“Stocks rebound but sentiment soft”

From Bob Doll at Nuveen Investments. His weekly top themes:

1. We think the odds of a U.S. recession are low, but we also believe growth will remain soft for a couple of quarters. U.S. growth may bottom in the first half of 2019 following a relatively disappointing fourth quarter and the recent government shutdown. We expect growth will improve in the second half of the year.

Agreed, though growth is likely to remain soft for an extended period. The Philadelphia Fed Leading Index is easing but remains healthy at above 1.0% (December 2018).

Leading Index

2. Inflation remains low, but upward pressure is mounting. With unemployment under 4% and average hourly earnings rising to an annual 3.6% level, we may start to see prices rise. So far, better productivity growth has kept the lid on prices, but this trend bears watching.

Agreed. Average hourly earnings are rising and inflation may follow.

Hourly Earnings Growth

3. Trade issues remain a wildcard. The U.S./China trade dispute appears to be making progress, but the timeline is slipping and significant disagreement remains over tariff levels and intellectual property protections.

This is the dominant issue facing global markets. Call me skeptical but I don’t see a happy resolution. There is too much at stake for both parties. Expect a drawn out conflict over the next two decades.

4. We do not expect Brexit to cause widespread market issues. We think the risk of a hard Brexit is low, since no one wants to see that outcome. Some sort of soft separation or even a Brexit vote redo appears more likely.

Agreed. Hard Brexit is unlikely. Soft separation is likely, while no Brexit is most unlikely.

5. The health care sector may remain under pressure due to political rhetoric. Health care stocks in general, and managed care companies in particular, have struggled in light of talk about ending private health care coverage. We think Congress lacks the votes to enact such legislation. But this issue, as well as drug pricing policies, are likely to remain at the center of the political dialogue through the 2020 elections.

Health care is a political football and may take longer to resolve than the trade war with China.

6. Downward earnings revisions may present the largest risk for stocks. As recently as September 30, expectations for first quarter earnings growth were +7%. That slipped to +4% by January 1 and has since fallen to -3%.

A sharp fall in earnings would most likely spring from a steep rise in interest rates if the Fed had to combat rising inflation. That doesn’t seem imminent despite rising average hourly earnings. The Fed is maintaining money supply growth at close to 5.0%, around the same level as nominal GDP, keeping a lid on inflationary pressures.

Money Supply & Nominal GDP growth

7. Equity returns may be modest over the next decade compared to the last. Since the bull market began 10 years ago, U.S. stocks have appreciated over 400%. It’s nearly impossible to imagine that pace will be met again, but we feel confident that stocks will outperform Treasuries and cash over the next 10 years.

Expect modest returns on stocks, low interest rates, and low returns on bonds and cash.

China slowdown

Consumer durable sales are falling sharply:

And from Trivium China:

Premier Li Keqiang reiterated that big stimulus isn’t coming:

“An indiscriminate approach may work in the short run but may lead to future problems.”
“Thus, it’s not a viable option.”
“Our choice is to energize market players.”

….It’s a decidedly different tack than the credit-fueled stimulus of yesteryear, and the practical outcomes of this new policy response are two-fold:

  • Given that it’s a new strategy, the transmission channels from policy to actual economic growth support are not well understood.
  • The one thing we do know – this approach will take longer to impact the economy than the credit-driven responses of previous cycles.

The bottom line: It will take China’s deceleration longer to bottom out than markets and businesses currently expect.

China’s stated intention is to avoid big stimulus, so a policy reversal, if we see it, would signal that the slowdown is far worse than expected.

S&P 500 optimism fades

10-Year Treasury yields are testing support at 2.60%. Breach of support would warn of a further decline in long-term interest rates. Declining yields reflect the outflow of funds from stocks and into safer fixed-interest investments.

10-Year Treasury Yields

Volatility on the S&P 500 has fallen close to 1% but a correction from here would be likely to form a trough above the 1% level, warning of elevated risk. Breach of 2600 would indicate another test of primary support at 2350/2400.

S&P 500 & Twiggs Volatility

Average hourly wages, total private, grew at 3.4% over the last 12 months, while production & non-supervisory wages grew at 3.48%. This keeps pressure on the Fed to raise interest rates as underlying inflationary pressures grow. The dampening effect of the trade dispute with China may have bought the Fed more time but a spike above 3.5% would be difficult to ignore.

Average Hourly Wages Growth

Impact of the trade dispute is more clearly visible on the chart below, with growth in total hours worked retreating below 1.5%. Slowing growth in hours worked warns that real GDP growth for Q1 2019 is likely to disappoint.

Real GDP and Hours Worked

China Trade Talks

US-China trade talks have made little in the way of real progress.

BEIJING—The U.S. and China have yet to set a date for a summit to resolve their trade dispute, the U.S. ambassador to China said Friday, as neither side feels an agreement is imminent. (Wall St Journal)

There is opposition to concessions on both sides:

China has a secret program to support the microchip and software industries. That’s according to Wang Jiangping, Vice Minister of Industry and Information Technology. Wang was speaking to CPPCC delegates at the Two sessions on Thursday, but the comments leaked to reporters (FX678):

“Last year, the Ministry of Industry and Information Technology planned the ‘Zhengxin Zhuhun’ project under the leadership of the Party Central Committee and the State Council.”
“The state will give strong policy and funding support, because industries such as microchips and software need to be iteratively developed.”

