I admit, I’ve been missing in action. I took a prolonged summer break and have been traveling Europe for months now. As a matter of fact, I’ve been traveling the world for 11 months now and have not yet returned back to Australia. Last newsletter, which initially did not work properly due to technical issues (but works now), showed a few places I recently visited including the beautiful Adriatic coastline. Since I haven’t properly commented on asset class performance in awhile, today’s post will be more in-depth than usual. Furthermore, in coming posts I will also be diving into some commentary that covers various portfolio returns, and not just classic tactical opinions. There are many ways to do this, but I shall try to track the “imitational lookalike” performance of several famous asset allocators and comparing them against the way I invest my own capital. But for now, let us cover recent market conditions.
2016 has been a great year for asset classes, in particular the bond market. Federal Reserve raised rates at precisely the wrong time at the end of 2015, just as the global economy continued to slow. What followed was a nasty equity market correction in January and February, which pushed the Fed back into the dovish corner. Bond market started a powerful rally, sensing that the US central bank was in a “one-and-done” case scenario.
The chart above shows annualised performance for Treasuries, Treasury Inflation Linkers, Investment Grade bonds, Emerging Market bonds and High Yield Junk. While EM debt has outperformed over the last 12 months (up 15.3%), every other sector of the bond market has done very well, including Junk Bonds (up 7.3%). This is precisely why we made a tactical call in early July that the bond market and other safe havens should correct.
On the risk asset side (not shown in the chart above), we have sound performing assets as well. On an annualised basis US equities are up 12.9%, EAFE equities are up 1.0%, EM equities are up 16.3%, US commercial real estate is up 18.3% and finally Gold is up 15.5%. Please note that all data above is from middle of August. Basically, its been difficult to lose money in 2016, not matter what one did. But the question is, what should we expect from here onwards?
First and foremost, it seems to me that we are still in a yield flattening environment. In plain English, this has almost always meant tighter monetary and credit conditions. The spread between the 2s and 10s, as well as the 5s and 30s seen in the chart above, continues to narrow. Every student of the market history should know that an inverted yield curve has been a pretty decent predictor of recessions and the last two occurrences (1999 prior to Tech crash & 2006 prior to Lehman crash) are no different. While we are not there yet (still another 105 basis points left), the recent consolidation of yield spreads narrowed within a small triangle and broke downwards. This breakdown has been linked to the recent comments by Janet Yellen & Co. Hawkish comments could be preparing us for a rate hike after the elections, as long as economic data continues to improve.
This could be a bit of a worry for the Treasury bond market investors, which on aggregate hold a decently bullish position within the futures market. Treasury COT data can sometimes send wrong signals, so I like to focus on the group known as Non Reportables or Small Speculators. When we combine the positioning throughout the whole yield curve, we can see that Specs aren’t net long so extreme optimism isn’t a worry here. However, they do hold only a small net short position relative to other major extremes such as early 2007, middle of 2008, early 2011, late 2013 and late 2015 (all of those marked major bond market bottoms). Therefore, if the Fed was to move rates higher in coming months, there is a chance that hedge funds will be forced to increase their Treasury net shorts as prices correct.
At this point, I know that some readers will automatically assume that shorting the US Treasury market, in particular the very volatile long duration maturity, could be a slam dunk play. However, that is very far from certain. Over the last three years, we have seen the Fed move slowly towards tighter monetary policy. Firstly, we had the tapering of the QE, where Mr Bernanke decided to stop printing money. Afterwards, we had the Federal Reserve start its tightening cycle, admittedly at very slow pace. So how did bond bears do over the last 3 years? Not so well, to be quite honest. The 30 Year Long Bond has produced a 12.8% compound annual growth rate (CAGR).
One could argue that this is the slowest and most dovish tightening cycle in Federal Reserves history (dating back to 1913). I wouldn’t argue against that. Therefore, let us focus on the tightening cycle prior to this one, where Ben Bernanke & Co. rises rates multiple times during mid 2000s and yet the 30 Year Long Bond never lost money when held over that 3 year rolling period as well. As a matter of fact, the last time longest maturity total return declined in any meaningful way was during inflationary periods of 1970s (Oil Embargo I & II). Even then, nominal losses were only around 5 percent per annum (very different story when adjusted for inflation).
I am not suggesting that the 30 Year Bond cannot drop in price. Long term bond investors suffered serious corrections in 1973, 1979/81, 1987, 1994, 1999, 2009 and 2013. However, unless you are an amazing market timer, shorting bonds isn’t for the faint-hearted investors. The same case could be made with the ML Junk Bond Total Return Index. Expectations by bearish investors that high yielding bond market will implode in similar fashion to 2008 was short lived… very short lived. Once again, great market timers would have made a nice profit by shorting in May 2015 (around the same time MSCI World peaked out) and closing those shorts in early 2016 (around the same time Crude Oil bottomed out).
But how many of us are truly capable of doing that on consistent basis? On the other hand, long term investors who earn interest and reinvest proceeds back into the index, have done great over the last two decades. Let us remember that to achieve this return, one must be able to ride though the volatile periods of 1998 Asian Financial Crisis, 2001 US Recession & Tech Crash, 2008 Global Financial Crisis, 2011 Eurozone Debt Crisis and finally the 2015 China Slowdown & Commodities Crash. So… should we be surprised that the High Yield market is now posting yet another record high in August?
