Doubling down on a bad bet?

Equity bears were further humiliated last week. Even investors positioned cautiously had to suffer the pain of watching the market destroy their relative performance. If you're coming into the Christmas period with a good bag of returns, it won't matter much. But if you have underperformed, it will sting to watch the market run away with the prize into year-end [1]. Luckily, the portfolio falls in the former category this year; no matter what happens 2016 will be a good year. The shorts in FTSE and Home Depot have been scathing in recent weeks, and the so far ill-advised punt on Syntel also remains a severe drag. But the overweight in financials via Wells Fargo and Sabadell, and the push higher in Japanese equities, has spared yours truly the worst embarrassment in the amateurs' peanut gallery. 

My base case was that equities would struggle after the summer and sell off towards a juicy tradable bottom in Q1. That may yet occur, but the call of weaker equities into year-end, mirroring the performance of 2015, has been blown out of the water. In my last look at markets I expressed caution, from the point of view a bearish stance, that breadth on the S&P 500 was improving. I mused that the index could well be a difficult short despite a number of my medium term models pointing to a defensive/short bias. That worry has been solidly confirmed by price action since.

I was reminded of the reality in equities by this tweet extolling the folly of betting against the mighty S&P 500. 

 Don't fight the trend

Don't fight the trend

Having accepted my failure to capture the violent swing higher in equities, though, does not mean that I want to chase the market. Indeed, I am happy to announce that I haven't learned anything. Most of the short-term indicators I look at indicate that Spoos is about to trip over. The first chart below shows the put-to-call ratio, which has collapsed recently. It has also incidentally been milked all over my Twitter feed, so apologise for being very un-original here. This ratio often mean reverts quicker than analysts have time to update their spreadsheets, but as of Friday December 9, it suggests that it will be hard work for bulls in the very short run. This message is corroborated by my homemade short-term oscillator for the S&P 500. Four week returns appear to have rolled over, and a forward looking mean-reversion score suggests further downside. 

 Investors are reaching for the sky after the recent push in Spoos…

Investors are reaching for the sky after the recent push in Spoos…

 …and could well be disappointed in the short run

…and could well be disappointed in the short run

Looking further ahead, the idea that U.S. equities would be unable to overcome the crash earlier this year is difficult to sustain. If you just look at the chart at least, it already has. The break higher has been convincing, and has comfortably left behind the most recent "panic levels" in Q4 2015 and Q1 2016. Based on everything we have seen so far, a sell-off would hit support a about 2100; bears and recessionistas would solemnly proclaim that the party is over, only for the market to sling-shot towards a new high. We have seen this movie so many times before.

More generally, global macroeconomic data certainly have picked up momentum recently, adding a welcome fundamental support for the recent break higher in global equities. It is often said that it is surprises relative to expectations that matter. If that is the case, investors chasing the market this month have had solid support from the data. 

Surprise indices.jpg

Even European equities have broken their recent tight range to the upside, led by none other than financials. Once again, financial markets have looked at the wall of political uncertainty, and walked through as if it wasn't even there. Analysts' interpretation of this state of affairs tend to be driven by personal biases. Either it is seen as a sign of extreme complacency, and an opportunity to get out before the ramifications of the new political landscape hit investors. Or it is a sign that political change ushered in by our new fierce leaders is exactly what the global economy and markets have been crying out for. It's probably neither of these two. But it's interesting to see that financial markets have become increasingly immune to political "shocks." That kind of cynical discounting by markets isn't necessarily a bad thing. 

