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Bullish in a bull market, bearish in a bear market

We are witnessing the transition from a bull to a bear market.

I subscribe to Jesse Livermore’s maxim (emphasis added):

“I began to see more clearly—perhaps I should say more maturely—that since the entire list moves in accordance with the main current…. Obviously the thing to do was to be bullish in a bull market and bearish in a bear market. Sounds silly, doesn’t it? But I had to grasp that general principle firmly before I saw that to put it into practice really meant to anticipate probabilities. It took me a long time to learn to trade on those lines.”

The second part of that quote is equally important. You determine whether a market is bullish or bearish by “anticipating probabilities”. Don’t take signals from the charts in isolation. You have to study general conditions.

Livermore gives a classic example in Reminiscences of a Stock Operator of how he anticipated a bear market in 1906 after the Boer War in South Africa had drained Britain’s coffers and the San Francisco earthquake led to massive insurance payouts, forcing insurers to liquidate large swathes of their investment portfolios. But he was wiped out as the market repeatedly rallied. He persisted and eventually was proved right when large rail stocks announced new stock issues. The fact that the issues were structured as instalment issues, with only a down-payment needed to acquire the stock, alerted Livermore that there was not enough liquidity in the market to absorb the stock issues. His broker extended him a line of credit and…

“I profited by my earlier and costly mistakes and sold more intelligently. My reputation and my credit were reestablished in a jiffy. That is the beauty of being right in a broker’s office, whether by accident or not. But this time I was cold-bloodedly right, not because of a hunch or from skillful reading of the tape, but as the result of my analysis of conditions affecting the stock market in general. I wasn’t guessing. I was anticipating the inevitable. It did not call for any courage to sell stocks. I simply could not see anything but lower prices, and I had to act on it….”

General conditions in the US are still strong.

Credit and the broad money supply (MZM plus time deposits) are growing at close to 5%.

S&P 500

Credit risk premiums are rising but are nowhere near alarming. A spread of more than 3.0% between lowest grade investments (Baa) and 10-year Treasuries would flag a warning.

S&P 500

The big shrink, as the Fed unwinds its balance sheet, is still a myth. Banks are drawing down excess reserves at a faster rate, so that liquidity is rising. The rising green line on the chart below shows Fed assets net of excess reserves.

S&P 500

But charts are bearish.

Market volatility is high and a large bearish divergence on S&P 500 Momentum warns of a bear market.

S&P 500

We need to look at global conditions to identify the cause for market concern: Brexit, slowing European growth, but primarily, a potential trade war with China.

It’s time to be cautiously bearish.

There is no training, classroom or otherwise, that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market.

~ Paul Tudor Jones

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Get ready for economic slowdown | Trivium China

While we cannot rule out the chance of a large Chinese stimulus, senior officials are talking this down. In 2008/2009, China injected a whopping 19% of GDP to revive its flagging economy, compared to roughly 6.5% of GDP by the Obama administration at the height of the GFC. The size and scope of the stimulus achieved the desired result but had several undesirable side effects, including accelerating the property bubble and rapid growth expansion of the informal shadow banking sector as speculative fever grew.

From Trivium China:

At his meeting with businessmen on Tuesday, Li Keqiang [Premier of the State Council of the People’s Republic of China] also laid out his views on the economy.

In a nutshell: Things do not look good (Gov.cn).

  • “Downward economic pressure is increasing.”
  • “[We must] thoroughly prepare to react to difficulties and challenges.”

But Li stressed (again!) that the government’s response to this slowdown will be different than in the past:

  • “[We] will not rely on traditional measures.”

Instead, Li wants to take a more measured, precise approach:

  • “Macro policies should be stable, precise, and effective in order to counter external uncertainties.”

The top priority will continue to be improving the business environment, with a focus on three areas:

  • Eliminating government interference in business operations
  • Reducing taxes and fees
  • Making financing easier and cheaper to get

Get smart: If you haven’t gotten the message yet, you have not been listening. The government is not going to repeat the massive stimulus that it enacted 10 years ago in response to the financial crisis.

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ASX 200 rallies but LT bearish

The Australian economy is creaking. This is not a time for the Treasurer to concern himself with a balanced budget, laudable as that long-term (LT) goal may be.

Household consumption is slowing, with falling car sales and international travel. Housing investment is about to go over a cliff. This time China is unlikely to rescue the damsel in distress with another record stimulus spend.