As a result of Federal Reserve turning dovish and backing away from aggressive rate hikes in the first half of 2016, credit spreads have narrowed dramatically. Worst quality high yielding bonds (CCC Or Below) have narrowed from 20.2% all the way to 12.5% against equivalent maturity risk free Treasuries, while BBB’s have come down from 3% towards 1.8% last week. Finally, the recent commodity collapse did not put much pressure on the highest quality bonds and the spreads in this area have not been affected much since the Eurozone Debt crisis in 2011/12.
Speaking of Eurozone debt crisis, 2015 was the worst performing year for global equities since 2011/12 period. As I’ve written many times before on this blog, US has outperformed and continues to outperform, posting new record highs. This is the stock market that has been tricking all the global macro investors. If one was to closely observe the chart above, other Developed Markets including Japan suffered throughout 2015, while Emerging Markets (and in particular China) went through an outright crash.
After the February lows, global equities have staged a seriously strong comeback. S&P 500 has broken out of its trading range, while MSCI All Country World Index is playing catch up and is trading at the highest level since middle of 2015. Technical analyst could make a case that the ACWI has now successfully completed an inverse head & shoulders bottom and new highs may lay ahead. Additionally, February also marked the low in breadth readings and for the first time since mid 2014 we have 100% of major global indices (priced in USD) trading above their respective 200 day moving average. While this does single short term overbought readings (and a potential for a pullback), it also tends to signal wide participation rate over the medium to long term (and a potential for higher prices ahead).
Over the short term time frame, breadth isn’t the only important indicator signalling a potential for a pullback. Volume and volatility have dropped to levels which indicate that complacency is widespread (especially volume on the QQQ ETF). Furthermore, while “Sell in May and go away” has not worked this year, it is important to remember that September is traditionally and historically the worst month for equities. Finally, looking at NAAIM survey and to lesser extent II survey, bullish sentiment has returned to levels where equity pullbacks tend to occur. As a result of these indicators, and several others not discussed here, I wouldn’t chase equities immediately despite a bullish S&P breakout from an 18 month trading range.
While my personal message and tone is leaning more towards a bullish stance, and a cautiously bullish one at that, certain readers will disagree. Don’t worry, all it takes is for me to look at the extremely high equity valuations by any one of the more widely followed metrics (CAPE, PB ratio, Price to Sales, etc, etc) and I will also disagree with myself too. Having said that, here I would like to add a few points.
Firstly, sentiment was universally bullish coming into late 2014 and early 2015. At the same time, breadth was very weak as far more NYSE stocks declined during 2014/15 period than rose. As we noted above, credit spreads were already widening. Also of importance was the decline in company earnings and slowdown in economic growth (in particular places outside of the US like China). Many famous investors, “celebrity” hedge fund managers and widely followed “gurus” called for the S&P 500 to decline and yet over the last 3 years US equities have managed to achieve 11.8% compound annual return… slaughtering the bears. And now we have a two year long consolidation, which has been broken to the upside and could have bullish consequences.
A very successful and wise investor once told me that “good traders get out when the market moves against them, while great traders reverse their position.” I believe that US equities resilience is a surprise to just about all of us. So maybe if it doesn’t want to go down, it still wants to go up?
One way to play the remaining innings of the bull market could be via value stocks instead of chasing market darlings and momentum. More depressed sectors, such as Energy, have gone through a serious bear market while S&P 500 traded sideways. We discussed how the Large Cap index posted impressive compound returns over the last 3 or even 5 years, but obviously this is not the case for commodity producers and other related sectors. I would argue that the US Energy sector is now attractive both nominally as well as relatively.
There is an above average probability that we have seen the bottom in this downhearted part of the market and on any meaningful pullback, I would start to acquire some positions. The sector is so oversold (even despite a strong rebound in the first half) that the 3 year rolling CAGR remains one and half standard deviations below the 50 year mean. Such dreadful performance happens during major Oil busts like we saw in mid 1980s, early 2000s and during 2008 GFC… and that is usually the best time to buy!
Keeping value as the central point and emphasis, certain investors could make a case that relative to both US stocks and US bonds (which are at all time record highs) Gold remains very attractive. The bear market from September 2011 until December 2015 shed more than 40% (on monthly closing basis) of yellow metals value. Furthermore, despite a robust first half performance, the precious metal is still in a drawdown of almost 30%.
There are merits to this argument, however I would like to add a few important pieces of information. Historically, Gold investors have accepted the same risk and volatility of EM equities, but for only half the return. Observing the chart above, some readers might come to a conclusion that Gold is possibly one of the more lousy asset classes for the long run, providing the worst risk relative to reward.
Furthermore, consider the fact that over any 2 year rolling period within the last 50 years, global equities tend achieve positive returns 83% of the time while Gold does so only 56% of the time. By the same token, record highs are achieved only 9% of the time and drawdowns can last for generations (please refer to the first Gold chart). Obviously, past performance isn’t a good predictor of the future and at times this precious metal has done fabulously well. Sometimes up 11 years in the row, like from 2001 until 2012.
