Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

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TECHNICAL ANALYSIS

NEW$ & VIEW$ (10 JULY 2015):

Where’s the Growth? IMF Chops Americas GDP Forecasts

The IMF revised lower its global GDP forecast to 3.3 percent this year, from a 3.5 percent prediction made in April. The biggest downward revision by country was in Canada, which it now sees expanding by 1.5 percent this year, from a 2.2 percent prior forecast. The other major changes to GDP growth calls for 2015 were in the U.S. (down 0.6 percentage point to 2.5 percent), Mexico (down 0.6 percentage point to 2.4 percent) and Brazil (down 0.5 percentage point to 1.5 percent contraction). The IMF, which has been the most accurate GDP forecaster over the last 10 years, left its euro-area outlook unchanged at 1.5 percent.

Ford to Move Current Small Car Production Outside U.S. Ford will move production of small cars from a plant in Michigan to a factory outside the U.S. in 2018 in a new setback to efforts to create a market for small cars made in the U.S.

The move could put pressure on the United Auto Workers union to temper demands for wage increases in upcoming contract negotiations. Ford, General Motors Co. and Fiat Chrysler Automobiles NV, although profitable, are struggling to keep pace with lower-cost Asian auto makers that now have the added advantage of weaker currencies compared with the U.S. dollar.

Small cars like the Focus deliver far lower profit margins than the pickup trucks and sport-utility vehicles the Motor City is best known for, but they are essential to helping car makers meet stringent fuel economy mandates. (…)

The UAW enters negotiations with the Detroit Three aiming to win higher pay packages amid what has been a trend of annual profit-sharing checks that auto makers prefer over fixed increases. As Detroit car makers’ profits increase, union members have grown increasingly discontent with a wage scheme that pays entry-level workers about $19 an hour, or $9 less than workers hired before the financial crisis.

While the roughly $57-an-hour wage and benefit costs Ford spends per UAW worker is less than the $75 an hour it was spending a decade ago, it is still between $8 and $20 an hour higher than Honda or Volkswagen AG, according to Ann Arbor-based researcher Center for Auto Research.

China New Car Sales Drop in June New car sales fall by most in more than two years

China’s new car sales recorded the first year-over-year decline in more than two years in June, as slowing economic growth and falling stock markets hit the world’s largest auto market.

China sold 1.51 million passenger vehicles last month, down 3.4% from a year earlier, the China Association of Automobile Manufacturers said Friday. That compares with a 1.2% year-over-year rise recorded in May and a 3.7% increase in April.

The performance was the worst since February 2013 when car sales fell 8.3% on-year during the weeklong Lunar New Year Holiday when car showrooms are closed. Stripping out the holiday factor, the last time China’s car market posted a decline was in September 2012, when a territorial dispute between Beijing and Tokyo over a group of uninhabited islands in the East China Sea hit demand for Japanese cars.

In the first half of this year, sales of passenger vehicles rose 4.8% to 10 million units from the year-earlier period, said the auto manufacturer group. Year-to-date, sales of total automobiles including both passenger and commercial vehicles in China rose 1.4% to 11.85 million units. The body also cut its growth forecast for China’s automobile market in 2015 to 3% from the previous 7%. (…)

Demand for cars remains tepid despite auto makers offering price cuts and other incentives. The latest survey by the association shows that total inventories of passenger cars are equal to more than 50 days of sales in May, above the warning level of 45 days.

IEA Says Oil Prices May Fall More The International Energy Agency said global demand for oil would slow down next year, as it warned that crude prices could resume a recent downward spiral.

In its first oil-consumption assessment for next year, the IEA—which advises industrialized nations on their energy policies—said global oil demand growth is forecast to slow to 1.2 million barrels a day in 2016. That compares with an average 1.4 million barrels a day this year.

It said a return of Iranian oil and if Greece were to exit from the euro could put further pressure on oil prices—which have lost about 10% in the past month.

Tehran this week failed to meet a deadline to clinch a nuclear deal with world powers. But if sanctions were lifted, it could raise exports immediately out of 40 million barrels currently stored on its vessels, the IEA said.

It estimates OPEC crude oil output climbed by 340,000 barrels a day in June to 31.7 million barrels a day-–the highest since April 2012 and 1.7 million barrels a day higher than a production target it agreed to maintain last month. The rise was due to record production in Iraq, Saudi Arabia and the United Arab Emirates, it said.

Below-Average S&P 500 Readings Seen as Little Reason for Concern

S&P 500 vs. 200-day moving average

The Standard & Poor’s 500 Index’s dip below a level tracked by chart watchers might be less of a reason for concern than usual, according to Ryan Detrick, a former money manager at Haberer Registered Investment Advisor Inc.