It’s time for the government to go big on infrastructure spending. Not school halls or pink batts but real infrastructure like transport and communications investment (5G for example) that will boost long-term GDP growth. We are going to need government (and private) infrastructure to offset the sharp fall in housing investment and prevent a serious contraction.

The ASX 200 rallied off support at 5400 and is headed for a test of resistance at 6000. What could go wrong? This is a bear market and one strong rally is not going to change that. Respect of resistance at 6000 is likely and would warn of another test of primary support at 5400. Breach of support would offer a target of the 2016 low at 4700.

ASX 200

Banks are vulnerable because of the falling housing market. The ASX 200 Financials Index is testing long-term support at 5400. Bullish divergence on the Trend Index indicates buying pressure but I believe this is secondary in nature. The primary trend is down and breach of 5400 would offer a LT target of 4000.

ASX 200 Financials Index

The Resources sector is in far better shape but bearish divergence on the  ASX 200 Materials Trend Index warns of LT selling pressure. Reversal below 10500 would confirm a primary down-trend.

ASX 200 Materials

I have been cautious on Australian stocks, especially banks, for a while, and hold 40% cash in the Australian Growth portfolio.

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Gold: Bull or bear?

Gold is testing resistance at $1300/ounce and is likely to follow-through to the long-term (LT) ceiling at $1350. Trend Index  on the LT  monthly chart displays a large triangular consolidation, indicating uncertainty. Upward breakout would signal a primary up-trend but this is unlikely, for three reasons. First, this is a bear market. A decline is more likely for that reason alone. Target for a decline is the 2015 low at $1050/ounce.

Spot Gold in USD

Second, a strengthening Dollar is likely to weaken Gold. I have inverted the LT chart of the Dollar Index (and Trend Index) below so that it is easier to relate to gold. As the Dollar strengthened, denoted by a LT fall on the inverted chart, Gold has weakened. The Dollar index shows a broadening consolidation since 2015, with bull and bear traps, again indicating uncertainty. At present, the Dollar is testing resistance at 97 but is likely to follow through to test LT resistance at 100. Rising Trend Index troughs above zero (remember the scale is inverted) signal buying pressure.

Dollar Index inverted

Third, falling Crude Oil prices are bearish for Gold. The LT chart below compares spot crude  to  spot gold, both adjusted for inflation to bring earlier peaks into proper perspective. The LT relationship is clear: gold and crude tend to rise and fall together. Crude prices have recently tumbled, exerting downward pressure on Gold.

Gold and Crude Oil, adjusted by CPI

Conclusion: We are witnessing a rally in Gold because of global uncertainty but the LT outlook is bearish.

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The Aussie economy is quietly falling apart | Macrobusiness

You’d have to be as blind as the RBA to miss the signals. GDP is made up of six components and they are not going well on balance:

  • government consumption is strong and likely to stay that way;
  • government investment is peaking as the NBN rolls off and infrastructure starts fade;
  • household consumption is weakening with car sales and international travel down sharply plus retail looking highly questionable;
  • business investment has been good and the outlook for six months is solid but it will track broader demand and housing investment is about to tumble;
  • inventories will ebb and flow;
  • net exports (volumes) are weak owing to China’s thermal coal blockade and the drought despite the LNG ramp up.

In short, the Australian economy is quietly falling apart and if it does not receive any new juice soon it is going to crater as we enter the Hayne Royal Commission recommendations, the federal election stall and Labor’s reform agenda. I have now downgraded my outlook for domestic demand from what was already bearish:

This is an environment in which unemployment will rise at a decent clip threatening much worse outcomes as that feeds back into asset prices.

That markets and economists are still forecasting rate hikes is ridiculous. That cuts remain off the radar of nearly all is bizarre.

By Houses & Holes (David Llewellyn-Smith). Reproduced with kind permission from Macrobusiness.

Comment: Time for the government to go big on infrastructure spending. Not school halls or pink batts insulation but real infrastructure like transport and communications investments (5G for example) that will boost long-term GDP growth.

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PEmax and why you should be wary of Robert Shiller’s CAPE

Robert Shiller’s groundbreaking works, Irrational Exuberance and Animal Spirits, led to a Nobel prize in 2013 but we need to be careful of placing too much reliance on his CAPE as an indicator of stock market value.

What is CAPE?

