Cam Hui | Dec 14, 2014 11:23PM ET
Trend Model signal summary
Trend Model signal: Risk-on
Trading model: Bullish
The Trend Model is an asset allocation model used by my inner investor. The trading component of the Trend Model keys on changes in direction in the Trend Model - and it is used by my inner trader. The actual historical (not back-tested) buy and sell signals of the trading component of the Trend Model are shown in the chart below:
Update schedule: I generally update Trend Model readings on on weekends and tweet any changes during the week at @humblestudent. In addition, I have been trading an account based on the signals of the Trend Model. The last report card of that account can be found here.
h3 The equity market analytical framework/h3Last week I allowed my inner trader to take the stage (see My trading plan for December) and this week my inner investor will take to the podium. However, I will have a brief trading comment in light of the stock market downdraft seen in the past week.
My inner investor's main analytical framework for US equities is:
My main conclusion is that investors were spoiled in 2014 as stock prices went up more or less in a straight line, but the 2015 stock market, though appearing bullish, will see bouts of gut wrenching volatility.
How quant models respond to shocks
John Butters at Factset has neatly illustrated the importance of forward EPS to stock prices with this chart (annotations in red are mine). Forward EPS has tracked stock prices closely in the last 10 years and there is no reason to believe that they won't continue to do so.
Past episodes of market weakness have been associated with stalling forward EPS growth, which is what we are seeing now. However, the downdraft is going to be temporary for a couple of reasons. First of all, we are seeing most of the negative effects of falling oil prices first. Much of the downward revisions have been attributed to falling Energy sector estimates, which have tracked the price of oil (via Factset ):
On the other hand, the positive effects of falling oil prices have not been quantified by the Street yet. During the Asian Crisis, I can recall sitting in a meeting to assess its effects in light of what we were seeing in our quant models. One of our EM portfolio managers said that estimate revisions were not moving yet because analysts know that earnings are bad, they just have no idea how bad so they are not revising them yet. In the current instance where oil prices have cratered, the Street knows that the effects are good because of lower input prices and higher consumer spending, they just have no idea how good yet. As a consequence, EPS estimates are not rising.
The chart below from Factset (red annotations are mine) shows that we are mainly seeing only the negative effects of the oil price drop, as S&P 500 EPS estimates have been dragged down mainly by resource sectors (and Telecom, which has a tiny index weight), while EPS estimates for the other sectors are flat to slightly up. Expect the positive effects to start filtering through in the weeks ahead.
The second question in my analytical framework is to gauge the health of the American economy. While economic growth does not correlate well with stock prices, it does bear a major influence on the corporate earnings and revenue outlook. This chart shows how closely tied the employment picture is, as measured by initial claims (inverted), to the SPX.
The US economic picture is one of steady improvement, which can be summarized by the comment from Bespoke about the Q3 GDP report, which showed positive internals:
Looking at the internals of the report, there were broad upward revisions to key areas that were slightly weak last quarter, including consumption, fixed investment, and inventories. We previously said that inventories were due for an upward revision after a very weak initial reading, while we expected net trade - especially imports - to be revised upwards, negatively impacting total growth. The rest of the revisions, which we did not expect, were positive: higher consumption and higher investment. As a consequence, domestic final private demand, which strips out trade, government, and inventory changes, jumped half a percent, coming in at a healthy 2.48%, while final demand registered a 4.02% increase.
While Q3 GDP was unusually high and Q4 will likely see a negative snapback, the general outlook remains positive. Indeed, we saw a clue to the positive effects of falling fuel prices when retail sales and consumer sentiment surprised to the upside last week. Indeed, the Citigroup US Economic Surprise Index is ticking up.
The combination of a steadily growing economy with falling energy prices should result in rising EPS estimates in the very near future. I therefore look for stock prices to continue their climb into 2015.
Falling oil prices should also be a net positive for global growth. Business Insider recently highlighted the UBS estimates of the effect on GDP growth.
If we were to focus on the US, UBS estimates that a $10 decline would boost US GDP growth by 0.1%. Assuming that oil prices stabilize at $70-80, the current fall from about $105 would translate into incremental GDP growth of 0.3% for the American economy.