As the attached chart shows, the S&P 500 fell this week below its 200-day moving average, a gauge of its performance over time. The index breached the average in the last three trading days, and closed lower in the last two.

Stocks fall more often when the S&P 500 is lower than the 200-day average than when it’s higher, Detrick wrote yesterday in a posting on Yahoo! Finance. He based this conclusion on an analysis of the index since 1928, when calculations begin. Yet the Cincinnati-based analyst wrote that the pattern may not hold with this week’s slump for two reasons:

— The S&P 500 stayed within 5 percent of its record, set May 21. Stocks did relatively well in the past when the gap was that small, according to data compiled by Detrick. For example, the index rose 79 percent of the time in the next three months and added 4.6 percent on average. For gaps exceeding 5 percent, the figures were 53 percent and 0.8 percent, respectively.

— The timing of the move. July was the only month in which the S&P 500 had a day-to-day gain on average when it was below the 200-day reading. The 0.05 percent advance contrasted with losses that reached 0.30 percent in other months.

“Breaking the 200-day so close to new highs might not be such a bearish event,” he wrote. “The fact that it happened in July might also be a plus.”

Never mind the timing. For me, the fact that the m.a. is still rising is the only source of comfort. That said, the 200d m.a. has been flattening lately and the 100d m.a. is now declining. That bears watching! So is this channel…

SPY Channel

CHINA

This is from Andy Rothman, investment strategist at Matthews Asia which manages nearly $1 billion in Chinese equities:

(…) With a little more certainty, we can say that from a valuation perspective, many Chinese stocks have been in ridiculous territory. Commentators often focus on the ChiNext market, where 79 companies have a forward price-to-earnings (P/E) ratio* of more than 100, and the median forward P/E is about 63. This is clearly very high. Commentators, however, often neglect to mention that everyone in China understands this is a very small, very speculative, tech-heavy market, with only 460 companies overall. Chinese who own those stocks know they are gambling, and very few foreigners play that game.

The A-share market is much bigger (about 2,800 companies) and is much more broadly held. But it is also driven by retail investors, who account for 80% of turnover. Institutional investors play a minor role, and foreign investors account for only about 3% of holdings. This, too, is an expensive market, with a median forward P/E of companies that are covered by at least one brokerage analyst (to remove the most speculative stocks) of about 54.

If we cross the border into Hong Kong, where there is more institutional and foreign investment, the median forward P/E falls to only 14. This is the market (with about 1,800 Chinese companies) in which most foreign exposure to China takes place.

More importantly for us—and we are the largest Asia-only investment manager in the U.S., with about US$31 billion* under management, and about 30% of that in Chinese equities—the median forward P/E of our China holdings is 17. Coincidentally, the median forward P/E of the S&P 500 Index is also about 17. (These P/E ratios are as of late May/early June, before the market correction began.)

Margin Trading

The issue of margin trading is one that has been highlighted by many commentators as a key issue and driver of recent stock market activity. But how much of a concern is it? It’s certainly important, because a falling market leads an increasing number of investors to have to sell to repay their margin loans.
The scale of margin trading, however, should be manageable. The margin balance outstanding is now about 1.8 trillion renminbi/RMB (US$285 billion). This accounts for about 3.5% of total market cap, or about 4.3% of the free-float market cap (according to the Chinese securities regulator) or about 9% of the free-float excluding Chinese government holdings (according to Bloomberg).

Regulations limit margin trading to those with at least RMB 500,000 in their accounts (US$80,000), although some brokers may have lent to smaller investors. While a continuing decline in the market will lead to painful losses for some investors, the total number of retail punters using borrowed money should not be very large. And to put this into context, total margin positions are equal to about 3% of total household bank deposits.

Perhaps more importantly, it is worth noting that the majority of Chinese are not in the market. There are about 50 million active individual investors, which is equal to about 4% of the total population or 7% of the urban population. And most investors are punting a fairly small amount of money. As of last November, 66% of active accounts had less than the RMB equivalent of US$15,000 in them, and less than 1% of accounts had more than US$1 million. Very few Chinese are likely to be betting anything close to their life’s savings, and I imagine all of them are aware of recent history: in 2007 the A-share market rose even more sharply than it did this year, and then in early 2008, it crashed hard.