CAPE is the cyclically adjusted price-to-earnings ratio, normally applied to the S&P 500, to assess future performance of equities over the next decade. CAPE is calculated by dividing the S&P 500 index by a moving average of ten years of inflation-adjusted earnings. Higher CAPE values imply poor future returns, while low values signal strong future performance.

Economists John Y. Campbell and Robert Shiller in 1988 concluded that “a long moving average of real earnings helps to forecast future real dividends” which in turn are correlated with returns on stocks. Averaging inflation-adjusted earnings smooths out short-term volatility and medium-term business cycles in the economy and, they argued, was a better reflection of a firm’s long-term earning power.(Campbell & Shiller: Stock Prices, Earnings and Expected Dividends)

Shiller later popularized the 10-year version (CAPE) as a way to value the stock market.

S&P 500 CAPE

Strengths

CAPE correctly identifies that the S&P 500 was over-priced in the lead-up to Black Friday (October 1929) and ahead of the Dotcom bubble in 2000. It also correctly identifies that stocks were under-valued after the Depression of 1920-21, during the Great Depression of the 1930s, and during the 2008 Global Financial Crisis.

Weaknesses

Some CAPE readings are rather odd. The rally of 1936, in the midst of the Great Depression, shows stocks as overvalued. Black Monday, October 1987, which boasts the highest ever single-day percentage fall (22.6%) on the Dow, hardly features. Current CAPE values, close to 30, also appear exaggerated when compared to current earnings.

Causes

There are several reasons for these anomalies, two of which relate to the use of a simple moving average to smooth earnings.

The simple moving average (SMA) is calculated as the sum of earnings for 10 periods which is then divided by the number of periods, 10 in our case. While the SMA does a reasonably good job of smoothing it has some unfortunate tendencies.

First, the SMA tends to “bark twice. If unusually high or low data is recorded, the SMA will rise or fall accordingly, as it should. But the SMA will also flag unusual activity, in the opposite direction, 10 years later when the unusual data is dropped from the average.

Second, the SMA is fairly unresponsive. If earnings rise rapidly, the SMA will lag a long way behind current values.

The third anomaly relates to the use of a moving average of earnings to reflect future earnings potential. Companies may incur losses at the low-point in the business cycle, especially in a severe down-turn like 1929 or 2008, but the impact on future earnings capacity is marginal.

Take a simplistic example, where earnings are $1 per year for 9 years but a loss of $5 is incurred in the following year.  When the business cycle recovers, potential earnings are likely to be $1, not $0.50 (the 10-year SMA).

Examples

All of these flaws are evident in the CAPE chart above.

Problem 1

Expect a fall in CAPE next quarter (Q1 2019) when losses from Q4 2008 are dropped from the SMA period.

Problem 2

Earnings multiples in the lead-up to Black Friday (1929) and the DotCom bubble (2000) are both overstated because of the lag in the SMA caused by rapidly rising earnings.

Problem 3

Potential earnings in 1936 are understated because of the sharp fall in earnings during the Great Depression, resulting in an overstated earnings multiple. The same situation occurs 2009-2018 when losses from 2008 inflate CAPE values.

Proposed Solution

I tried a number of different moving averages in order to avoid the above anomalies but all, to some extent, presented the same problems.

Eventually, I tried dropping the moving average altogether, instead using the highest previous four consecutive quarter’s earnings to reflect future earnings potential. I call this PEmax © (price over maximum historic earnings). PEmax matches normal historic price-earnings ratio (PE) most of the time, when earnings are growing, but eliminates the distortion caused by sharp falls in earnings near the bottom of the business cycle.

S&P 500 PEmax

PEmax overcomes distortions associated with the 1936 bear market rally, Black Monday in 1987 and our current situation in 2018.

Compare how the two perform on a single chart below.

S&P 500 PEmax compared to CAPE

The spikes on Black Friday and the Dotcom bubble are more muted on PEmax but still warn that stocks are over-priced relative to future earnings potential. The 1936 bear market rally is restored to its proper perspective. As is the 1987 Black Monday spike, by removing the distortion caused by declining earnings in the early 90s. The same happens after the Dotcom bubble. And again in 2009 -2018.

Potential Uses

The historic average (1900 – 2018) for PEmax is 12.79. For what it’s worth, standard deviation is 5.32 but this is not a normal distribution.

S&P 500 PEmax distribution

The median (middle) value is slightly below the mean, at 12.23.

