HUMBLE STUDENT OF THE MARKETS

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1 Analyst Article May 30, 2016 HUMBLE STUDENT OF THE MARKETS eresearch Corporation is pleased to feature an article by Cam Hui, CFA who offers investment and trading insights on his website, HumbleStudentOfTheMarkets.com Mr. Hui posts a market comment on the weekend plus one or two articles of interest during the week. His subscription service includes annual, monthly, or daily pass options, and is focused on building a community of like-minded individuals with a common interest in investing and trading. Today s article begins on the following page, and is entitled: The Road-Map To A Market Top You can access his website and subscribe to his service at the following link: eresearch was established in 2000 as Canada's first equity issuer-sponsored research organization. As a primary source for professional investment research, our Subscribers (subscription is free!!!) benefit by having written research on a variety of small- and mid-cap, under-covered companies. We also provide unsponsored research reports on middle and largersized companies, using a combination of fundamental and technical analysis. We complement our corporate research coverage with a diversified selection of informative, insightful, and thought-provoking research publications from a wide variety of investment professionals. We provide our professional investment research and analysis directly to our extensive subscriber network of discerning investors, and electronically through our website: Bob Weir, CFA Director of Research Note: All of the comments, views, opinions, suggestions, recommendations, etc., contained in this Article, and which is distributed by eresearch Corporation, are strictly those of the Author and do not necessarily reflect those of eresearch Corporation. eresearch Corporation 78 Cameron Crescent, Suite 202 Toronto, Ontario M4G 2A3

2 Sunday, May 29, 2016 The Road-Map To A Market Top Not Turning Bearish Yet No, my inner investor is not turning bearish, but I believe it is prudent to be thinking about how a market top develops. The bull market that began in 2009 is getting mature and I am getting starting to watch for signs that a market top is developing. My analytical framework is as follows: Macro-economic analysis: I am grateful for the work by New Deal democrat in his recent post A roadmap to the next recession. This chart from Gene Epstein at Barron's shows the risks to equities should economic growth stall and roll over. While stock prices can fall and correct at any time, the most severe declines have been associated with recessions. Growth and valuation: I think of stocks in terms of the two components of the PE ratio. First, how much is E likely to grow? Second, will the P/E ratio expand or contract? The big question in the current environment is the intersection of growing E as the Fed embarks on a tightening cycle. How will stock prices respond as earnings rise, but higher interest rates puts downward pressure on the P/E ratio? eresearch Corporation Page 2

3 A Roadmap To The Next Recession In his post, New Deal democrat laid out a very sensible checklist for anyone watching for the next recession (comments in parentheses are mine): 1. Interest rates continue to fail to make new lows. (Check: he means short rates). 2. House prices and stock prices stop meaningfully appreciating. (Stocks, yes. Houses, not yet but it could be soon as sales lead prices - and sales have stalled). 3. Inflation picks up to 2% or more as energy prices begin to go up again. (Check: see Core CPI). 4. Maybe - the Fed raises rates in response to increased CPI readings, perhaps enough to invert the yield curve. (Yield curve is not inverted, but see the risks in my post Three steps and a stumble). 5. Corporate lending stalls, housing turns down, and consumer spending begins to turn down, resulting in a recession. We are roughly between stages 3 and 4 of this process as the Fed is itching to raise rates. We have seen a coordinated campaign by numerous Fed speakers correcting the market s perception about the trajectory of rate hikes for the rest of this year. The June meeting is "live", with the usual caveats about "data dependency". Don't be surprised if there are two more rate hikes this year. CNBC reported that Janet Yellen did nothing on Friday to contradict the other Fed officials and said that a rate hike was probably appropriate in the next few months. <continued> eresearch Corporation Page 3

4 CME Fedwatch is currently showing a 28% chance of a hike in the overnight rate at the June FOMC meeting:...and a 60.7% chance that rates will be more than the current 0.5% by the July meeting: eresearch Corporation Page 4

5 Mission accomplished. Fed speakers have done their job. The market now believes that the FOMC will likely stay steady in June, which makes sense in light of the risks from the Brexit referendum, but hike by a quarter point in July. The Growth Outlook The second leg of my analytical framework is the growth outlook. Indeed, growth is returning after the recession scare in January and February. John Butters of FactSet shows that forward EPS estimates continue to rise, as optimism is returning to the Street. <continued> eresearch Corporation Page 5

6 The Citigroup Economic Surprise Index (gold line), which measures whether economic data is beating or missing expectations, is on the rise again. The big question is what happens to stock prices. During past rate hike cycles, equities have been able to shake off the first few rate hikes and rally in the face of tight monetary policy. The reason can be attributable to the positive effects of strong growth overcoming the negative effects of a rise in interest rates. A post by Jeroen Blokland indicates that history shows that Fed rate hikes have led to better returns by commodities and global equities. <continued> eresearch Corporation Page 6