China’s Economy

The impact of all of this on China’s economy is a key question. A continued equity market decline will have a small but material negative impact on GDP growth.
The financial sector accounted for 7.4% of China’s GDP in 2014 with that share rising to 9.7% in 1Q15, and it is likely that the securities industry drove most of that increase. A very rough estimate is that in the last quarter of 2014, the booming A-share market accounted for about 5% of GDPgrowth (0.4 ppts of 7.3% GDP growth). If the market remains weak, leading to low trading turnover, this could slow 2H15 GDP growth by about the same amount.

Given the relatively small number of retail investors, and given that two-thirds of active accounts had less than US$15,000, I expect only a modest impact on retail sales growth if the market continues to fall. Even including margin trading, consumer debt is very low and savings very high. Household bank deposits are the RMB equivalent of US$8.5 trillion, which is greater than the combined GDPs of Brazil, Russia, India and Italy.

Reforms

Looking ahead, the government’s efforts to put a floor under the market do not signal that it is abandoning its economic reform agenda. In my view, the Party’s attempt to intervene in China’s equity markets is futile. But it isn’t surprising, as the Party has long used its power, as well as its control of major brokers, to try to move markets. The futile aspect is the Party thinking it can micromanage a stock market in which 80% of turnover is by retail investors in the same way it micromanages the RMB’s exchange rate.

We can imagine Party leaders responding to this criticism by noting that the U.S. government intervened to support American markets during the Global Financial Crisis. But that analogy is weak, as China’s economy is healthy today, with double-digit retail sales growth, 8% real income growth, and GDP up by more than 6%. The rise in China’s markets did not generate a significant wealth effect, so the market’s fall shouldn’t have serious negative economic consequences. There is no valid macro reason for the Party’s intervention in the market.

There is, however, a good reason to believe that the Party will not halt its push toward creating a more market-oriented financial system: the Party’s continued rule depends on continued reform. With the private sector accounting for 80% of employment and all new job creation, as well as most investment, more financial sector reforms are required to support entrepreneurial firms. The Party understands those reforms are key to continued economic growth, which is key to the Party remaining in power.

NEW$ & VIEW$ (9 JULY 2015): Fed up or not? Equities: Testing, testing…

Global Tumult Gives Fed Some Pause on Rates Worries about global turbulence and soft spots in the U.S. economy weighed on Federal Reserve officials when they gathered in June, trepidations that could cause them to wait longer before raising interest rates

Several Fed officials have said publicly since the June meeting that a first interest-rate increase in nearly a decade could be warranted as early as September. But minutes of the June 16-17 gathering, released Wednesday, showed their underlying unease about taking that big step. (…)

Among the Fed’s worries, the minutes noted, were “uncertainty about whether Greece and its official creditors would reach an agreement and about the likely pace of economic growth abroad, particularly in China and other emerging market economies.” They also expressed concern about the slow pace of U.S. consumer spending. (…)

“Many participants expressed concern that a failure of Greece and its official creditors to resolve their differences could result in disruptions in financial markets in the euro area, with possible spillover effects on the United States.” (…)

“I visited China recently, and I arrived fully cognizant of the concerns people highlight—slower growth, the unsustainability of the current export-driven model, debt buildup, bubbles in the equity and housing markets, the risk of falling investment, and the overall international implications of those risks,” John Williams, president of the Federal Reserve Bank of San Francisco, said in a speech Wednesday. “But I have to say that, after talking to officials and academics there, I was a lot less concerned about China’s near-term economic outlook on my return flight than I was heading over.” (…)

“Until I have more confidence that inflation will be moving back to 2%, I’ll continue to be in wait-and-see mode,” Mr. Williams said Wednesday.

Wait, wait! In the same WSJ, referring to the same speech:

Fed’s Williams: U.S. Still on Track For 2015 Rate Rise

“Policy is data dependent,” Mr. Williams said. But given the positive outlook for the U.S., “I still believe this will be the year for liftoff, and I still believe that waiting too long to raise rates poses its own risks,” he said.

The official added that the easiest path is for the Fed to move rates up off near- zero levels before inflation goes over the central bank’s 2% price target, saying “I see a safer course in starting sooner and proceeding more gradually” with rate rises. (…)

He said “our employment goal is in sight” and he expects the jobless rate to edge down from its current 5.3% level to around 5% by the close of 2015, moving even lower next year. He said wage gains are a sign the job market is “nearly healed.”

Mr. Williams also said inflation, which has fallen short of the Fed’s 2% target for three years, is likely to tick higher and hit desired levels by the end of next year. But he added he’d like to see confirmation inflation is moving up before shifting the stance of Fed interest rate policy.

