All of Europe’s a stage…


Author Cam Hui

Posted: 10 Mar 2012

Bloomberg had a good summary of Mario Draghi’s comments from the ECB press conference on March 8, 2012 in an article entitled Draghi Lays Groundwork for ECB Stimulus Exit as Inflation Takes Spotlight [emphasis added]:

Declaring that the environment “has improved enormously” and there are “many signs of returning confidence in the euro,” Draghi yesterday turned the spotlight on “upside risks” to inflation, which is now forecast to remain above the ECB’s 2 percent limit this year. That suggests policy makers don’t plan to cut rates further or add to their 1 trillion euros ($1.32 trillion) of long-term loans to banks, economists said….

The Frankfurt-based ECB must “go back to normal, classical central bank policy,” he said.

Draghi’s message to the politicians was, “We’ve done our part, it’s time for you to do yours” as he hinted that not only would there be no further LTROs, but the next ECB step would be some form of tightening.

How much of that is to be believed?

The Theatre in Europe
I wrote about how Draghi revealed the Grand Plan in a WSJ interview, which consisted of:

  • “Good” government austerity, in the form of lower taxes and less spending; and
  • Structural reform, in the form of the elimination of the European social model.

For the that Grand Plan to work, you need a compliant central bank to print money so that the system doesn’t seize up. So how much of what Draghi said is bluster and how much is real?

I interpret what Draghi said as being totally consistent with the message of: We will print more money if necessary, but on the condition that the politicians move forward with the Grand Plan’s reforms. Otherwise, be prepared for tightening.

It seems to me that even the Germans are on board with the Grand Plan. Despite the German cultural aversion to money printing, notice that there wasn’t a single complaint from either the Bundesbank or any of the German hardliners about LTRO, which has been documented to enormously expand the ECB balance sheet? Instead, we got a letter from Weidmann of the Bundesbank complaining about a technical point with LTRO, i.e. the quality of collateral.

Is this complaint about collateral quality just theatre? If so, then is Draghi’s comment about going “back to normal, classical central bank policy” also part of that theatre?

I interpret all these statements as part of the “show” that’s been going on in Europe as the elites proceed with the Grand Plan. The German complaint is part of the chorus of doubt that accompanies the main show and so is the ECB response, but they are not likely to be significant. No doubt, the ECB has the power to derail everything should any government step out of line, but my guess is that everyone pretty much knows the score. If needed, don’t be surprised if the ECB stepped up with further LTRO or LTRO-like programs. Recall that I wrote that analysis reveals that the European banking systems may need up to four LTROs in order to fund their liquidity needs to 2013.

I recognize that the ECB doesn’t want the banks to get addicted to LTRO, but do you expect the Draghi to allow European banks to fail as long as the Grand Plan is proceeding smoothly?

Expect more drama, but also expect a happy ending as long as all the players know their lines.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

China saves the world


Author Cam Hui

Posted: 18 Feb 2011

When my Asset Inflation-Deflation Trend Model flashed an asset inflation signal on February 6, 2012 to buy high beta and high octane inflation hedge and emerging market stocks, the major risk to the bullish forecast was a Chinese hard landing. One of the key indicators that I was watching at the time was the Shanghai Composite, which had been in a well-defined downtrend.

All that has changed. Since I wrote those words in early February, the Shanghai Composite has managed to stage a rally through the downtrend, signaling that China’s hard landing scenario is becoming less likely.

Indeed, Reuters reported the PBoC indicated that it is prepared to ease policy gradually in order to keep inflation in check:

In its monetary policy implemention report for the fourth quarter of 2011, the central bank said it will use a mix of policy tools, including interest rates, to maintain reasonable credit growth while keeping a lid on inflation.

Next door in Hong Kong, the Hang Seng Index has already rallied through its downtrend line and the 200-day moving average at about the same time, which is another signal of global healing and recovery.

Now that both the Shanghai Composite and Hang Seng Index have rallied through their respective downtrend lines and the fundamentals are becoming more positive, it seems that China is in the process of confirming the global bull move in risky assets. In fact, it’s saving the world as it indicated that it would continue to buy euro denominated debt, which it said it would do once the Europeans got their act together (and it is in the Chinese self-interest as Europe is a major export market).

