Longview on Friday

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.

(more) Reasons to Buy the (relief) Rally

Yesterday we outlined the case for a ‘counter trend relief rally’ in our latest 1 – 4 month tactical equity asset allocation publication – see HERE. That case is based upon the observation that: “Equity markets are fearfully priced, risk averse and well protected to the downside”.

In addition to the strong BUY signals on the market timing models highlighted in yesterday’s piece, a variety of other models carry a similar message. Various sentiment models, for example, have moved back to BUY. US equity advisory optimism (FIG 1 below) has moved rapidly back onto BUY at -1 standard deviation. This is close to its lowest level in this cyclical bull market (i.e. since 2009). Data on this sentiment survey is available (on a weekly basis) back to 1979. The second chart below shows the data back to 1990 (full dataset available on request). Of interest, while the model does (of course) move occasionally below -2 standard deviations, that typically happens in the depths of cyclical bear markets. In the 2007 – 09 GFC bear market, for example, the indicator worked its way lower over the course of the bear market, making lower lows after each phase of the SELL-off (and on each major local low). As such a -2 standard deviation reading at this stage of a pullback/bear market is unlikely*.

FIG 1: US equity advisory optimism (weekly data) – this bull market (since 2009)

*Having said that a move towards the 40 level is possible at this current juncture – i.e. a similar low to that of late 2015/early 2016 and 2010 & 2011 – FIG 1.

FIG 2: US equity advisory optimism (weekly data) – this bull market (since 1990)

Weekly AAII retail sentiment holds a similar message to the equity advisory optimism. It’s arguably slightly more encouraging as it’s closer to its record lows in this cyclical bull market (i.e. than the equity advisory optimism). History for this indicator, like US equity advisory optimism, is also relatively long. Data for the AAII stretches back into the late 1980s. Also, like the US equity advisory optimism, readings of -2 standard deviations are rare (which is, of course, a mathematical identity) with those extreme readings occurring primarily in the middle of, or towards the end of, major cyclical bear markets (e.g. during the GFC and the 2000-02 bear markets).

FIG 3: AAII US retail sentiment (towards equities)

What’s happens after a relief rally? Judging the bear market lows

Overall, therefore, the evidence for a counter trend relief rally is strong and building. Perhaps the key remaining question, in that respect, is whether or not we get a retest of the late December lows before the relief rally starts in earnest. Determining the answer to that question is difficult. The price action in the stock market, immediately following SELL signals generated by our short term 1 – 2 week risk appetite model(s)**, is instructive in that respect. Of interest, since our latest 1 – 2 week SELL signal (generated on 1^st Jan) the S&P futures are (at time of writing) broadly unchanged. If the S&P500 can continue to consolidate its gains since late December, that will constitute impressive price action and much reduce the likelihood of a near term retest (and reinforce our expectation of an extension to this relief rally).

**(i.e. from our Daily RAG publication)

Beyond that, though, the key question is: What is needed to bring this cyclical bear market to a conclusion? In other words, will there be another leg lower after the counter trend rally?

At this stage it’s worth emphasising that we don’t view this as a bear market driven by a brewing US recession, but a bear market that’s been brought about by overly tight global monetary policy (and, linked to that, the rising risk of global macro shocks). The current state of the US corporate sector, with plentiful cashflow, means that the US economy should continue to grow for the next few years (given a proper US monetary response – see HERE for full analysis). Given, though, that global monetary policy is currently overly tight, there are two factors, in particular, that we are watching (other than global macro trends) and one key risk.

Those two factors are as follows:

1. The signalling and behaviour of key global central banks (especially the Fed). In particular, they need to change course, and ease monetary policy/provide liquidity. That’s the message of tight financial conditions (FIG 5) and of the slowdown in global M1 money supply growth. In the US, markets are already starting to price a rate cut in 2019 (FIG 4). We would concur with that expectation: a rate cut is more likely than a rate hike in 2019. Despite strong labour market gains and rising wage inflation (NB lagging indicators), there are increasing signs of a slowing US economy (first flagged up HERE – and evident from leading indicators of US housing). Those signs include yesterday’s ISM manufacturing survey data, most especially the new orders component (i.e. coincident economic data), as well as recent housing data. More critically though, the tightening of financial conditions chokes off some of the funding sources of future growth (i.e. a leading economic indicator). As such the Fed, the ECB, the PBOC (and probably others like the BoE), need to change course.

Encouragingly comments from Jerome Powell this afternoon (whilst writing this piece) indicate an increasing willingness to adjust Fed policy with respect to, not just the path of interest rates, but also the plans to shrink the balance sheet.

"If we came to the view that the balance sheet normalization plan — or any other aspect of normalization — was part of the problem, we wouldn't hesitate to make a change"

“We’re listening sensitively to the messages markets are sending.”

Source: Jerome Powell, 4^th January 2019, American Economic Association’s annual meeting in Atlanta, Georgia

FIG 4: US interest rate expectations in 2019 (proxied by Jan 2020 less Jan 2019 fed fund futures)

FIG 5: US, Asian (ex-Japan) and European financial conditions indices***

***NB recent tightening is only in part due to the fall in equities

2. Positioning in investors’ portfolios in major pullbacks (bear markets) typically shifts to become fully defensive. Once that shift is complete, then seller exhaustion, in combination with factor 1 above, contributes to the market finding its bear market lows. Our models are helpful in judging when that shift has occurred. Our global sector risk appetite model, our safe haven positioning model and our sentiment scoring system all give some indication as to when positioning has finally shifted from largely ‘risk-on’ to principally ‘risk-off/defensive’. That’s illustrated by swings in these models from high SELL levels through to low -1 or -2 standard deviation BUY levels. This last occurred from late 2014/early 2015 through to early 2016. In early 2015, for example, our sentiment scoring system was at a high +1 standard deviation. By the end of the pullback, in early 2016, it had reached -1 standard deviation. The global sector risk appetite model had similar behaviour reaching oversold levels by early/mid 2016 (FIG 6).

While this model has adjusted considerably, it remains moderately above its major lows in 2016, 2011/12 and 2009.

FIG 6: World sector risk appetite model shown vs. US 10 year bond yield

Key risks to that scenario

Various risks exist with respect to that outlook. The Fed, and other central banks, for example might be too slow to react or may not respond as the markets expect (albeit that has become less likely given Powell’s comments today). Even still, US (UK & other) wage inflation trends may discourage central banks from changing course. While, finally, delays in shifting the outlook for monetary policy might lead to the bursting of bubbles which, once burst, then become difficult to control. Indeed Charles Kindleberger, in his work on financial market bubbles, demonstrates that four factors are present/contribute to the building-up of a bubble and one factor triggers its bust. That one factor is when money gets too tight. Today there are clearly multiple bubbles (as a result of years of cheap money) in the global economy. Those include: The Chinese credit bubble, high US corporate and leveraged loan debt growth, (recent) high asset price valuations, and high house prices, amongst others, in a number of economies. Today’s weak UK house price data (FIG 7) is a timely reminder of one of those bubble risks. Watching those risks, as well as the factors mentioned above, is key with respect to judging the end of this bear market.

FIG 7: UK Nationwide house price inflation (Y-o-Y % & M-o-M %)

Kind regards,

The team at Longview

Longview Research recently published

This week:

Tactical Outlook, 3^rd January 2019:

"Counter Trend Rally Expected" – see HERE

Last week:

LV on Monday, 24^th December 2018:

“Tactical & Strategic Outlook on the Equity Markets" – see HERE