Wang said the ministry had kept the policy under wraps. That’s presumably because of the recent international backlash to the Made in China 2025 program…..Wang’s comments have already disappeared from the Chinese internet.

Get smart: Given Xi’s self-reliance push in key technologies, nobody really thought China would give up its industrial policies for these sectors. (Trivium China)

Whoever leaked Wang’s comments was not trying to make trade negotiations any easier. Impact of the trade dispute is starting to emerge in both economies but resolution and enforcement of a trade agreement is a long and tenuous path.

Hope is an expensive commodity. It makes better sense to be prepared.

~ Thucydides (460 – 400 B.C.)

GDP up but ETF flows bearish

Real US GDP grew a healthy 3.1% in Q4 2018. Rising hours worked point to further gains in the new year.

Real GDP and Hours Worked

10-Year Treasury yields rallied slightly but only breakout above 2.80% would hint at a reversal in the down-trend, while breach of 2.60% would warn of further weakness. Inflows into Treasuries normally coincide with outflows from stocks, indicating a bearish outlook.

10-Year Treasury Yield

According to etf.com, US equities have seen $21.2 billion of ETF outflows YTD, while fixed income recorded $16.5 billion of inflows. The market remains risk-averse.

The S&P 500 continues to test resistance at 2800. Bearish divergence on 13-week Momentum (below) often precedes a market top. Another lower peak would reinforce the signal.

S&P 500 & Twiggs Momentum

A correction in March is likely, possibly on conclusion of US trade talks with China. Breach of 2600 would signal another test of primary support at 2350/2400.

“President Donald Trump said on Monday that he may soon sign a deal with Chinese leader Xi Jinping to end the countries’ trade war, if the two sides can bridge remaining differences.

But the lead U.S. negotiator said on Wednesday it was too early to predict the outcome. U.S. issues with China are ‘too serious’ to be resolved with promises from Beijing to purchase more U.S. goods and any agreement must include a way to ensure commitments are met, U.S. Trade Representative Robert Lighthizer said.” (Reuters)

We are in a bear market that is likely to continue for the foreseeable future. The strength of the next correction will confirm or refute this.

Right, as the world goes, is only in question between equals in power, while the strong do what they can and the weak suffer what they must.

~ Thucydides (460 – 400 B.C.)

Retail sales fall while trade talks stall

Retail sales

Retail sales growth (USA advance retail sales excluding autos and parts) fell sharply in December, indicating that consumer confidence is fading despite strong employment figures.

Advance Retail Sales

The decline in consumer confidence also shows in lower January 2019 light vehicle sales.

Light Vehicle Sales

Trade talks make little progress

Trivium provide a useful update on US-China trade negotiations:

The latest round of trade talks with the US are finishing up as we go to press. There hasn’t been much progress (Bloomberg): “As of Friday afternoon, there had been no visible progress on efforts to narrow the gap around structural reforms to China’s economy that the U.S. has requested, according to three U.S. and Chinese officials who asked not to be identified because the talks were private……Chinese officials are angry about what they see as US efforts to undermine their state-led economy.”

These are issues that will take generations to resolve. The chance of a quick fix is highly unlikely.

Stocks

The stock market continues to rally on the back of a solid earnings season.

Of the 216 issues (505 in the S&P 500 index) with full operating comparative data 154 (71.3%) beat, 51 (23.6%) missed, and 11 met their estimates; 135 of 215 (62.8%) beat on sales. (S&P Dow Jones Indices)

Index volatility remains high, however, and a 21-day Volatility trough above 1.0% would warn of a bear market. S&P 500 retreat below 2600 would reinforce the signal.

S&P 500

Crude prices continue to warn of a fall in global demand.

Light Crude

As do commodity prices.

DJ-UBS Commodities Index

10-Year Treasury yields are testing support at 2.50% and a Trend Index peak below zero warns of buying pressure from investors seeking safety (yields fall as prices rise).

10-Year Treasury Yield

The Nasdaq 100 shows rising Money Flow but I believe this is secondary in nature. The next correction is likely to provide a clearer picture.

Nasdaq 100

My conclusion is the same as last week. This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

Concessions to adversaries only end in self reproach, and the more strictly they are avoided the greater will be the chance of security.

~ Thucydides (460 – 400 B.C.)

Robust US employment but global bear market warning

The US economy remains robust, with hours worked (non-farm) ticking up 2.2% in January, despite the government shutdown. Real GDP growth is expected to follow a similar path.

Real GDP and Hours Worked

Average hourly earnings growth increased to 3.4% p.a. for production and non-supervisory employees (3.2% for all employees). The Fed has limited wiggle room to hold back on further rate hikes if underlying inflationary pressures continue to rise.