These developments confirm my recent observations that we are seeing a intermediate term bull market in stocks and risky asssets.

So party on and let’s rock ‘n roll!

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

 

QE3 is still on the table


Author Cam Hui

Posted: 04 Feb 2012 12:17 AM PST

After the blowout number from Friday’s Non-Farm Payroll (NFP) release, there was some buzz that it would lessen the probability that the Federal Reserve would undertake QE3. I don’t think so.

According to its statement after its January 2012 FOMC meeting, the Fed has a 2% inflation target but no target for employment [emphasis added]:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments. Information about Committee participants’ estimates of the longer-run normal rates of output growth and unemployment is published four times per year in the FOMC’s Summary of Economic Projections.

Charles Schwab recently published a research note indicating that the Fed is watching inflation as measured by core PCE because it has a lower housing weight than CPI [emphasis added]:

The Fed also announced an explicit 2% inflation target for the first time in its history. This explicit inflation target also helps reduce uncertainty about policy long-term. The Fed will use the 2% annual target, based on changes in personal consumption expenditures (PCE) as their measure. The current year-over-year increase in PCE is 1.8% in the latest numbers. So they’re still a touch below those targets. Bernanke was asked in the press conference following the meetings, “why PCE and not the consumer price index?” One reason is that in CPI, housing has a far greater weight. It appears to have understated inflation during the housing bubble and may overstate it now that renting is more popular than buying. The PCE is also adjusted more flexibly to changing consumption patterns. Fed critics might also argue that annual increases in PCE also tend to be lower than changes in the CPI.

Remember, under the Fed’s new transparency initiative, we don’t have to guess what the Fed is going to do anymore and revealing their methodology. Consider these figures from the Dallas Fed for PCE, core PCE and trimmed mean PCE, which is another technique for excluding the more volatile components of the inflation rate.

Any way you look at it, core PCE and trimmed mean PCE remains stubbornly low and below the 2% target. This suggests to me that the Fed believes it has more room to stimulate without igniting an inflationary spiral. Watch this series for hints that QE3 might be moving off the table and don’t fret about signs of a cyclical rebound from economic releases like NFP.

The Bernanke Put still lives, at least for now.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Global healing, 2012 vs. 2009


Author Cam Hui

Posted: 23 Jan 2012 12:40 AM PST

Further to my post last week detailing signs of global healing, I have had a number of discussions with investors about the market outlook based on the events of 2008-2009. If we are indeed in a period of global healing, then can we expect the kinds of returns from stocks that we saw coming off the March 2009 bottom?

The answer is a qualified no.

Consider this chart of US equities spanning the periods in question. In 2008, the market crashed in the wake of the uncontrolled collapse of Bear Stearns and Lehman Brothers. In 2011, the European authorities manage to stem the panic. Both episodes are marked in the red boxes below.

In late March 2009, the Asset Inflation Deflation Trend Model moved from a deflation reading, indicating maximum defensiveness, to neutral. The same thing happened about two weeks ago.

Here’s the difference. In 2009, the market crashed. In 2011, the market didn’t. Moreover, many professional investors were positioned for a crash but their performance was hurt by the confusion over the political and economics of the eurozone crisis. As a result, hedge funds and the average long-only manager had a terrible 2011.

The road ahead in 2012
So what happens now?

I would like to discuss the outlook for return and risk for risky assets such as equities. First, because the market didn’t collapse in 2011 as it did in 2008, it would be foolhardy to ascribe near triple digit returns for equities going forward. If there are no accidents, such as a US recession, or a Chinese hard landing, investors should enjoy either high single digit or low double digit returns from a diversified stock portfolio.

The changing risk map
What has changed in 2012 is the map of risk. The actions of the ECB, Federal Reserve and other global central banks have effectively minimized tail risk for investors. Instead of having to worry about a market with a bimodal distribution, which Pimco manager Vineer Bhansali wrote about here, and is shown in the graph on the right below, I believe that stocks and other risky assets have returned to the classic unimodal bell-shaped return distribution shown in the graph on the left.