I believe that we are now at an important cross road for Gold, as well as the overall precious metals sector. Last weeks technical bullish reversal on the USD Index could mean that the bull market in the reserve currency is resuming (chart below shows a consolation period over the last 18 months). I wonder if we will look back on the current Gold & Silver rally as dead cat bounce or start of a new bull market? If its the former, quite a few people will be wrong. So many reports have been published about how Gold has started a new bull market. So many speculators and hedge funds have jumped into futures contracts and ETFs (chart above).
Nevertheless, we live in strange times as global central banks continue their monetary policy experiments. In the world of negative interest rates, bonds aren’t an asset but an actual liability (and a money losing proposition). Over and above that, in the world of negative interest rates, Gold is actually a positive yielding asset class. Finally, there have been periods in time when both the Dollar and Gold rose as safe havens (even though they are quite rare), so there should always be a place for Gold in any asset allocation strategy.
Holidays are always great. Amazing food, green & blue crystal clear waters and wonderful weather is always a blessing… what more could we ask from our life? But I am very happy to be back in work mode and fully focused.
Warmest of Regards, Tiho
I hope this post finds all of you well. In the first week of July I commented on financial market overextension, in particular for asset classes that were and still are deemed “safe” by various market participants. These included nominal Treasuries, inflation linked bonds, corporate bonds, emerging market bonds, US commercial real estate, utilities sector and Gold. So far so good, and it seems that majority of these asset classes continue to correct even as I write this post (I do admit EM debt did not correct and is still holding up at short term elevated levels).
Focusing on the stock market, it is not a secret that US equities continue to outperform, leading on the upside. S&P 500 remains the only major index at a new record high (priced in USD). On the other hand, MSCI All Country World Index is still below May 2015 highs. In my opinion, an important test for the US stock market is now approaching. We could potentially re-test the previous resistance around 2,100. If bulls successfully hold this level, further gains might be in the cards. However, if this area fails to hold, we will be facing a so called technical pattern usually known as a “bull trap” for this overly aged bull market with high valuations.
I am wishing everyone a wonderful holidays in August. I hope you are spending the time with family and friends. I shall do a proper in-depth commentary on the state of markets and financial assets sometime in late August… but for now I am sending regards from the greenest waters and bluest skies of the Adriatic Sea.
Just a quick technical update. It has come to my attention that variety of global macro asset classes have become overbought, over-extended and prone to a correction from both short term and medium term perspective. Market participants now believe that the Federal Reserve has all but given up on its rate hike intentions. Expectations from the bond pits show that FOMC will stay on hold until 2018. With that context unfolding over the last few weeks, and Brexit adding fuel to the fire, various bonds together with other interest rate sensitive assets have benefited. From a contrary point of view, despite the fact that my portfolio has benefited tremendously, I now hold an opinion that we are about to mean revert.
I’m going to keep the grid above, thanks to StockCharts.com website, in the same arrangement for both charts. Assets I am tracking here are Long Duration Treasuries ETF (NYSE: EDV), Treasuries Inflation Bonds ETF (NYSE: TIP), Investment Grade Bonds ETF (NYSE: LQD), Emerging Market Bonds (NYSE: EMB), US Commercial Real Estate (NYSE: VNQ) and Gold (NYSE: GLD). To be quite honest, I could have added a few more asset class subsections such as S&P Dividend Aristocrat Index, S&P Utilities Index and so forth. The first chart above is daily price (short term time frame). I am sure my readers will be able to make plethora of savvy observations, but I will just make simple three:
- Every single asset is at least 2 standard deviations above its 50 day bollinger band
- Every single asset has its relative strength index (RSI) above 70
- Every single asset has been gapping upwards and lately moving in vertical fashion
If we expend our time horizon with the second chart onto the weekly price (medium term time frame), we can see even more evidence of overextended trends, which are ripe for a correction. Firstly, several of these assets are up five, six or even seven weeks in the row. The prices are trading well above their respective 200 day moving averages. Weekly RSI readings are overbought (especially the Long Bond, Corporate Credit & EM Debt). Finally, once again we have large gaps on the weekly chart, accompanied by heavy volume (look at the ETF such as TLT and EDV). I would advise my readers to be very cautious when it comes to adding new capital towards the overall bond market, real estate and precious metals sectors. This warning would also extend to defensive sectors such as Utilities, Staples, Dividend and Minimum Volatility equity indices… all of which are overextended.
In the previous newsletter, I discussed recent developments concerning the S&P 500 index:
“On the topic of US resilience, what has me worried is an ugly technical reversal candle that occurred right at the resistance [S&P 500]. A decent short term support, as well as the 200 day moving average, are found around 2020 on this closely watched index. A breach of these levels, could signal further downside. Short term traders should pay close attention to S&P 500’s critical support level around 2020, and if breached could signal the continuation of the “risk off” trade. On the other hand, another sign of resilience by US equities right here will surely signal that new all time highs lay ahead.”