Visual inspection of the data suggests that low values are skewed towards the first half of the 20th century. The average over the last 50 years (1969-2018) is 15.85 but, again, this may be distorted by the Dotcom era.

Based on visual inspection, we suggest using a PEmax of 15.0 as the watershed:

  • PEmax greater than 15.0 indicates that stocks are over-priced; while
  • PEmax below 15.0 presents buying opportunities.

Potential Weaknesses

PEmax has one potential weakness. If S&P 500 earnings are ever exaggerated by an unusual event, to a level that is unlikely to be repeated, potential earnings will be overstated and PEmax understated. Fortunately, that is likely to be a rare occurrence, where earnings for the entire index spike above actual earnings capacity.

Conclusion

PEmax ©, an earnings multiple based on the highest previous four consecutive quarter’s earnings, is a useful comparison of price to future earnings potential. It eliminates many of the distortions traditionally associated with price-earnings multiples, including CAPE. High PEmax values (above 15) suggest poor future performance, while low PEmax values (below 15) correspond with greater investment opportunity.

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Big four banks protest against higher capital

“The big four banks are trying to convince the prudential regulator to reconsider its proposal to force them to raise an additional $75 billion of so-called Tier II bonds to meet “too big to fail” capital requirements.” ~ Jonathan Shapiro, Australian Financial Review

What is APRA thinking? They are deluding themselves if they think that Tier II bonds will shore up capital.

Imagine the panic in financial markets if bond-holders take a haircut. It could lead to a Lehman-style meltdown.

The same applies to Tier I hybrids which banks are happily flogging to retiree investors. Convert their investments into near worthless bank scrip after a financial meltdown and nan and pops will turn up in Melbourne Docklands and Darling Harbour, demanding their money back. I suspect regulators would rather face Ned Kelly.

The only true capital is Common Equity (CET1). Anything else is simply putting lipstick on the pig.

Aussie taxpayers are being duped if they believe that they are covered if there is a financial meltdown and that banks carry enough capital to absorb potential losses.

I would rather see legislation that calls it like it is and provides for government to backstop the banks in the event of a crisis. But at a price that makes their eyes water, as the Swedes did in 1992. It’s the best way to keep the banks honest.

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China’s newest export

“Polish authorities have arrested a Chinese employee of Huawei, the Chinese telecommunications giant, and a Polish citizen, and charged them with spying for Beijing, officials said on Friday, amid a push by the United States and its allies to restrict the use of Chinese technology based on espionage fears….
It is not the first time in recent months a Huawei employee has been arrested abroad. Meng Wanzhou, the company’s chief financial officer, was arrested in Canada last month at the request of the United States, where she had been charged with fraud designed to violate American sanctions on Iran….
A 2012 report from United States lawmakers said that Huawei and another company, ZTE, were effectively arms of the Chinese government whose equipment was used for spying. Security firms have reported finding software installed on Chinese-made phones that sends users’ personal data to China.”
From Joanna Berendt at The New York Times

Lack of independence of private companies in China, their use for espionage purposes including industrial espionage, and failure to open Chinese markets up to foreign competitors are likely to throttle attempts to resolve trade disputes with the US. An impasse seems unavoidable.

It is important that the West confronts China over their trade tactics, espionage and ‘influence’ operations. Whether Donald Trump is the right person to lead this, I will leave for you to judge.

I doubt that China wants to rule the world. Dominate, perhaps. But the overriding goal of their leaders is to ensure the survival of the Chinese Communist Party (CCP). They want to make the world safe for autocracy. They don’t seem to understand that this is an oxymoron. Autocracies make the world unsafe because they lack the checks and balances, imperfect as they may be, that ensure stable government in democracies whose citizens are protected by rule of law. If you think the world is already unsafe, imagine Donald Trump as president without the constraints of the US Constitution. History provides plenty of evidence of autocrats — Stalin, Hitler and Mao are prime examples — who abused their power with catastrophic results.

China’s newest export may be a global recession if world leaders are not careful. These two charts from the RBA highlight the current state of play.

Declining growth in retail sales is accelerating. Manufacturing PMI is rolling over and industrial production is likely to follow.

China Activity Levels

Output, on the other hand is surging, as the state attempts to spend its way out of a recession. Cement production is the sole laggard.