In other words, instead of worrying about catastrophic events, such as a Creditanstalt-like collapse, we just go back to worrying about earnings, recessions, growth, interest rates, etc. Bimodal distributions are much more difficult for professional managers to deal with because there is a single decision or event that can lead the market in two different directions. Will X default? Will the FDA decision be favorable for the company? How will the court rule in this key case that affects the survival of the company? It was largely these circumstances that led to the poor hedge fund and professional manager performance in 2011.

Unimodal return distributions, on the other hand, are far more manageable and much easier for professional investors to deal with. Modern portfolio theory is based on bell-shaped return distribution functions. Managers are well trained to manage risk in such situations and virtually everyone does it well.

What are the risks?
While I believe that equities are poised for reasonable returns in 2012, there are significant risks to the market. In the short term, I agree with Cullen Roche at Pragmatic Capitalism when he pointed out that investors appear to be overly complacent and due for a corrective pullback, a conclusion also shared by Mark Hulbert.

In the medium term,  believe that there are two major macro risks that face the market in 2012. First, there is the risk of a recession in the US, which has loudly trumpeted by ECRI. While the high frequency economic releases have generally been coming in above expectations, which points to a weak but non-recessionary economy, what bothers me is that respected investors who are not permabears, such as Jeremy Grantham and Jeffrey Grundlach, have been cautious.

If the American economy were to move into recession as per ECRI, then we should be seeing its effects now. I would be watching carefully corporate guidance and the body language of management as we go through Earnings Season. Last week, earnings were generally upbeat with the exception of GOOG.

The second major macro risk facing the market is a hard landing in China. While the Chinese economy is showing signs of slowing, the authorities are also taking steps to cushion the slowdown. Most worrying though, is analysis from Patrick Chovanec that indicates that Chinese GDP growth would have been 6.6% had growth from the property sector been flat – which is a brave assumption given the sad state of the property market today. A Chinese GDP growth rate of 6.6% would likely freak out the markets as it is in hard landing territory.

What about Europe?
Conspicuous by absence in my list of macro risks is Europe. I respectfully disagree with John Mauldin when he wrote this week:

As this letter will suggest, I don’t think this is the year you want your portfolio in typical long-only funds. There is a lot of tail risk this year coming from Europe.

In the worse case, consider what might happen if Greece experienced a hard default inside the euro, given that the ECB et al appear to be ready to fight the fire:

  1. Greece defaults.
  2. Banks have to mark to market their Greek paper and Credit Default Swaps get paid out.
  3. Banks become insolvent, but small depositors can get their money because of limited deposit guarantees up to X.
  4. Insolvent banks either get merged with strong banks (not many in Europe), get taken over by their sovereigns and restructured into good bank/bad bank (i.e. taxpayers take the hit), or go bankrupt.
  5. Some investors will get hurt, but there will be no mass panic because of ECB liquidity.
  6. The inter bank market would likely freeze up under such a scenario until there is more clarity about which banks live and which die. In the meantime they live on emergency ECB life support.
  7. Risk premium migrate to the sovereign bond market.

Any crisis will get contained if the ECB prints. The Germans, if they object, will be faced with a choice of a catastrophic failure vs. QE. In the end, I believe that they would choose QE.

This sounds more like a Long Term Capital Management crisis whose effects was contained, rather than a Creditanstalt event that takes down the banking system and set into motion the second leg down in the Great Depression.

Don’t worry, be happy
For now, my advice is to relax. Stocks look reasonably priced, barring catastrophic accidents. Even David Rosenberg is sounding somewhat bullish (or at least less bearish) these days:

We have a situation now where the P/E ratio, based on the trailing 12 months of earnings, is a mere 13. That may not be a classic trough by any means, but only 20 per cent of the time in the past quarter-century has the multiple been this low. That is something for investors to consider.

The multiple based on estimated earnings for the next 12 months – the “forward” P/E – is less trustworthy than the trailing P/E because it depends on analysts’ ability to accurately forecast the coming year. But as it stands, the forward multiple is now just a snick below 12.

In the past quarter-century, we saw only one other time when it was this low on a one-year forward basis, and that was the first quarter of 1988. A year later, the S+P 500 rallied 15 per cent.