Speaking of inflation:

Tim Duy has a good post on the Fed’s dilemma:

Mediocre Tranquility

The US economy is an island of mediocre tranquility in the midst of the stormy sea of the global economy. Tranquil enough to keep the Fed eyeing its first rate hike despite the surrounding storm, but sufficiently mediocre that they feel no reason to rush into that hike. As such, the Fed will remain on the sidelines until the forecast points toward sunnier skies. Uncertainty from Greece and China are likely raising the bar on the domestic conditions that would justify a rate hike. (…)

Bottom Line: The US economy is plain vanilla. Clearly not accelerating enough to justify a faster pace of monetary policy normalization, but not slow enough for the Fed to abandon their hope of at least initiating the first rate hike this year. They are still looking for stronger numbers, however, to pull that trigger. Fed officials on average are cautiously optimistic the issues in China and Greece will not spill over to the US economy, giving them the opportunity to hike rates.

Still, in the absence of confirmation of that hypothesis, those issues still decrease the odds of a rate hike this year. This is especially the case if the recent decline in commodity price places renewed downward pressure on inflation. Such an outcome would raise the bar on the strength of the remaining data to justify a rate hike. In her speech Friday, we will hopefully learn more of Federal Reserve Chair Janet Yellen’s view on the importance of Greece and China for US monetary policy. 

Bank of Korea lowers GDP growth forecast

The Bank of Korea has downgraded its forecast for gross domestic product to 2.8 per cent from a 3.1 per cent projection made in April. At the start of the year it expected to achieve 3.9 per cent growth.

The BoK estimated the country’s GDP grew just 0.4 per cent in the April-June quarter, far lower than its previous estimate of 1 per cent, as domestic spending took a hit after the spread of Mers forced schools to shut down and reduced the number of foreign tourists. (…)

“The downward revision was needed due to the impact of slowing exports, the Mers crisis and drought,” said Lee Ju-yeol, BoK governor. “But a gradual recovery is expected from the third quarter as the temporary shock of the last quarter subsides.” (…)

China Stocks Rebound; Biggest Gain in Six Years Chinese shares made their biggest daily gain in six years Thursday, restoring confidence in Beijing’s suite of attempts to rescue its struggling stock market.

The Shanghai Composite rose 5.8% to 3709.33, after losses in eight of the last 10 trading days. The smaller Shenzhen market rose 3.8%. Still, both indexes have lost around a third of their value in the past month. The small-cap ChiNext board, which has shed some 38% from its June highs, rose 3%.

Some companies that had halted trading of their shares lifted suspensions, and their stock prices immediately rose by the maximum 10%. (…) A total of 1,473 companies, or 51.1% of all stocks on the Shanghai and Shenzhen markets, remain suspended. (…)

China’s outstanding margin loans fell to 1.5 trillion yuan ($241.7 billion) as of July 8, down from 2.27 trillion yuan at its peak on Jule 18, according to data provider Wind Info. But some say the unwinding of margin loans—one of the main triggers for the recent spate of volatility—is still far from complete. (…)

Testing, testing…

From Ed Yardeni:

(…) In the past, this index was highly correlated with the price of copper, which failed to confirm the recent ascent in Chinese stock prices. Instead, the nearby futures price of copper remained near its lowest reading since July 2009.

The latest moves by Chinese officials to prop up stock prices certainly won’t revive confidence in China’s stock market. Why would anyone want to invest in a market where the government can ban selling?

Yesterday, Bloomberg reported: “China’s securities regulator banned major shareholders, corporate executives and directors from selling stakes in listed companies for six months, its latest effort to stop the nation’s $3.5 trillion stock-market rout. Investors with stakes exceeding 5 percent must maintain their positions, the China Securities Regulatory Commission said in a statement. The rule is intended to guard capital-market stability amid an ‘unreasonable plunge’ in share prices, the CSRC said.”

Regulators have introduced market-boosting measures almost every night over the past several days, as the following selected timeline shows:
6/25: PBOC injects cash into the financial markets.
6/27: PBOC cuts interest rates and lets banks lend more money.
7/1: Investors allowed to put up real assets as collateral to buy stocks.
7/2: Stock manipulation will be investigated.
7/4: IPOs suspended.
7/4: People’s Daily urged investors to stay calm.
7/4: Twenty-one brokerage firms will invest $19 billion in a stock market fund.
7/7: Trading suspended in more than 1,300 companies.
7/8: State-run companies ordered to maintain holdings in listed units.

Charting the Rise and Fall of China’s Equity Market

The real Grexit:

Emerging currencies in line of fire China displaces Greece as main cause for concern

(…) MSCI’s emerging equity index suffered a 2.5 per cent drop on Wednesday, its biggest in two years.