We got yet another sign of resilience. The US index refuses to go down and Brexit selling was quickly reversed. US equities are having yet another go at the 2,100 to 2,120 resistance in the attempt to make new all time highs (total return index has already achieved this). I’ll be watching price and breadth participation very closely.
Finally, I leave for Russia tomorrow. I shall be visiting Moscow and St Petersburg for several weeks, before I travel to the almighty European Union empire haha. I would love to meet any readers from either of these cities, so please email me back if you have free time.
Warmest of regards,
I hope this post finds all of you well. Since the last letter mainly focused on the global economic trends, which continue to show signs of slowing, it is interesting to note that Short Side of Long has not made commentary on financial markets in about two months now. In my defence, I have been busy traveling from Cambodia to Hong Kong, and from Papua New Guinea to The Phillipines. Returning back from my travels, I find the timing of this letter just about perfect so let us get straight into it. Recapping the post written in early May, I wrote that:
“The most disappointing period of stock market performance is May to October, while outperformance occurs from November to April. I’m sure we have all heard the famous “Sell In May & Go Away” quote. …the oversold conditions and extremely pessimistic sentiment in February led to a sharp [stock market] rally over the last 10 weeks. With seasonality now turning negative, I would advise my readers to exercise caution. Vertical rallies, such as the one we recently witnessed in the S&P 500, are not sustainable on annualised basis. Certain market pundits have advised buying the recent dip, but we would argue… that the market isn’t oversold just yet.
Advance decline line & up down volume averaged over 10 trading days haven’t fallen enough to signal oversold conditions; percentage of S&P stocks trading above their 50 day moving average hasn’t even fallen below neutral levels yet; percentage of S&P stocks trading at 20 day new lows hasn’t spiked to at least 50% of the index components; NYSE 52 week new highs versus 52 week new lows ratio still remains elevated and not even close to neutral levels; and NYSE Mcclellan Oscillator is close to becoming oversold, but we would prefer lower readings of around -80.”
A lot of technical aspects there, but in summary I held a cautious view which proved wise with global equities as a whole continuing to struggle. We should not be blaming last weeks “Brexit”, nor think of it as the cause for a sell off. Instead, it just yet another catalyst in a downtrend that started in May 2015, in what seems to be a slow but steady bear market. The truth is, if it wasn’t for United States’ resilience, MSCI All Country World Index would probably be close to making new 4 year lows, similar to the MSCI EAFE Index seen in orange above. After the panic on Friday, there are now less than 50% of global indices trading above their respective 200 day moving averages.
While US indices such as S&P are one of them, the other major ones include: Australia, Canada, Brazil and Russia. Can we notice the theme here? All of these countries are commodity producers and exporters, benefiting from a rebound in natural resources this year. These were some of the most hated markets coming into 2016, and yet they are showing a lot more resilience compared to the Eurozone markets. While we witnessed a dramatic sell off in EU shares on Brexit’s Black Friday, with UK and Swedish markets registering moves that were around 4 standard deviations from the mean, it is important to note that the bear market in this region actually started long time ago (when priced in US Dollars).
European equities were the favourite investment destination for the majority of global fund managers, all of whom believed that ECB’s monetary policy measures such as QE and negative rates will benefit their trades. Not only did these policy measures (better yet, lets call them mistakes) not stimulate the economy, but they actually also failed to goose up asset prices. If we observe the chart above, we notice that all four major equity markets (UK, Germany, Sweden & Switzerland) basically peaked out in middle of 2014. Moreover, while we have short term oversold conditions from which stock markets could bounce for a week or so, there is still no evidence thus farther the primary downtrend in European shares is showing signs of reversing.
I would urge my readers to closely pay attention to the following paragraph, incase they hold investments in S&P 500 and related shares. On the topic of US resilience, what has me worried is an ugly technical reversal candle that occurred right at the resistance. A decent short term support, as well as the 200 day moving average, are found around 2020 on this closely watched index. A breach of these levels, could signal further downside.
Reading all of the above, one would get a sense that I am quite pessimistic and that being an investor has been rather unforgiving as of late. However, that cannot be further from the truth. As we can clearly see in the chart above, over the last 12 months majority of the asset classes have performed rather wonderfully. It only seems like a scary year because global equities went through a mini crash in January and February on China “hard landing” fears, which was followed up this week with the “Brexit” Black Friday crash.
The fact of the matter is that diversification, investment strategy that I am very keen on, has been a wonderful tool that not only protected investors capital, but is also making them money. Diversified investors would have benefited enormously from holding a variety of assets including commercial real estate (REITs), Gold, DM government & DM corporate bonds, EM government & EM corporate bonds and Inflation linked bonds. Even commodities, the most hated asset class coming into 2016, has been on a tare recently. Crude Oil has basically double from the February lows, in what has been one of the strongest and sharpest rallies since the Gulf War.
