningfully over recent months as this recent wave of risk-off has evolved. Illustrating that, our world sector risk appetite model (which draws upon the 67 Bloomberg equity sub sectors), has been moving rapidly from SELL (i.e. mid-year) towards a -1 standard deviation BUY level. Notably the last 3 major BUY signals on this model have occurred at the start of the three major reflationary trades since the GFC (i.e. 2009, 2013 & early 2016 – FIG 8****).
FIG 8: World sector risk appetite model vs US 10 year bond yields (%)
****albeit this model can remain on BUY for an extended period of time (e.g. see during the Euro crisis). We would also note that bond yields have not (yet) followed the model lower (see below for further detail).
On a more micro level, there’s also growing evidence that the shift into defensive sectors is reaching an extreme point. Healthcare, consumer staples and utilities, for example, are all notably overbought relative to the other sectors (see global sectors RSI heatmap – table A). They are also increasingly the stand out ‘expensive’ sectors on a relative valuation basis (e.g. see relative PER heatmap – Table B). All of which supports the contention that the rotation into safe havens is meaningfully advanced.
Table A: Global RSI sector heatmap
Source: Longview Economics, Bloomberg
NB This table should be read as ‘columns versus rows’ – i.e. the sector name above, relative to the sector name to the left.
Table B: Global sector PER heatmap
Source: Longview Economics, Bloomberg
NB This table should be read as ‘columns versus rows’ – i.e. the sector name above, relative to the sector name to the left.
Looking at that sector rotation from the perspective of the industrials sector, it’s again clear that ‘rotation out of cyclicals and into defensives’ is becoming ‘long in the tooth’.
FIG 9: Global industrials relative to global S&P1200 (i.e. relative performance)
From a top level asset class perspective, that rotation should be aided by US dollar weakness. A weak dollar would reflect an easier Fed monetary policy stance and enabling a loosening up of global financial conditions. In that respect, the recent large rise in net speculative LONG positions in the US dollar is interesting and highlights the somewhat advanced nature of this strong dollar move (see FIG 10)….
FIG 10: US dollar index vs. net speculative LONG/SHORT positions in the USD
Gold (as we’ve discussed many time before – see HERE & HERE) is giving some early warning signals that the dollar is slowly starting to top out. Equally, as we show below in FIG 11, where gold goes, so goes relative EM – DM equity market performance. That is, an easing of USD liquidity typically feeds into outperformance of those classic liquidity plays (i.e. gold & EM equities). Interestingly in that respect, according to BAML surveys, fund managers have been UW EM this year (albeit that’s recently begun to change).
FIG 11: Gold price (US$/oz) vs. EM equities relative to DM (shown with USD index)
Added to that, if our assessment is correct (that the Fed pauses in 2019), US bond yields are likely to fall across the curve. Of note, US 2 year yields have fallen sharply in recent trading sessions (see FIG 12 below).
FIG 12: US 1 & 2 year bond yields (%)
Oil – the coming supply response
Oil prices are currently down by 33% from their early October high (at the time of writing, i.e. WTI prices). Given the speed of that move, signals from a number of our technical models have become increasingly extreme (e.g. see our technical scoring system below, FIG 13). The key question therefore is how much more oil price weakness is likely (and, in particular, as a subset of that question, what is the likely timing and size of the supply response, if any?)… We address those questions in this week’s oil piece (see below).
FIG 13: Medium term scoring system vs. WTI oil price (US$/barrel)
Extract from this week’s oil piece…
Summary & Conclusion
This summer, oil market positioning was complacent on a number of measures. Long positioning was crowded, sentiment was bullish, the futures curve was backwardated and, with that, calls for $100 oil had become increasingly popular amongst market commentators (for detail see Commodity Fundamentals Report, 11th Oct 2018: “Oil: US bottlenecks easing, Iranian sanctions overblown, a.k.a. SELL OIL (near term)”).
Since then, though, two key parts of the ‘bullish oil price’ narrative have changed significantly, in particular: (i) Waivers for buyers of Iranian crude have been announced; and (ii) US oil production has been revised significantly higher1. As a result, those measures of complacent positioning have fully reversed (see figs 8 – 10). The key question, at this juncture, is how much ‘bad news’ is now in the price? Or, put another way, how much lower does the oil price need to fall to trigger a supply response (and, once again, change the global supply/demand balance outlook)?
Fig 1: WTI price (USD/bbl) vs. shale breakeven prices (USD/bbl)
1 In Q3 2018, US production was revised up by 0.49 mbpd.
See HERE for full analysis….
Have a great weekend.
Kind regards,
Longview
Longview Research recently published
This week:
Commodity Fundamentals Report No. 88, 21st Nov 2018:
“Oil: The Coming Supply Response” – available HERE
Weekly Market Positioning Update, 19th Nov 2018:
"Equity positioning: Becoming increasingly fearful"
Last week:
LV on Friday, 16th November 2018:
“The Rhythm of History – Short, Long and 'Super Long' Cycles” – available HERE
Longview Letter No. 118, 15th November 2018
“Asset Allocation: The Theory of (almost) Everything” – available HERE
Commodity Fundamentals Report No. 87, 14th November 2018:
"Uranium - The Ultimate (geopolitical) Hedge" – available HERE
Weekly Market Positioning Update, 12th Nov 2018:
"Oil positioning - shifting sharply"
