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.

With the S&P500 up 12% from its major Christmas local low and this relief rally now 4 weeks old, its increasingly behaving in the manner of a major relief rally. In prior bear markets, enduring relief rallies typically follow after significant, sharp SELL-offs.

With investors initially reticent to jump on board, and now increasingly chasing market momentum, the question is how much further might it go? And added to that, what is the likely sector leadership/composition of further gains?

The Relief Rally: How much further might it go?

Historically there’s been a relationship between the length and size of major SELL-offs, and the duration and size of the relief rally. FIG 1 illustrates that concept, showing the size of major declines plotted against the size of the subsequent relief rally. The chart draws upon multiple ‘decline-relief rally’ phases between 2000 and 2015 across several global and developed market equity indices (during several major bouts of volatility).  As the gradient of the line of best fit shows, the ‘relief rally’ on average retraces 67% of the losses from the decline.

FIG 1: Size of relief rallies plotted against prior declines (during major SELL-offs)*

*Each dot in the scatter diagram represents one pullback phase shown against its related subsequent relief rally. We draw upon data from 2000 to 2015 from various global equity indices.

If that pattern is replicated, then the S&P500 should rally back to around 2,743 (using closing prices). Of note in that respect, there’s a confluence of other key levels at around that point including: i) the S&P500’s 200 day moving average, a key resistance level, which is currently at 2,741; and ii) the key Fibonacci ‘golden ratio’ (61.8%) retracement level, which is at 2,704 (using intraday S&P500 March futures prices).

In addition to levels, various proprietary and non-proprietary models are also helpful in judging the end of relief rallies. As we outlined in this morning’s ‘Daily RAG’ publication, a degree of short-term exuberance typically re-enters equity prices towards the local highs of relief rallies. That exuberance can be measured several ways including, for example: i) our SELL-off indicator (which often generates SELL-off warnings at/towards the end of relief rallies); ii) market measures of exuberance, including various volatility and downside protection models, which tend to signal complacency at the ‘relief rally’ highs; & iii) our risk appetite scoring systems (albeit these models can be early).

Interestingly in that respect, several volatility models highlight that fear levels remain elevated. FIG 2, for example, shows the steepness of the VIX implied volatility futures curve. Currently this is just above its ‘normal’ BUY levels…

…..(i.e. no complacency shown here)…..

FIG 2: Steepness of VIX curve (6 less 1 month futures) vs. S&P500

……In the October 2015 relief rally (just prior to the November local highs), this model reached a level just shy of SELL. Then in the initial bull market rally (after the SELL-off to the Feb ’16 lows), the model retraced all the way back to SELL, before the S&P500’s rally stalled out in late April (i.e. as complacency came back into asset prices)….

FIG 3: Steepness of VIX curve (6 less 1 month futures) vs. S&P500 (2015 & 2016)

Sector behaviour in relief rallies

Ahead of major pullbacks, sector risk appetite is typically persistently risk averse. That can occur for a period of weeks, even months, and is a good market signal of an impending SELL-off in the headline indices.

That happened in Q3 last year (FIG 4). From July through to late September last year, our model struggled to move much above -1 standard deviation. That persistent risk aversion generates the consistently low sector risk appetite readings (see FIG 4). After two months of that behaviour, the S&P500 then followed, and fell sharply in October (NB This is the typical sector pattern ahead of major pullbacks).

After major pullbacks, there is then a scramble to put money back to work. With that, sector risk appetite reverses sharply and the model rallies rapidly (i.e. the market becomes persistently and enduringly risk seeking). This is the type of ‘risk-on environment’ that markets are in at the moment.

Of note, during the pullback, the sector risk appetite model will typically trough ahead of the headline equity market index. In this latest SELL-off, for example, the model troughed in October last year, while the S&P500 reached its lows in December.

FIG 4: Longview US Sector Risk Appetite Model vs. S&P500 (2018)

In a similar manner, during the relief rally the model will typically peak ahead of the market……

In March 2016, for example, the model peaked early, moving onto SELL in early March ahead of the eventual 19^th April 2016 local high (see FIG 5). In early 2012, the pattern was similar with the sector risk appetite model peaking in January and the market then continuing its relief rally through to April 2012….

With the sector risk appetite model currently just shy of SELL (FIG 4), then that implies further upside for the market in the near term (perhaps a further 2 to 6 weeks of strength) – but arguably some imminent change in sector leadership.

FIG 5: Longview US Sector Risk Appetite Model vs. S&P500 (2015 & 2016)

What’s goes down the most – goes up the most….

In terms of sector leadership during relief rallies, the playbook generally follows the simple market maxim: “What goes down the most, rallies the most”. That works in the initial phase of the relief rally (or renewed bull market) because the gains are principally driven by the repricing of volatility. In particular, the sharpest fallers in the pullback typically end up with the highest implied volatility readings, and therefore bounce the hardest (as those high volatility levels are priced out).

This relief rally hasn’t been any different in that respect. As Table 1 shows, the largest sector fallers have rallied the hardest.

Table 1: Global sectors – size of pullback & subsequent relief rally

Source: Longview Economics, Standard & Poor’s

Sector leadership from here...

If past relief rallies are a good guide, then the initial phase of the rally is lead by the high volatility sectors (i.e. the biggest losers). During the pullback, once our sector risk appetite model generates a SELL signal, that leadership should change.

That’s the logical conclusion from the typical sharp pullbacks from high sector risk appetite readings (i.e. from SELL) to mid-range or low readings (i.e. to NEUTRAL/BUY). In March 2016, for example (FIG 5 above), the sector model reached SELL in early March, and while the S&P500 continued to rally through to mid-April, the sector risk appetite model pulled back sharply to reiterate BUY (i.e. by early April).

Given that the model is about to generate a SELL signal, discerning near term leadership (for the next few weeks) is challenging. In the very least, though, a near term pause in recent sector leadership is likely to start over the next week (i.e. as the sector risk appetite model peaks at SELL).

If that’s correct, the pattern of sector leadership is likely once again (and very temporarily) to favour the more recent laggards, i.e. favour the defensives.

More on sector leadership (hopefully) next week….

See below for an extract of this week’s publication…

Macro Trade Recommendation No. 96: "Move LONG UK rates & GBP" – extract from piece

With parliamentary deadlock, the probability of the UK remaining in the EU, in some form, has increased materially (see point 1 below). This in turn should lead to a rally in the GBP while dampening the case for BoE rate increases due to disinflationary pressures. That case is already strong given the poor cyclical outlook of the UK economy (absent of Brexit effects, point 3). Currently, the UK rates market is pricing a 55% chance of at least one rate hike in 2019 (using Bloomberg’s WIRP function). There is, though, a strong/growing case for ZERO BoE rate increases in 2019. That rationale is three fold:

Fig 1: UK all services inflation (Y-o-Y, %)

See HERE for full analysis….

Have a great weekend.

Kind regards,

Longview

Longview Research recently published

This week:

Macro Trade Recommendation No. 96, 17th January 2019:

"Move LONG UK rates & GBP" – see HERE

Last week:

LV on Friday, 11^th January 2019:

"All over? 15/16 playbook? Or something more sinister?" – see HERE

Commodity Fundamentals Report, 10th January 2019:

"OIL: Technicals & Fundamentals (starting to) Align, a.k.a. Increase OIL LONG positions on weakness” – see HERE

Global Macro Report, 9th January 2019:

"UK: Where Housing Goes, So Goes The Economy" – see HERE