One development that has inflationists scratching their heads, is the collapse of global bond rates despite the fact that inflationary assets such as Gold and Crude oil are going through monster rallies. Let us recap what I wrote in middle April regarding the Treasury bond market (at the time Treasury 10 Year yield was at 1.75% compared to 1.58% right now):
“While positioning towards the debt markets is not that extreme, there are other sentiment gauges arguing that Treasury yields could rise somewhat from here. Firstly, small speculators positioning in the futures market shows dumb money is chasing Treasuries with an expectation of lower yields. Secondly, Mark Hulbert’s Bond Newsletter Sentiment Index (click here to see the chart) shows record bullish recommendations by various advisors and newsletter writers. Thirdly, number of shares outstanding on various Treasury ETFs has spiked in recent weeks (click here for the chart, thanks to Tom McClellan). Finally, according to ICI, fund inflows towards government bonds have been very elevated for weeks.
Putting it all together, one can see that there is room for unwinding of positions in the Treasury bond market. We have been long for a few months now and have recently changed our duration towards very short term Treasuries and Corporate grade bonds, as we expect a correction. Having said that, Treasuries still remain attractive for three reasons: 1) relative to rest of the developed world, Treasuries look attractive and could be considered high yielding sovereigns with only Australia & New Zealand paying you more; 2) we still continue to favour assets priced in US Dollars as we see the greenback resume its bull market once the current correction runs its course; and 3) we think that longer duration Treasury yields could eventually break down from the technical consolidation patterns.”
The correction in the bond market came in the form of a sideways consolidation instead of a sharp pullback, which was a further proof of strong demand for Treasuries. Eventually, yields broke down from the triangle pattern we discussed a few months ago. Treasury 10 Year Note yield dropped to new 52 week lows, while the 20 Year Bond yield closed a new lows. This overall movement is an anchor dragging the overall bond rates lower and therefore bond prices higher.
As already shown above, a truly diversified global portfolio would have benefited not only from holding Treasuries, but also other sections of the bond market such as investment grade corporates and emerging market debt. The reason deflationary assets such as bonds are benefiting, is also the same reason that inflationary assets such as commodities are benefiting: re-pricing of Federal Reserves inability to hike short term interest rates. When Janet Yellen hiked the Fed Funds rate from 0.25% to 0.50% in December of 2015, she also made a statement that through 2016 her committee has the desire to hike rates up to 4 times. Look at the chart above, I do not find it a coincidence that the overall bond market bottomed in early 2016, as did commodities including Gold (chart below).
To some of the readers all of this will seem counterintuitive, where markets bottom on bad news and top on good news. With that in mind, it is my belief that safe haven assets, which have been rallying for majority of the year already, will correct as soon as Federal Reserve and other central banks turn even more dovish. With bullish positioning and overly optimistic sentiment in Treasury Bonds, Corporate Bonds, Japanese Yen and Gold, it just further increases that probability.
In summary, I would advise my readers to remain well diversified throughout this volatile period. This means not just geographically, but also with variety of assets including stocks, bonds, commodities, precious metals and real estate. The problem exists with some of these safe havens being rather overbought and prone to a significant pullback. This is even more true if and when policy makers intervene to shore up panicked investors post the Brexit vote. Short term traders should pay close attention to S&P 500’s critical support level around 2020, and if breached could signal the continuation of the “risk off” trade. On the other hand, another sign of resilience by US equities right here will surely signal that new all time highs lay ahead.
Finally, after a few questions regarding my portfolio mention in the last post, I thought I would discuss matters a bit further. I run private investment capital with two strategies. First one is low risk model, which averages half of S&P 500’s volatility, but tries to achieve similar historical returns to the popular index itself. The second one is an aggressive risk model, which I personally use for my own money. Historically, it has experienced similar volatility to the American equity index, but it has the potential to achieve some amazing returns (obviously, not without risk).
The model uses variety of tools at an investors disposal which include momentum, trend, value investing, global macro exposure, risk parity diversification, leverage, a bit of tactical positioning and of course the one which you cannot program no matter how powerful your computer is… good old fashioned timing. Regular readers of the blog know that I believe in buying market lows or selling market tops and have shown that over the years. We are having a fabulous 2016 and those interested in knowing more for various purposes can contact me personally.
Warmest of regards,
We are almost half way through 2016 and I have to say it has been an interesting year so far. I’m sure you would agree. In my humble opinion, major theme isn’t the Chinese economic slowdown and potential for more RMB devaluation, even though a lot of folks would argue for it. I also believe it isn’t Federal Reserve’s next interest rate hike, which just about everyone is obsessed with (especially the financial media). Nor is it the US election and the potential setup of Trump vs Clinton. European readers would advocate for “Brexit”. Personally, I would have to say it’s something that the financial media hasn’t yet started to focus on. The US stock market, which has dramatically outperformed other assets over the last few years, is not “the only game in town” anymore. Global macro investors (like me), are finally starting to gain in performance by holding assets other than the S&P 500 and it’s about time. Let us discuss further.
There are now variety of assets outperforming the S&P 500 over the last 12 month timeframe (this is even more true on a 6 month rolling basis). These include nominal Treasury Bonds, Treasury Inflation Protected Securities (TIPS), Emerging Market Bonds (USD denominated), investment grade Corporate Bonds, listed US Commercial Real Estate (REITs) and the Grains Index (Soybeans, Corn & Wheat futures). Even Gold was doing so until the recent correction. We believe this trend will continue for awhile and expect better returns for asset managers which aren’t overly exposed towards equities in the United States.