Historically, an oil price drop caused by oversupply has generally been bullish for equities (via Ambrose Evans-Pritchard ):
Tumbling oil prices are a bonanza for global stock markets, provided the chief cause is a surge in crude supply rather than a collapse in economic demand.HSBC says the index of world equities rose 25pc on average over the twelve months following a 30pc drop in oil prices, comparable to the latest slide. Equities rose 19pc in real terms.
Despite the bullish outlook for stock prices, no review is complete without some assessment of the risks. In 2015, there will be plenty of risks that will likely induce much higher volatility in asset prices. Here is what I am watching, in order of likelihood:
2015 will be the year when the Fed starts to normalize interest rates and move off ZIRP. In a must-read FT Alphaville ):
Ever present is the ECB will-they-or-won't-they QE guessing game as the tensions between Draghi and the Bundesbank linger. I believe that the more serious problem in Europe is the lack of action by member states on reform (via the Ambrose Evans-Pritchard :
In the meantime, oil below $70 is already playing havoc with budgets across the global petro-nexus. The fiscal break-even cost is $161 for Venezuela, $160 for Yemen, $132 for Algeria, $131 for Iran, $126 for Nigeria, and $125 for Bahrain, $111 for Iraq, and $105 for Russia, and even $98 for Saudi Arabia itself, according to Citigroup.
What happens if the regime change occurs and the west has to put boots on the ground in Nigeria, Libya or Algeria? Are those kinds of scenarios in the market?
Opec may not be worried about countries such as Nigeria, but even there a full-blown economic and political crisis could turn the north into a Jihadi stronghold under Boko Haram.The growing Jihadi movements in the Maghreb – combining with events in Syria and Iraq – clearly pose a first-order security threat to the Saudi regime itself.
The Libyan city of Derna is already in the hands of the Salafist group Ansar al-Shariah and has pledged allegiance to Islamic State. Terrorist movements in the Egyptian Sinai have also rallied to the black and white flag of IS, prompting Egypt’s leader Abdel al-Sisi to call last week for a “general mobilisation” of all leading Arab and Western powers to defeat the spreading movement.
The new worry is Algeria as the Bouteflika regime goes into its final agonies. “They have an entrenched terrorist problem as we saw in the seizure of the Amenas gas refinery last year. These people are aligning themselves with Islamic State as part of the franchise,” said Mr Newton.
Algeria exports 1.5m bpd of petroleum products. Its gas exports matter more but the price of liquefied natural gas shipped to Europe is indirectly linked to oil over time.
The one key tail-risk that I have not heard discussed is Mexico, which shares a border with the United States. Already, the Mexican peso has plunged to levels that challenge Lehman Crisis lows:
Notwithstanding what has happened in the energy market, political instability is rising in Mexico with protests that some analysts have compared to an Arab Spring (via A wealth of common sense ):
In short, my inner investor remains cautiously bullish on equities for 2015, though with higher levels of volatility. Choppiness and gut-wrenching corrections, yes, but don't expect a bear market to start.
h3 Inner trader: Too late to sell/h3Finally, I have a brief trading comment. My inner trader was caught off-guard by the swiftness of the the sell-off. The Trend Model had flashed an unconfirmed trading sell signal on Tuesday and I usually wait a couple of days before acting on trend following signals as they have a habit of reversing themselves. But the short-term trading model was signaling oversold conditions consistent with a market bottom at the close Tuesday (see Why today (Dec 9) was like the October bottom) and Thursday (see Here for a good time, not a long time).
As the closing bell rang on Friday, my most consistent bottom-calling models were flashing buy signals. As seen in the chart below, the combination of an inversion of the VIX term structure and TRIN greater than 2 forms a powerful buy signal that was 100% in the last two years. In addition, the VIX Index had closed above 20, which is a level that is consistent with trading bottoms.
In retrospect, my inner trader wished that he could have caught the downdraft, but by the time he received confirmation of the downtrend, it was too late to sell and it was time to buy. Nevertheless, there remains a high level of event risk this coming week, with the FOMC meeting and Greek election on Wednesday.
My inner trader therefore remains modestly long equities at this point and nervously hoping for a rally in the early part of the week.
Disclosure: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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