The Bearish Scenario That Keeps Me Awake At Night

Cam Hui | Aug 26, 2014 12:35AM ET

This is the second part of a two-part comment about the US equity market. Yesterday's comment ( July money supply and credit growth figures shocked the market (emphasis added):

New Yuan Loans 385.2bn (vs. expected 780.0bn and prior was 1080.0bn)
Aggregate Financing 273.1bn yuan (vs. 1500.0bn expected and prior was 1970.0bn)
Money Supply M0 5.4% y/y (vs. +5.7% expected and prior was 5.3%)
Money Supply M1 +6.7% y/y (vs expected 8.6% and prior was 8.9%)
Money Supply M2 +13.5% y/y (vs expected 14.4%, prior was 14.7)

As Business Insider ):

To put it very simply, stock prices depend on three elements:

Earnings growth

Interest rates

Risk appetite, or risk premium

So what happens if global growth started to slow? What would happen to large cap earnings growth?

While the characteristics of US large and small capitalization stocks are not directly comparable, this chart from UBS shows the differential in EBIT margins between the two. Should foreign growth start to slow, large and small cap EBIT margins will likely start to converge, with large cap margins falling toward their small cap counterparts for cyclical reasons.

Should we start to see an operating margin squeeze because of a weakening economic cycle, large caps will likely see a double whammy of reduced risk appetite, which would then see PE ratios compress.

Bearish tripwires

I had this scenario in the back of head when I observed that commodities and European stock markets were struggling (see Global growth scare = Trend Model downgrade ). While European markets have started to recover somewhat, commodity prices remain under pressure and we are not out of the woods yet. Given the kind of macro downside risk, the consequences of a policy mistake is heightened.

Here is what I am watching as my "bearish tripwires" for the US stock market:

What is the effect of the ECB TLTRO program on the eurozone economy and financial system? How will peripheral bond risk premiums react? Is the European consensus shifting away from the all-austerity-all-the-time viewÉ How will European stock prices, which are a component of my Trend Model, react to these initiatives?

Were the China July figures indicating a slowdown a blip, or the start of a new trend? The chart below shows the relative performance of the stock markets of Greater China, which consist of China (FXI in red), Hong Kong (EWH in black), Taiwan (EWT in green) and South Korea (EWY in orange) relative to ACWI. Is the recent episode of outperformance the start of a rally, or will these markets roll over as evidence of the ephemeral nature of the rebound emerge? How will commodity prices, another key real-time indicator of Chinese growth, react?

Most importantly, how are the Street's consensus S&P 500 EPS estimates evolving? On the last question, Ed Yardeni's analysis showed that consensus EPS estimates continue to rise, which is a relief for the bulls.

So far so good and I remain cautiously optimistic. However, these three tripwires bear watching as they could warn of the start of either a serious correction or the start of a bearish impulse in US equities.

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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None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Written By: Cam Hui

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