Bernd Berg, EM currencies strategist at Société Générale, said that while many EM investors had been focusing on Greece, attention had clearly shifted to China, which provided about a third of global growth.

“More and more investors will see there has been a significant drop-off in commodity prices since June, and China has clearly taken centre stage in EM.’’ (…)

EQUITIES: Testing, testing…
Signs to Watch for a Major Peak in Stocks and Impending Bear Market

I am not a great fan of technical analysis but there are a few things I like watching. There are all in this chart:

This chart presents a possible roadmap for monitoring the risk of a major peak and bear market by comparing the technical similarities between the prior two market tops and where we are today. 

signs market peak

Red Flag Number One (√)

The first technical warning sign indicated in the chart above is a significant divergence between the relative strength index (RSI) and the market itself, as we see today. This is noted by a declining pattern of lower highs in the RSI as stocks continue to make higher highs, a sign that the market is “topping out”. In the late ‘90s this divergence persisted for many years as the tech bubble reached ever-higher valuation levels. In 2007 this divergence lasted over a much shorter period (6 months) before the market finally peaked and succumbed to massive selling.

Since this divergence can persist for months or years, we also look to two other technical red flags for possible signs of a market peak and impending bear market.

Red Flag Number Two (√)

The second technical sign to look for is a major crossover in the MACD (moving average convergence-divergence) indicator shown in the bottom panel. This is often used by technical analysts as a buy and sell signal. As shown by the dotted lines, a MACD sell signal occurred near both prior market tops in May of 2000 and December of 2007. We now see the MACD buy signal issued in 2009 has crossed over to a sell, indicating the possibility of a major market top.

Important note: though I have smoothed this indicator to eliminate any prior buy and sell signals that didn’t correspond to major market turning points, as you’ll often hear, “past performance is not indicative of future results.” Since we must be alert to the possibility of a false sell signal at the current time, we look to an additional red flag for further confirmation.

Red Flag Number Three

When a major line of support becomes resistance, you now have confirmation of a possible trend change in the market. This occurred around January-February of 2001 and May-June of 2008 (see red circled regions on the chart) when the S&P 500 failed to break back above its 12-month moving average. After that point in time, the market persisted in a bearish downtrend until a confirmed change of direction with a new bull market. Currently, the S&P 500 is trading just above the 12-month moving average and has yet to break down further. If it does and fails, our third red flag will be raised.

Important Caveat

As we all know, history does not repeat itself, but it does rhyme. Even if the same technical pattern plays out again (i.e., all three red flags come to fruition), no one can predict the exact magnitude (depth) or duration (length) of a subsequent market decline, should one occur, since no two tops or bear markets are alike. The most prudent investment strategy is to monitor market action, incoming data, and make corresponding adjustments as the situation requires. The chart presented is one of many tools for doing just that.

I particularly watch the 200 day moving average: where the Index (2045) is vs the m.a. (2056) and whether the m.a. is still rising (yes).

SPY MA

The S&P 500 is sitting on its rising 200 day m.a. and right on 20 on the Rule of 20.

image

Trailing S&P Index earnings are forecast to decline 0.8% QoQ when the Q2 earnings season is over, possibly throughing after having dropped 3.4% since Q3’14, before recovering 4.4% after Q4 if current estimates are met. This, coupled with diminishing inflation expectations, will help support valuations unless deflation risks pop up again.

Let’s watch how earnings behave over the next few weeks. Rising earnings are always the best tailwind for equities. Without the earnings tailwind, markets are a lot more vulnerable to shifting sentiments.

Fingers crossed Corporate Earnings Will Easily Hurdle a Low Bar Falling oil prices and a rising dollar will weigh on earnings season, but health care, financials look strong.

Analysts are predicting a weak second-quarter earnings season, with profits falling for the first time since the third quarter of 2012.

As usual, however, estimates have come down to the point that Corporate America can probably clear the hurdle, “beating” lowered expectations. Analysts surveyed by FactSet Research are forecasting profit per share generated by companies in the Standard & Poor’s 500 during the second quarter to fall 4.5% to $28.70. That’s weaker than the 2.1% drop forecast in late March. (…)

Two big drags on earnings are the energy sector — far and away the weakest component of the S&P 500 — and the strong dollar, which has eaten away at foreign earnings for U.S. multinationals. The market collapse in China, rising labor costs in the U.S., and hints of deflation in a lackluster global economy have added to the headwinds. (…)

Energy company profits are expected to fall a whopping 54% this year. Remove the sector from forecasts, and the S&P sees better than 8% profit growth, powered by double-digit earnings increases for the health-care, financial, and consumer discretionary sectors. (…)

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