Of course the burden of evidence increasingly rests with the bulls who believe that the current asset price cycle will persist. And here the problem, in terms of betting aggressively on the Trumponomics reflation story, is that it could well have a short shelf life. The more successful Mr. Trump is, the more likely the Fed is to make its way further into "normal" interest rate territory. This isn't a bad thing, mind. A world where yields are not zero is a world where financial markets are sending proper signals to investors again. But this sequence of events also begins to look a whole lot like a traditional late-cycle U.S. economy. First the curve steepens as the Fed moves, but then it flattens as the central bank scrambles to catch up with inflation and wage growth. This movie is also one we have seen before, and it ends with a U.S. recession. The hangover from higher rates in corporate debt markets in particular could be severe, when higher yields hit overlevered non-financial equities. The party in corporate bond markets has been spectacular since 2008, and when we close the book on this cycle, it will be because of an accident in this space. I can't pinpoint where and when it will happen, but I am pretty convinced that a liquidity event in one or more of the big hybrid asset managers, who also are huge corporate bond fund providers, will mark the end of this cycle. I concede, though, that this has been my number one worry since 2013, so it isn't exactly a convincing argument for making dramatic changes to your playbook.

 

An inflection point between cyclicals and defensives?

If you're not into game of predicting the next crash or recession, let me point you in another direction. How about the idea than an inflection point could be looming in the run of outperformance of cyclicals relative to defensives, and indeed stocks relatively to bonds in general? In short, I think bonds and defensives are about to claim back some outperformance. But annoyingly, trailing returns aren't really hugely contrarian extreme levels yet. The long/short trade in cyclicals and defensives—in MSCI World guise—has gone vertical, but history suggests that further upside is more than possible. The first chart shows that the relative return of cyclicals to defensives. It has jumped in the second half of the year, but it can go higher. The second chart shows the stock-to-bond ratio in the U.S. It is high, but far from extreme. Trying to trade against a trend which is just getting started is the most painful errors in this game. 

 Cyclical equities are fighting back…

Cyclical equities are fighting back…

 …and bonds are underperforming equities. Can it last? 

…and bonds are underperforming equities. Can it last? 

Other absolute return indicators, however, are more sympathetic to the idea that the traditionally defensive part of the market could be about to lead again. Trailing returns on U.S. bond futures have collapsed, which is partly why my valuation model to its highest level since 2014. I have a feeling the bond bears aren't done yet, and that 3% on the U.S. 10y is possible. That would make me very interested! In equity-space the story is mainly one of collapsing returns in health, telecoms and utilities in combination with higher forward looking valuation indices. The chart below is for U.S. utilities—S5 UTIL index—but the story is broadly the same for health and telecoms. Healthcare is particularly interesting although the uncertainty over pricing power is high. In a gung-ho free market world, these guys have huge market power due to population ageing, but if government moves to curb some of that power, valuations look extended. In addition, many healthcare firms have levered up too much for my liking in this cycle. 

Ty1 valuation score.jpg

If the scenario above plays out in some form or the other, it would add further evidence to the idea that those waiting to take advantage of a deep dive in global equities akin to the horror seen in 2008 could well be disappointed in the short run. This is to say that a strong rebound in traditionally defensive sectors could easily be a significant driver of the index itself, at least for a while. 

 

Make your bets! 

The main propositions I am forwarding above are, perhaps disappointingly, not much different from what I have argued previously. Don't chase equities higher when the put/call ratio is at depressed levels, but don't kid yourself into believing that the next sell-off will be the "big one." As the war between the Zero Hedging Armageddon preppers and the POMO punters has reached extremes, I have been a strong advocate for the middle ground. And I think that financial markets have, by and large, proven me right. The pendulum always swings back, but if you're stuck too far on either side of the spectrum you won't see it. Right now, it seems as if investors who are waiting eagerly for Mr. Trump to deliver are hoping for too much. If they decide to take profit, they might find that crates of Cristal have been stacked to block off the main exits.  After all, it isn't every day we get a Barron's cover like this; 

 Uh-oh ... 

Uh-oh ... 

The Economist is (in)famously known for its covers on the dollar which usually are excellent contrarian indicators; it is a lazy cheap shot to apply the same idea to Barron's. But I thought it was worth pointing out, to add some colour. Bulls will predictably scoff, though, and point out that in my case, it amounts to nothing more than doubling down on a bad bet. 

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[1] - I hear Polemic screaming at his screen now for the focus on December 31st as some magic end-date. But I am trained on the sell-side, and we never miss a chance to present a narrative.