China Output

Matt O’Brien at The Age describes China’s dilemma:

…in the depths of the Great Recession, Beijing unleashed a stimulus the likes of which the world hadn’t seen since World War II.

It amounted to some 19 per cent of its gross domestic product, according to Columbia University historian Adam Tooze. By point of comparison, US President Barack Obama’s stimulus was only about 5 or 6 per cent of US GDP.

Aside from its size, what made China’s stimulus unique was the way it was administered. The central government didn’t borrow a lot of money itself to use on infrastructure, but it pushed local governments and state-owned companies to do so.

The result was a web of debt that’s been even harder to clean up than it might have been because of all the money that unregulated lenders – “shadow banks” – were frantically handing out above and beyond what Beijing had been hoping for….

What is new, though, is that this isn’t working quite as well as before. As the International Monetary Fund reports, China seems to have reached a point of diminishing returns with this kind of credit stimulus.

So much new debt is either going toward paying off old debt or toward economically questionable projects that it takes a lot more of it than it used to just to achieve the same amount of growth.

Three times as much, in fact. Whereas it had only taken 6.5 trillion yuan of new credit to make China’s economy grow by 5 trillion yuan per year in 2008, it took 20 trillion yuan of new credit by 2016.

I don’t share Matt’s conclusion that Wall Street fears the broad market will follow Apple (AAPL) into a tailspin as Chinese retail sales decline. I covered this in my last newsletter.

Nor do I think that falling Chinese steel production will plunge the global economy into recession. Though it would certainly affect Australia.

China has $3 trillion of foreign reserves and has shown in the past that it is prepared to spend big to buy its way out of a recession. Whether they succeed this time is uncertain, but old-fashioned stimulus spending will soften the impact.

I believe Wall Street has no idea how the trade dispute will play out. And financial markets have gone risk-off because of the uncertainty, despite a booming US economy.

Earnings ratios have fallen dramatically, back to 17.8, from what was clearly bubble territory above 20 times historic earnings. I use the highest preceding four quarters earnings, to smooth out earnings volatility, so my P/E charts (PEmax) will look a little different to anyone else’s.

S&P 500 PEmax

Market volatility remains high, with S&P 500 Volatility (21-day) above 2.0%. A trough above 1% on the next multi-week rally would confirm a bear market — as would an index retracement that respects 2600.

S&P 500

Momentum shows a strong bearish divergence.

S&P500 Momentum

Similar to the Dotcom era below. It would be prudent to wait for a bullish divergence, as in 2003, to signal the start of the next bull market.

S&P500 Momentum

I repeat the same quote as last week as an important reminder of current market volatility.

What beat me was not having brains enough to stick to my own game – that is, to play the market only when I was satisfied that precedents favored my play. There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time.

~ Jesse Livermore

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ASX 200 bear rally

Credit growth in Australia is falling (with help from the Royal Commission) and broad money growth is anemic, below the lows of the GFC, warning that the economy is close to a contraction.

RBA: Credit & Broad Money

Banks are particularly vulnerable because of the falling housing market. The bubble threatens to burst after a long expansion and the RBA is low on ammunition. How many rate cuts do you think they have left in reserve?

The ASX 200 Financials Index is testing long-term support at 5400. Declining Momentum peaks warn of a bear market. Breach of support is likely to lead to another decline, with a long-term target of 4000.

ASX 200 Financials Index

The Resources sector is in far better shape but the ASX 200 Materials Index is also slowing, with a strong bearish divergence on 13-week Momentum. Reversal below primary support at 11000 would confirm a primary down-trend.

ASX 200 Materials

The ASX 200 is testing resistance at the former band of primary support between 5650 and 5800 (revised up from 5750). The rally could go further, possibly as high as 6150, but this is a bear market and the probability that this rally will change that is low. Respect of resistance is likely and reversal below 5650 would confirm the bear market for Australian stocks. Initial target for a primary decline is 5000.

ASX 200

Our hope is that China rescues us with another massive stimulus spend,  as in the GFC, lifting the resources sector. But hope isn’t a strategy.

I have been cautious on Australian stocks, especially banks, for a while, and hold 40% cash in the Australian Growth portfolio.

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Jesse Livermore: The Wall Street fool

“What beat me was not having brains enough to stick to my own game – that is, to play the market only when I was satisfied that precedents favored my play. There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time.”

~ Jesse Livermore in Reminiscences of a Stock Operator