In the recent newsletter issues I discussed variety of opportunities on both the long and short side, including: the upcoming bottom in the Chinese mainland equities; a longer term opportunity that exists in the forgotten Vietnamese stock market; a surprisingly stubborn underweight equities exposure by global fund managers despite a strong rally since Feb lows (I like Asian equities in this space); extremely high sentiment on Treasuries just before Fed nears its 2nd hike; current correction in the Gold & Gold Mining shares; extremely depressed performance of raw materials (CRB Index) over the last 5 years; and finally one of my favourite trades for 2016: potential for strong upside in the Grains Index due to up-and-coming La Nina.
Year to date, my normal portfolio has managed to achieve 8% gain, with the month of May being my first down month (there is also a more aggressive version, but that’s a story for another day). So far, I have matched the Treasury Long Bonds performance, while outperforming US Equities and publicly listed Real Estate Trusts. This return was achieved by holding a diversified portfolio spread across global assets such as: equities, bonds, real estate, precious metals, commodities and cash (relative currency positions). Moreover, if we measure apples with apples and observe the 12 month returns (similar to the first chart), my fund is up 9.4% with standard deviation risk of 7.6%. I am happy to say that we have outperformed S&P 500 by some 800 basis points and more importantly with only 46% of the S&P’s volatility. Let me now switch gears from investing towards the global economy, where there is a growing evidence that not all is well.
In the recent Bloomberg article, the Organisation for Economic Cooperation and Development (OECD) warned policy makers that “the global economy is slipping into a self-fulfilling ‘low-growth trap'”. Recent OECD LEIs, seen in the chart above, have been sending a warning signal that growth is now below trend and slowing in all major regions. Bloomberg writes:
According to the Paris-based group, which advises its 34 member countries, too much of the burden of lifting growth has been left to central banks. After pushing interest rates below zero and pumping money into their economies through asset purchases, they are starting to see diminishing returns and their actions could even generate financial-market volatility.
“Overall a rather mediocre, a rather dismal outlook,” the OECD secretary-general, Angel Gurria, said in an interview with Bloomberg Television in Paris before the outlook was released. “Trade is growing at 2 to 3 percent; it should be growing at 7.”
Global trade, which is so critical for healthy economic activity, definitely remains very slow according to recent South Korean export numbers. Regular readers of this blog already know that I closely track this data point, which I believe is a great barometer of the overall global economy (note: South Korean major exports include semiconductors, petrochemicals, machinery, automobiles, ships, steel, LCD and wireless communication devices; while major trading partners include China (25 percent of total exports), ASEAN (14 percent), the United States (10 percent) and the European Union (9 percent)).
When I saw a huge drop in South Korean exports to China in the month of May, I was personally scratching my head and wondering if it’s a data mistake. The truth is, global trade figures are not improving despite the fact that central banks continue to goose up financial markets with more and more monetary easing. In Q1 of 2016, G20 trade figures slumped yet again. Furthermore, as my good friend in Hong Kong recently noted, container benchmark rates between LA and HK have fallen dramatically in 2015 and first half of 2016. Moreover, Caterpillar sales to Asia continue to post contraction readings since December 2012. Obviously, a fall in global trade is closely correlated to the ongoing slowdown in manufacturing. For the month of May, JP Morgan Global PMI report stated that:
The global manufacturing sector maintained its lethargic start to 2016. Rates of expansion in production and new orders also eased to a near-stagnation, while the pace of contraction in new export business was one of the steepest during the past three years. The muted performance of manufacturing was also reflected in the labour market, as staffing levels fell for the fourth straight month.
Breaking it down region by region, JP Morgan report had a narrative towards anaemic growth in North America and Europe, with a continued slowdown in Asia and South America (chart above):
Although the US PMI remained above the 50.0 no-change mark, its rate of expansion eased to its lowest since the (Markit) survey began in October 2009. The euro area PMI slid to a three-month low in May, but nonetheless remained above the global average for the fifteenth month running. The two largest Asian manufacturing economies – China and Japan – both contracted in May. The downturn in Russia eased closer to stabilisation. The Brazil PMI sank to its weakest level in over seven years, placing it at the bottom of the global rankings.
It is just as important to note that not all of Asia is struggling. I’ve been living in Vietnam for the last 6 months and I can tell you Saigon is a boom town. The countries growth rate, manufacturing sector and export volumes remain one of the bright spots in the region. It seems that we are experiencing a slow, but steady relocation of factories from China towards Vietnam and the TPP deal (if it passes through) should create further benefits for this rising economy.
The same cannot be said about the United States, where May’s regional surveys from Richmond to Philly showed a huge reversal in manufacturing sentiment. The rebound from Q1 was short lived and more disappointments could be on the way, especially with so many uncertainties such as Fed’s next rate hike and the looming US election with undesirable candidates.
Philly Fed General Activity Index is another indicator which makes it to my personal favourites list. In mid February newsletter, just as risk assets were bottoming out, I wrote that:
“…the current [Philly Fed] conditions closely resembles the slowdown of the 1998 Asian Financial Crisis and my best guess is that the US economy is not in a recession just yet. However, I would like to add that without any notable recovery from here onward, we could very well be on the cusp of one.”