Average Wage Rate Growth

History shows that the Fed lifts short-term interest rates more in response to hourly wage rates than core CPI.

Average Wage Rate Growth, Core CPI and 3-Month T-Bills

The Leading Index from the Philadelphia Fed ticked down below 1% (0.98%) for November 2018. While not yet cause for concern, it does warn that the economy is slowing. Further falls, to below 0.5%, would warn of a recession.

Leading Index

Markets are anticipating a slow-down, triggered by falling demand in China more than in the US.

S&P 500 volatility remains high and a large (Twiggs Volatility 21-day) trough above 1.0% (not zero as stated in last week’s newsletter) on the current  rally would signal a bear market. Retreat below 2600 would strengthen the signal.

S&P 500

Crude prices have plummeted, anticipatiing falling global (mainly Chinese) demand. Another test of primary support at $42/barrel is likely.

Light Crude

Dow Jones-UBS Commodity Index breached primary support at 79, signaling a primary decline with a target of 70.

DJ-UBS Commodity Index

China’s Shanghai Composite Index is in a bear market. Respect of resistance at 2700 would confirm.

Shanghai Composite Index

Bearish divergence on India’s Nifty also warns of selling pressure. Retreat below 10,000 would complete a classic head-and-shoulders top but don’t anticipate the signal.

Nifty Index

DJ Stoxx Euro 600 rallied but is likely to respect resistance at 365/370, confirming a bear market.

DJ Stoxx Euro 600 Index

The UK’s Footsie also rallied but is likely to respect resistance at 7000. Declining Trend Index peaks indicate selling pressure, warning of a bear market.

FTSE 100 Index

My conclusion is the same as last week. This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

Concessions to adversaries only end in self reproach, and the more strictly they are avoided the greater will be the chance of security.

~ Thucydides (460 – 400 B.C.)

Deal or no deal

Brexit

No one knows what the outcome of Brexit will be but, whatever the outcome, it is unlikely to send global markets into a tail-spin. There is bound to be short-term pain on both sides but the long-term costs and benefits are unclear.

China

Far more likely to send investors scuttling for shelter is a ‘no deal’ outcome on US trade negotiations with China. I would be happy to be proved wrong but I believe that a deal is highly unlikely. There may be press photos with beaming officials shaking hands and tweets from the White House promising a rosy future for all (with or without a wall). But what we are witnessing is not straight-forward negotiations between trading partners, which normally take years to resolve, but a hegemonic power struggle between two super-powers, straight out of Thucydides.

Thucydides wrote “When one great power threatens to displace another, war is almost always the result.” In his day it was Athens and Sparta but in the modern era, war between great powers, with mutually assured destruction (MAD), is most unlikely. Absent the willingness to use military force, the country with the greatest economic power is in the strongest position.

One of the key battlefronts is technology.

“China is now almost wholly dependent on foreign chipsets. And that makes leaders nervous, especially given a series of actions by foreign governments to limit the ability of Huawei and ZTE to operate internationally and acquire Western technology.” ~ Trivium China

“To address this risk, President Xi Jinping aims to increase China’s semiconductor self-sufficiency to 40% in 2020 and 70% in 2025 as part of his ‘Made in China 2025’ initiative to modernize domestic industry.” ~ Nikkei

Xi is unlikely to abandon his ‘Made in China 2025’ plans and the US is unlikely to settle for anything less.

USA

The US economy remains robust despite the extended government shutdown and concerns about Fed tightening.

“Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they had expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.” ~ The Wall Street Journal

This is just spin. As I explained last week. Fed run-down of assets is more than compensated by repayment of liabilities (excess reserves on deposit) on the other side of the balance sheet. Liquidity is unaffected.

Charts remain bearish as the market views global risks.

Volatility is high and a large (Twiggs Volatility 21-day) trough above zero on the current S&P 500 rally would signal a bear market. Retreat below 2600 would strengthen the signal.

S&P 500

Asia

Hong Kong’s Hang Seng Index is in a bear market but shows a bullish divergence on the Trend Index. Breakout above 27,000 would signal a primary up-trend. This seems premature but needs to be monitored.

Hang Seng Index

India’s Nifty has run into stubborn resistance at 11,000. Declining peaks on the Trend Index warn of selling pressure. Retreat below 10,000 would complete a classic head-and-shoulders top but don’t anticipate the signal.

Nifty Index

Europe

DJ Stoxx Euro 600 is in a primary down-trend. Reversal below 350 would warn of another decline.

DJ Stoxx Euro 600 Index

The UK’s Footsie has retreated below primary support at 6900. Declining Trend Index peaks warn of selling pressure. This is a bear market.

FTSE 100 Index

This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

War is a matter not so much of arms as of money.

~ Thucydides (460 – 400 B.C.)

‘It could be on the scale of 2008’ | SMH

Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.

“People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.

“China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told UK’s The Daily Telegraph, speaking before the World Economic Forum in Davos.

“There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.

Read the full article from Ambrose Evans-Pritchard at smh.com.au: ‘It could be on the scale of 2008’: Expert sends warning on China downturn

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

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.