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.
Is a Major Asset Allocation Switch Brewing?
The direction of the US dollar has been reasonably well correlated with the direction of emerging market equities (as a group) in recent decades. One good way, therefore, of judging relative equity weightings of ‘developed market’ vs ‘emerging market’ equities is to forecast the direction of the dollar.
In many ways this is logical. A stronger dollar typically reflects tightening dollar, and other, liquidity. A weaker dollar anticipates, and then prices in, loosening liquidity (i.e. reflation). EM, as a key reflation trade, therefore performs well when the dollar is weak (and poorly when it’s strong). Over the course of 2018, for example, as the dollar has strengthened, EM has underperformed.
There are nascent signs, however, that the underperformance of EM may be reaching its conclusion. Whilst this is not evident looking at the dollar index (which has strengthened over the past 24 hours*), other key macro factors, which also correlate with EM equities, are beginning to stabilise/reverse direction.
Those include:
a. Gold: Which has correlated well with the relative performance of DM vs. EM, and indeed often moves ahead of that DM-EM relative pair (FIG 1).
Gold, in recent weeks, has been outperforming most assets as the risk SELL-off has played out. That, in our view, reflects its out of favour status, the positioning of our models as well as an anticipation of some softening of the Fed’s rate hiking plans (see Macro Trade Recommendation No. 92, 21st August 2018: “GOLD: Close SHORT position – Start BUILDing LONG exposure”). We expect gold’s outperformance to continue in coming months.
FIG 1: Gold ($/oz) vs relative performance of DM vs. EM equities
*i.e. until the US existing home sales data was published at 3pm (London time).
b. Emerging market FX (as proxied by the JP Morgan emerging market index). Like gold, EM currencies, in aggregate, have also been outperforming in the past few weeks (having been deeply oversold ahead of this recent bout of risk-off). Since its recent trough on 4th September, the EM FX index has rallied by 4%. That is also encouraging with respect to EM equities.
FIG 2: EM FX index (JP Morgan) vs. MSCI EM equity index (large & mid caps)
Ultimately, though, whether or not the dollar has peaked (on a multi month timeframe) is likely to depend on the Fed and their future actions, i.e. whether or not they remain on this current modest tightening path, accelerate rate hikes or indeed slow/pause the path of hikes (or even cut rates).
Two things, in particular, are likely to be key in the Fed’s thinking about the path of future rate moves:
a. The tightness of financial conditions. In that respect if we’re correct about another wave of selling in this pullback (i.e. a wave three – see below), then accompanying tightening financial conditions might push the Fed to enact an extended pause in their hiking cycle; and…
b. a slower rate of US economic growth. As highlighted in recent publications (see HERE & HERE), that is our current expectation, and reflects amongst other factors an expectation that the US housing market activity will slow going forward. That expectation was added to this week as most of the housing data weakened (see building permits & start, and existing home sales). Retail sales also disappointed.
FIG 3: US existing home sales (Y-o-Y %)
At this stage, the jury is still out: Fed governors remain resolute with respect to their intentions to keep on a steady rate rising path, as confirmed by the Fed minutes on Wednesday: “Fed Minutes Point to Continued, Gradual Interest-Rate Increases WSJ”; whilst some of the recent data has been softer (as highlighted above). How equity markets behave as we move into November is likely to be key in that respect. If we’re correct and a ‘wave three’** of selling in this pullback occurs, then financial conditions are likely to tighten. If that tightening is significant enough (and the data remains soggy relative to expectations) then it’s likely that the Fed will start signalling a pause, bringing about dollar softness and kick starting a round of EM equity outperformance.
Wave Two Relief Rally, Base Building and Update on Key Medium Term Models
Last week, we wrote about the three wave pattern** that occurs in most equity market SELL-offs (see Longview on Friday, 12th October, “After that, What’s Next?”) and laid out our arguments as to why a ‘wave two’ relief rally was likely underway/about to be underway:
“Our central expectation (is) that a wave two relief rally has either just commenced (i.e. today/overnight) or is likely to commence over the next few trading sessions”
Source: Longview on Friday, 12th October, “After that, What’s Next?”
Over the course of this past week, most major (western) equity indices have been base building, i.e. consolidating their losses/trending sideways. The interaction of our models with that base building generates key insights into the likely direction of those indices in coming trading sessions. That is, short term models have retained their collective BUY signal, while medium term ones have increasingly moved onto BUY. Medium term models are designed to generate multi month timeframe signals. Typically in waves of risk aversion, they generate BUY signals after wave one of the SELL-off and then re-iterate those BUY signals (or move onto strong BUY) at the end of ‘wave three’. As such the initial BUY signals should be taken as added confirmation of an expectation of a wave two rally.
FIG 4: S&P500 December futures 10 day tick chart (shown with overnight prices)
**i.e. SELL-offs typically consist of three waves: an initial (often modest) phase of selling (wave 1), then a relief rally (wave 2) before a final third wave lower (wave 3).
Many of those medium term models are laid out below, as follows:
1. Percentage of stocks trading above/below their 50 day moving averages: Across key developed world equity indices, a significant majority of individual names are trading below their 50 day moving averages. On Monday this week, this model reached a reading of 13% (equalling its low levels from 9th February this year and below the post BREXIT SELL-off lows) – FIG 5.
2. Percentage of stocks trading above/below their 200 day moving averages: The situation is similar for the percentage of stocks trading below a longer term trend line, i.e. their respective 200 day moving averages. That model on Thursday last week (11th Oct) reached its lowest level since February 2016 (FIG 6).
FIG 5: Percentage of western stocks above their 50 day moving averages vs. MSCI world equity index
FIG 6: Percent of western stocks above their 200 day moving averages vs. S&P500
3. The medium term ‘risk appetite’ scoring system is also back on BUY. As FIG 7 shows, BUY signals generated by this model are reasonably rare and typically timely.
FIG 7: Longview medium term ‘risk appetite’ scoring system vs. S&P500
4. The Colvin model (which measures, and aggregates, how overextended a range of global assets are) has also been at multi month lows in recent trading sessions. On Thursday 11th October, it was on strong BUY and at its lowest since January 2016 (FIG 8).
FIG 8: Colvin model (global over-extendedness indicator) vs. S&P500
5. The medium term put to call ratio (a measure of how protected portfolios are to the downside, i.e. how hedged) reached strong BUY overnight last night (and is at its lowest level since April 2018 – FIG 9).
FIG 9: Medium term CBOE put to call ratio vs. S&P500
All of these models, therefore, reinforce that ‘wave two’ relief rally expectation, as laid out last Friday.
Have a great weekend.
Kind regards,
Longview
Longview research recently published
This week:
Longview Letter No. 116, 17th October 2018:
“Extreme Valuations
a.k.a. Is the cyclical bull market over? Should we be worried?” – available HERE
Weekly Market Positioning Update, 15th October 2018:
"Positioning suggests speculators wrongfooted"
Last week:
LV on Friday, 12th October 2018:
"Equities: After that, What's Next?"; PLUS 'possibly one of the most important foreign policy speeches since......' – available HERE
Commodity Fundamentals report No 86, 11th October 2018:
“OIL: US bottlenecks easing, Iranian sanctions impact overblown
a.k.a. SELL oil (near term)” – available HERE
Macro Trade Recommendation No. 93, 11th October 2018
“Start BUILDing LONG Bond Positions” – available HERE
Global Macro Report, 10th October 2018:
“UK: The Economy Beyond Brexit” – available HERE
Weekly Market Positioning Update, 8th October 2018:
"Sharp rise in yen SHORTs"