The three month moving average has jumped back above the zero line and the US economy still continues to muddle through (for now). However, the numbers are skewed towards only one positive monthly reading, during which ECB and BoJ were adding more stimulus while the Federal Reserve turned dovish and delayed the rate hike. In general, recession risks continue to linger for the world’s largest economy.
In June, the US expansion turns 84 months old (which is right on a 7 year mark). This is now the fourth longest expansion since World War 2, with an average one lasting 62 months and median one 58 months. Common sense would state that the longer the expansion goes for, the closer we are to the next downturn. However, we don’t live in the common sense kind of a world anymore. My belief is that Federal Reserve (and other central banking buddies) have made it their outright mandate, above inflation and employment data, to keep this expansion going for as long as possible. Eventually, markets will refuse to play the “easing” game and a financial shock could easily fabricate another meaningful slowdown in global economy. With debt levels higher than 2007, we should be asking ourselves if the next downturn will be worse than 2008?
Warmest of regards,
I hope this newsletters finds you well.
I am currently writing from a very warm and extremely humid Saigon (or Ho Chi Minh City), where change is coming – the rainy season is about to start. The interesting fact about this change in weather phenomena is its close similarity and correlation to the stock market seasonality. Saigon’s rainfall increases dramatically from May to October, while the dry season occurs from November to April. Likewise, the most disappointing period of stock market performance is May to October, while outperformance occurs from November to April. I’m sure we have all heard the famous “Sell In May & Go Away” quote. This year, we enter May with the following year to date performance for major asset classes:
What stands out to me is the underperformance of global equities against all other asset classes. It is worth mentioning that the oversold conditions and extremely pessimistic sentiment in February led to a sharp rally over the last 10 weeks (we discussed these points in our mid Feb post). With seasonality now turning negative, I would advise my readers to exercise caution. Vertical rallies, such as the one we recently witnessed in the S&P 500, are not sustainable on annualised basis. Certain market pundits have advised buying the recent dip, but we would argue in the following several charts, that the market isn’t oversold just yet:
- Chart 1: Advance decline line & up down volume averaged over 10 trading days haven’t fallen enough to signal oversold conditions
- Chart 2: percentage of S&P stocks trading above their 50 day moving average hasn’t even fallen below neutral levels yet
- Chart 3: percentage of S&P stocks trading at 20 day new lows hasn’t spiked to at least 50% of the index components
- Chart 4: NYSE 52 week new highs versus 52 week new lows ratio still remains elevated and not even close to neutral levels
- Chart 5: NYSE Mcclellan Oscillator is close to becoming oversold, but we would prefer lower readings of around -80
More importantly, the bull market has entered its 7th year and has tripled since March 2009. It should not be a surprise to any shrewd investor that valuation statistics rank US equities as very expensive. Therefore, is it even worthwhile trying to “pick up a few pennies in front of a steamroller?” Investors who remain bullish on stocks as an asset class, should look abroad towards more attractive foreign markets. In particular, emerging markets remain cheap despite the recent 25% rally. Personally, I do not see much opportunity in any stock market apart from China and Vietnam. Regular readers of this blog might remember our bearish China case from July 2015 newsletter:
“Here I am making an extremely significant point. I want my readers to understand that when it comes to investing, any financial asset including the stock market can (at times) completely disconnect from reality, fundamentals and common sense. Markets are ruled by human emotions just as much as intellect, mainly greed and fear.
While I am bullish [on China] from the long term perspective, I do not think that a buying opportunity is present just yet. While the 30% fall in four weeks is a serious crash by any standards, I hold a view that the market hasn’t finished its mean reversion just yet (please observe the chart above). The recent speculative rally took the Shanghai Composite price more than 55% above its 200 day moving average. There are definitely similarities to the previous two peaks in October 2007 and August 2009, which traded 70% and 45% above 200 day moving average respectively.
Historically, periods when asset prices trade excessively above the mean, are usually followed by a reversion where prices also trade below that mean. Vigilant investors among you should notice that the index is still trading more than 16% above the 200 day MA and if history is of any guide, price will eventually find its way below this mean.
Several investment banks that missed almost the entire rally, as they stubbornly carried on with their neutral outlook (code word for remaining bearish) through the 2013-14 bottoming period, have recently started recommending their clients “to bottom fish” the crash. Majority of these investment bankers are usually too early to buy the fall and always too late to participate in the new rally.”
We have stayed patient all this time and are now hoping for the final leg down in mainland Chinese shares, which have become one of the worst performing stock markets over the last 12 months. There is a strong support around 2,500 points on the index and a fall towards this level would entice us to start our purchases. Investors can use ASHR ETF in United States to play this stock market.
The analysis mentioned above, regarding Shanghai’s rally above its 200 day moving average, can also be applied to the recent surge in Gold Miners. Firstly, I would like to congratulate any speculator who has managed to catch this movement in price, the most powerful short term rally in several generations. I would shake your hand twice over if you caught the Silver Junior Miners rally, which are up more than three fold since January. Regardless of whether one believes Gold has embarked on a new bull market or still has further correcting to do, the rally in Gold Mining equities is extremely… and I repeat, extremely overbought from the short term perspective. The price will soon revert back towards its mean, so we opened some short positions against the GDX ETF at the start of the week and would like to add a few more if given the opportunity.
