Risk-Reward Skewed To The Upside
Cam Hui | Mar 30, 2015 12:20AM ET
Trend Model signal summary
Trend Model signal: Risk-on
Trading model: Bullish
The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. In essence, it seeks to answer the question, "Is the trend in the global economy expansion (bullish) or contraction (bearish)?"
My inner trader uses the trading model component of the Trend Model and seeks to answer the question, "Is the trend getting better (bullish) or worse (bearish)?" The history of actual (not backtested) signals of the trading model are shown by the arrows in the chart below. In addition, I have a trading account which uses the signals of the Trend Model. The last report card of that account can be found here.
Update schedule: I generally update Trend Model readings on weekends and tweet any changes during the week at @humblestudent.h3 Volatility is back/h3
I would love to say that I am right all the time, but the market gods will humble anyone who does that (hence the name of my blog "John Butters of Factset shows that forward EPS is rising again, which is supportive of higher prices. It seems that the headwinds from falling oil prices and the rising USD are abating (annotations in red are mine).
h3 Risk appetite remains healthy/h3
Despite the minor pullback we saw in equities last week, I am not seeing any signs of rising risk aversion. Consider, for example, this chart of the relative performance of HY bonds (via iShares H/Y Corporate Bond ETF (ARCA:HYG)) to Treasuries (via iShares Barclays 3-7 Year Treasury Bond ETF (ARCA:IEI)) compared to the stock market. Even as stock prices fell, HY bonds actually outperformed, indicating rising risk appetite.
A similar picture can be found in the relative performance of the high-beta, high octane and glamour groups of the stock market, such as biotech (via iShares NASDAQ Biotech ETF (NASDAQ:IBB)), internet (via PowerShares NASDAQ Internet ETF (NASDAQ:PNQI)), broker-dealers (via iShares DJSU Broker-Dealers Index (NYSE:IAI)), IPOs (via Renaissance IPO ETF (NYSE:IPO) and social media stocks (via Global X Social Media Index (NASDAQ:SOCL)). Does this look like a picture of an impending correction?
In addition, small caps (via iShares Russell 2000 Index (ARCA:IWM) and WisdomTree Europe SmallCap Dividend ETF (NYSE:DFE)) are outperforming large cap stocks (via SPDR S&P 500 (ARCA:SPY) and Vanguard MSCI EU ETF (ARCA:VGK)). The pattern is evident not only in the US, but in Europe as well.
When I put it all together, I can only conclude that the recent weakness is a hiccup. The intermediate-term trend remains up.h3 More weakness: Not oversold enough?/h3
Get The News You Want
Looking to the week ahead, however, I do have some concerns that the recent bout of weakness may not be over. While the stock market averages have softened, they have not pulled back enough to register extreme oversold readings that indicate a durable, short-term bottom. As the chart below shows, the 5-day RSI, 14-day RSI are nearing oversold readings, but there is room for them to fall a bit further. As well, the SPX has fallen to the lower Bollinger® Band before reversing itself during recent episodes of market weakness.
From a short-term technical viewpoint, I would have to allow for the possibility that stock prices weaken further in the coming week. Downside risk for the SPX stands at about 2035, which is slightly more than 1% below the closing levels on Friday.
h3 Event risk: Heads I win, tails I tie (?)/h3
No market review would be complete without the consideration of event risk, the outcome of which is binary and difficult to predict. There are three on the radar screen right now:
- Saudi-Yemen
- Greece
- Iran
The market was spooked last week by the news of Saudi airstrikes against the al-Houthi rebels in Yemen. Oil prices spiked in a knee-jerk fashion and stock prices deflated. Yet, this Stratfor analysis shows that the conflict is a regional one and al-Houthi does not appear to be a major threat in the region (via tweeted the news that Italy had managed to sell 2017 zero-coupon paper for an incredible 0.162% yield. I interpret this as an indication that Greece has largely been firewalled.
Any possible downside from a negative reaction to the Greek proposals is likely to be limited. On the other hand, the proposals could be accepted and we would likely see a risk-on rally.
Marc Chandler Oil dives 5 percent as worries about Iran talks trump Yeme n" tells the story of market expectations:
Oil tumbled 5 percent on Friday, erasing the previous session's gains, as Yemen's conflict looked less likely to disrupt Middle East crude shipments and investors turned their focus to talks for a potential Iran nuclear deal that could put more supply on the market.
In other words, a deal with Iran trumps any concerns over Yemen. Such a blockbuster deal would spark a market positive reaction and a risk-on rally. If there is no deal, we go back to the status quo. (Note that my comments are focused on the likely market reaction. As for the issue of whether a deal with Iran is positive or negative from a geopolitical viewpoint, that question is beyond my pay grade.)
As I write these words, there are indications from news reports that the broad outlines of a tentative deal are in sight, though nothing is certain:
Iran and six world powers have reached tentative agreement on key parts of a deal sharply curtailing Tehran's nuclear programme, Western diplomats said Sunday while cautioning that the pact is by no means done.One of these diplomats in talks in Switzerland said Iran had "more or less" agreed to slash the number of its centrifuge machines by more than two-thirds and to ship abroad most of its stockpile of nuclear material.
As negotiators in Lausanne raced to nail down by midnight Tuesday the outlines of a deal, due to be finalised by June 30, the diplomats cautioned however that with some tough issues still to resolve, things may change.
Iranian diplomats denied that any tentative agreement on these points has been struck, saying that reports of a specific number of centrifuges and exporting its stockpiles were "journalistic speculation".
(Lightly) pencil a third in for the bulls.
In short, there are a number of tail events with binary outcomes that could affect global markets in the near future. While I have no way of forecasting what will happen, the risk-reward ratio seems to be skewed to the upside.
As I review market conditions, they can be summarized by an intermediate term bull trend, mildly (but possibly insufficient) oversold readings and event risk that is skewed to the upside.
Bottom line: My inner investor remains bullishly positioned. My inner trader was caught offside by last week's decline and he is staying long despite the pain he endured. The risk-reward remains tilted positively with a long position rather than a short position.
Disclosure: Long SPXL, TQQQ
Disclaimer: 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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