7 The chart below shows the 10-2 year yield spread (in black, as a measure of the yield curve), the gold to bond price ratio (green, as a measure of inflationary expectations) and the Dow Jones Industrial Average (bottom panel). I chose the DJIA as an indicator because it contained relatively few technology stocks and, therefore, had fewer distortions from the NASDAQ Bubble of the late 1990s. In the past, when inflationary pressures (green line) ticked up, the Fed responded by raising rates and eventually inverting the yield curve. Stock prices were flat to up during those inflationary uptick episodes (marked by the red rectangles) for the reasons I mentioned above. We are entering a similar period where inflationary expectations are starting to rise again. Based on past historical experience, stock prices should see new highs before rolling over into a bear market as the Fed over-tightens the economy into the recession. eresearch Corporation Page 7

8 Conventional analysis suggests that the next U.S. recession should be fairly mild, as there have been few excesses built up in the current cycle. But the Great Financial Crisis taught us that the world is highly inter-connected. The main risks to the market and the economy come from outside U.S. borders. Europe is by no means fixed and European bank balance sheets are still very stretched. China`s challenges with its white elephant infrastructure and debt overhang are well known. So what happens when the U.S. economic locomotive slows down and the American consumer stops spending? The WSJ reported that Ed Yardeni believes that the rest of the world is far more sensitive to a Fed rate hike than the American economy. Just take a look at the correlation (don`t say causation) between the Treasury yield curve and global industrial production. <continued> eresearch Corporation Page 8

9 Here is the Treasury yield curve and global trade. I can easily imagine a scenario where a slowing U.S. economy puts the brakes on global trade and industrial production, which exposes the problems in China and European bank leverage. The aftermath would not be a pretty picture. The Road Ahead I do not write for Zero Hedge and this is not meant to scare anybody. So far, all we have is a "this will not end well" investment story. The trigger has not been pulled yet and growth is still holding up. In a more bullish scenario that I had written about before, I postulated a similar roadmap, but with a more dovish Fed that was willing to hold its fire until the December meeting (see How the SP 500 could get to 2400 this year). Nevertheless, much of the analysis I wrote for that post still holds true. Earnings could rise another 5-10% from current levels as energy and commodity prices are "less bad". Assuming no change in the P/E ratio, this would translate to a 5-10% rise in stock prices, which puts an upside SPX target of for this year. eresearch Corporation Page 9

10 The unknowns are how Federal Reserve policy affects the yield curve and the U.S. Dollar. USD weakness has provided a tailwind for stock and commodity prices, but the recent bout of strength could reverse many of those gains. A strong greenback puts downward pressure on the earnings of multi-nationals doing business outside U.S. borders and further USD strength would exacerbate the negative effects of interest rate hikes. <continued> eresearch Corporation Page 10

11 Analysis from FactSet shows that the sectors with the greatest foreign sales exposure are Technology, followed by cyclically-sensitive sectors like Energy, Materials, and Industrial companies. In effect, USD weakness is a pro-cyclical factor, or a double-edged sword, affecting stock prices. <continued> eresearch Corporation Page 11

12 The Near-Term Market Outlook For now, the short- and intermediate-term stock market outlooks are still bullish. Sentiment readings are neutral to bearish, which means neutral to contrarian bullish for stocks. My inner trader is encouraged by the continual bearish tilt in sentiment despite the strong rally last week. Michael Harnett of BoAML indicated that their global fund flows model is getting very close to a buy signal (via Marketwatch): eresearch Corporation Page 12

13 Momentum is still positive and Leuhold Group wrote it was getting close to a buy signal should the SPX close May above 2062 (it currently stands at 2099). The pending Leuthold Group signal is consistent with my thesis that the market can make new highs in <continued> eresearch Corporation Page 13

14 The message from the credit markets is also supportive of higher stock prices. The chart below of the prices of U.S. junk bonds and emerging market bonds against their duration equivalent U.S. Treasury benchmarks shows a pattern of higher lows and higher highs, which is reflective of improving risk appetite. <continued> eresearch Corporation Page 14

15 Even the market reaction on Friday to Janet Yellen's comments was revealing. It first weakened as Yellen indicated that a rate hike was just around the corner. It then shrugged off the bearish content and rallied to new recovery highs. This was a sign that the bulls have control of the tape. My inner trader flipped from bearish to bullish last week (see The correction is (probably) over). My inner investor remains bullish on stocks, but he is carefully monitoring the recession indicators in the Ultimate Market Timing Model (see Building the ultimate market timing model) for signs that the Fed is engineering a recession in Disclosure: Long SPXL Regards, Cam Hui Humble Student of the Markets, Inc. eresearch Corporation Page 15

16 eresearch Disclaimer eresearch Disclosure Statement eresearch Corporation was established in 2000 as Canada's first equity issuer-sponsored research organization. As a primary source for professional investment research, its Subscribers (subscription is free!!!) benefit by having written research on a variety of small- and mid-cap, under-covered companies. eresearch also provides unsponsored research reports on middle and larger-sized companies, using a combination of fundamental and technical analysis. eresearch complements its corporate research coverage with a diversified selection of informative, insightful, and thought-provoking research publications from a wide variety of investment professionals. eresearch provides its professional investment research and analysis directly to its extensive subscriber network of discerning investors, and electronically through its website: eresearch does not manage money or trade with the general public, provides full disclosure of all fee arrangements, and adheres to the strict application of its Best Practices Guidelines. eresearch Corporation Page 16