I have spent the last several months coming and going out of Vietnam. Out of the whole South East Asia region, which has great prospects for future growth, to me Vietnamese economy stands out above the rest. Surprisingly, the stock market (priced in USD) has barley responded and it is here that we find a great opportunity. After dropping almost 85% during the Global Financial Crisis of 2008, the nations equities have largely moved sideways and remain depressed after long eight years (prolonged base-building phase). If one holds a view that just about all financial asset prices (especially S&P 500) are artificially juiced up by central bank easing, then Vietnamese equities have NOT even had a whiff of that sugar high. This market is all but forgotten and thats the way we like it. We started buying recently.
Close family friends from the very remote Papua New Guinea came to visit me in Vietnam recently. They were also pleasantly surprised by the booming economy and saw huge opportunities. I’ve been invited to visit their beautiful country very soon, and I plan to post a lot of picture from this untouched part of the world. I’m sure at least some of you will be interested to see this these amazing beaches and tropical rainforests. Finally, next week I shall be returning back to Hong Kong for awhile, so any readers who would like to catch up and discuss financial markets over a coffee or a beer, please do not hesitate to email me.
Warmest of regards,
Today we will focus on Merrill Lynch’s monthly survey of global fund managers, who overlook around $600 billion in AUM. Majority of the time, but not always, surveys such as these should be taken from the contrary perspective and include some great insights as to how the consensus is positioned. As always, there are some pretty good charts and interesting observations, so lets get started.
Equity allocations remain quite low, especially when one considers the recent multi-month powerful rally in global equities. Fund managers allocations towards the stock market fell to 9% overweight this month, from 13% last month and 54% in April 2015 (just before equities rolled over). The chart above shows that data with MSCI Hong Kong, which has been one of the most oversold markets since the Chinese rout began. However, on our Twitter account readers can also see the same data with the MSCI Australia index. We would assume equities have further to run based on this data alone, however we would advise caution on using only one indicator to make your financial decisions.
Bond allocations remained similar to previous two months, as readings came in at 38% underweight. Worth noting however, fund managers were 64% underweight in December, just before the equity market sold off and bond market rallied. In the chart above, we have shown the difference in allocation of equities vs bonds, together with the ratio of stocks vs bonds. Globally, managers have been quite risk averse. While positioning towards the debt markets is not that extreme (allocations have risen to 20% underweight or even higher historically), there are other sentiment gauges arguing that Treasury yields could rise somewhat from here.
Firstly, small speculators positioning in the futures market shows dumb money is chasing Treasuries with an expectation of lower yields. Secondly, Mark Hulbert’s Bond Newsletter Sentiment Index (click here to see the chart) shows record bullish recommendations by various advisors and newsletter writers. Thirdly, number of shares outstanding on various Treasury ETFs has spiked in recent weeks (click here for the chart, thanks to Tom McClellan). Finally, according to ICI, fund inflows towards government bonds have been very elevated for weeks.
Putting it all together, one can see that there is room for unwinding of positions in the Treasury bond market. We have been long for a few months now and have recently changed our duration towards very short term Treasuries and Corporate grade bonds, as we expect a correction. Having said that, Treasuries still remain attractive for three reasons: 1) relative to rest of the developed world, Treasuries look attractive and could be considered high yielding sovereigns with only Australia & New Zealand paying you more; 2) we still continue to favour assets priced in US Dollars as we see the greenback resume its bull market once the current correction runs its course; and…
… 3) we think that longer duration Treasury yields could eventually break down from the technical consolidation patterns.
Finally, cash balance increased in the month of April to 5.4%, from 5.1% a month earlier. As already discussed above, despite a very strong multi-month stock market rally, fund managers continue to hold extremely high levels of cash. Risk averse behaviour resembles bear markets of 2000-02 and 2007-09, however year to date performance of all major asset classes is pretty much positive (chart below).
Our take on high cash allocations by fund managers requires an investor to step away from day to day activities of the financial market, and focus on the longer term picture. We believe there is an overvaluation in all major asset classes, where global central bankers have goosed up and inflated value of just about everything. We are very nervous and seem not to be the only ones with this view (Bloomberg: Peter Thiel Says Just About Everything Is Overvalued).
Bonds and cash are more expensive than they have ever been, with yields on Treasuries lower than at any other time in the last 220 years. Europe and Japan have gone into “la-la land” of negative interest rates, something that hasn’t happened in over 5,000 years of recorded history. Cash yields essentially zero or even negative in some countries. US stocks are the most expensive ever, apart from a few months during dot com bubble, with some metrics showing future expected returns to be flat over the coming decade. Basically, we have a situation where stocks, bonds and cash are expensive all at once. Depending on how events unfold, returns on all major asset classes could be very low or even negative (in tandem). No wonder global fund managers are frightened!
Sending you warm regards for the remainder of the week, Tiho
Just a reminder to follow Short Side of Long on Twitter for constant chart updates.
I hope your enjoying your weekend! Best wishes to you and your family,