Market Musings: 7/2017

US equity markets are slightly off their highs, Mooch is in the White House, and Bezos is again the second richest man in the world. None of this has historically been bearish given that 1/3 is unprecedented, 1/3 resulted in ATH’s, and the remainder has strong data to back it up through a few different studies:

The first is from J. Lyons Fund Management which breaks down market tops by month going back to 1900. As you can see below, the Dow has never put in a 12 month top in the month of July. [A 12 month top is defined as the DJIA not exceeding its current monthly high over next 12 months]. While there may be some pull back over the next 3 months, this study provides evidence for further gains.

The next is from @SJD10304, which also shows that return profiles are attractive over the next 6/12 months based on the SPX hitting a new high in July, with average returns of 3.51% and 9.96%, respectively.

This is consistent with the third and final study from Schaefer Research, which details 2nd half returns based on first half draw-downs being less than 5%. As you can see below, the average second half return is 7.84%.

The data clearly puts the odds in favor of continued gains going forward; however, given my fundamental view of the economy over the next 6/12 months, the probabilities of these scenarios manifesting comes in a bit. I’m cognizant however of the data, so being relatively flexible over this period will be important.

My hesitation for further gains is due to multiple leading indicators that I have built out over the past year or so, as well as my operating assumption that the industrial rebound was primarily driven by the commodity rally, which was the result of China’s 2015-2016 $4.5T infrastructure project.

I can illustrate this by the strong relationship between total Chinese credit creation (greater than TSF) and commodities, which it leads by roughly 5-6 months, as shown below.

And the relationship between commodities, specifically oil, and the ISM.

And therefore, Chinese create creation and the ISM.

@JBOU also pointed out that this is apparent by taking China’s M1/GDP and overlaying US ISM, indicating that we should see a downward move going forward.

Admittedly, I was not aware of this relationship prior to my first comments on it in April, and was therefore caught mis-footed towards the beginning of the year as the US data came in with some strength on the industrial side. That said, I have been surprised by the recent strength of base metals, and have been wrong. While I still maintain my view on industrial weakness into the end of the year and a sharp slowdown in the ISM, I’m following copper closely for clues.

An interesting chart I saw recently from my friends at leads me to believe that the move over the past month may be faded, as there has been a sharp divergence between copper prices and miners, shown below. Coupled with sentiment and the dollar, it looks short term the probabilities favor a pullback from 2.88. While I understand my bias, I’m holding the view until the market proves me wrong by either continued strength in copper or the ISM.

On the other side of things, and as many of you know, I am quite obsessed with the consumer backdrop. Over the past year, I’ve built out multiple leading indicators that have yet to prove themselves in this cycle (will find out soon), but are the basis behind my view.

I’m operating under the assumption that consumption will continue to slow over the next 12 months, as job gains potentially turn negative and consumers are forced to repay outstanding credit balances that have been one of the primary drivers of consumption.

The jobs view comes from an indicator that I’ve titled ‘labor market breadth’. While I don’t disclose how this is calculated, I will say that this is similar to the breadth of the stock market. Historically, this has given us a 7/8 month lead on NFP growth:

As well as wages and salaries 

This is quite adverse for economic consumption, especially in the face of credit deleveraging.

Below is a chart of what I have dubbed the consumer margin. This looks at a consumer as one would a business to derive the equivalent of gross margins. It takes personal income and deducts primary expenses such as taxes, housing, health care, etc. As you can see, the consumer margin has declined meaningfully since 2011, primarily due to rises in healthcare costs.

During margin compression periods, consumers use revolving credit to either fill the consumption gap or pay for the increased cost, as shown above. Now, the chart below leads me to believe they are financing a lot of the increased costs via credit, as the aggregate dollar change in revolvers fails to find its way into retail sales (spread widens), which in turn tracks consumer margins.

That said, access to credit to me looks to be rolling as delinquencies rise, which based on my leading indicator below should continue to move higher.

This is very adverse for retail sales as delinquencies y/y lead by roughly 4/6 months. The lead time is less important than the direction, and I’m operating under the premise that the direction in delinquencies is higher, thus retail sales lower.

The most recent print confirmed my operating assumptions [chart above 2 months dated], as retail sales ex autos and gas fell to the lowest level since 2014 and looks to be rolling.

Looking at the sub indices, we can also see there is some weakness across multiple categories.

Based on this thesis, I believe bonds are very attractive over the next 3-12 months. In addition to this, you have very strong seasonal backdrop.

And a potential analog/replay from 2011 that I am still observing.
I’m currently long TLT from $123.5 and looking to re-evaluate sub $122, which would  break the current uptrend. If that scenario plays out, and TLT trades below $120, I’ll be more open to the reflation thesis.

Until then, I’m building a short crude position via USO from $10.16 base. While the supply side is becoming more balanced, I’m less optimistic on the demand side. Additionally, the Bermuda Vol model that I am in the process of building out is signaling upside exhaustion.

I’m paying close attention to geopolitical risk. It seems Russia and North Korean tensions are becoming more elevated, which further supports bonds and less so crude.

Separately, it feels that there has been some shift in tech. Google’s ad model seems to be coming under some pressure due to bots. Apples iphone seems like its losing luster to the Google Pixel. Amazon’s AWS feels like it’s coming under more competition. I’m short all three primarily from a technical perspective [AAPL largest weight due to least bias after owning it for years, S 153.3 (wrong highs)], but will develop this thesis further in the next musings that I hope to have out next month.


Until then, good luck.