That, too, is something to mull over.

For now, my Trend Model is showing a neutral reading and I anticipate some short-term choppiness as the market consolidates and digests the recent gains from the October lows. Beyond the short-term choppiness, equities should show some reasonable returns for the remainder of the year.

Don’t worry, be happy.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

Global healing


Author Cam Hui

Posted: 16 Jan 2012 05:51 AM PST

I’ve been pretty bearish in the last few months, but it may be time to change my outlook. Last week, the Asset Inflation-Deflation Trend Model moved from a deflation to a neutral reading. As a confirmation of this trend, my review of the charts show a picture of global healing after the trauma last year of a near banking crisis meltdown in Europe.

Is LTRO the Draghi Put?
Most notable is the performance of the banks. The relative performance of the Banking Index shows a pattern of a rally through a relative downtrend. The ECB’s LTRO program of providing unlimited liquidity for up to three years to eurozone banks has bought the politicians time and created the perception of a Draghi Put for the market. The recent relative performance of the BKX, which is heavily weighted with the large TBTF banks, is reflective of this relief.

Similarly, the performance of the Euro STOXX Index shows a pattern of global healing. Despite all of the financial stress evident in the eurozone, this index formed a wedge and the wedge resolved itself to the upside.

In addition, we have been seeing positive European price action in the face of bad news, which is bullish. I wrote last week that European banks have been testing a key support but that level has been holding up, despite all of the bad news in the last few months. Italian 10-year bond yields, which is a key measure of investor confidence, has stayed below the important 7% level in the face of the downgrades.

Inter-market analysis confirms the turnaround
Sectorally, I am seeing signs that the market expects a cyclical rebound, at least in the US. The chart below shows the relative performance of the Morgan Stanley Cyclical Index against the market, which has been rallying and is now in the process of testing a relative resistance level.

The Industrials are also showing a similar pattern of relative strength as the sector began a relative uptrend in October.

So have the Materials sector, which show the familiar pattern of rallying through a relative downtrend:

…while defensive sectors such as Utilities have lagged the market and is now in the process of testing a relative support level.

Constructive on commodities
Commodity prices are also showing signs of global healing. The chart below of the CRB Index shows that commodities have rallied through a minor downtrend and it tested the longer term major downtrend, which remains intact.

The commodity heavy Canadian market is also showing a similar pattern of rallying through a short-term downtrend, though the longer term major downtrend remains intact.

Regular readers know that I am a long-term commodity bull. These charts indicate a constructive outlook on the commodity complex. Mary Ann Bartels of BoA/Merrill Lynch recently showed that large speculators (read: hedge funds) have unwound their crowded long in commodities and readings have retreated to a level where previous bull phases have begun in the past:

Positive breadth divergence
Tom McLellan, writing at Pragmatic Capital, has confirmed my observation of a market turnaround. He wrote that the Ratio Adjusted Summation Index is showing strength:

So all of this leads us to the current RASI reading, which at +618.2 is above the +500 level but still below the peak of +763 seen on Nov. 15, 2011. So it is a divergent lower high, but it is still high enough to say that the uptrend which started in October 2011 is not over. There can be ordinary pullbacks along the way, but the message of the RASI is that the final highs of this current new uptrend have not yet been seen.

 

Not out of the woods yet
To be sure, it’s not up, up and away here for stocks and numerous risks remain. Greece is edging closer to a default as talks with creditors appeared to have broken down. The situation in Hungary remains volatile and has the potential to take down the Austrian banking system. Just because there is a Draghi Put in the market doesn’t mean that investors are immune from losses, but I would encourage investors to think of the Draghi Put as an insurance policy with a deductible where you have to incur the first X% in losses.

In addition, China isn’t out of the woods. While the Chinese leadership is making noises about stimulus, the property bubble in China is deflating in a dangerous way and it is unclear whether the authorities can achieve a soft landing. The Shanghai Composite has been rallying in line with global equity markets but the index remains in a downtrend. The one silver lining for the bulls is that there appears to be a turn-of-year effect in Chinese equities. The current rally is consistent with the pattern of market updrafts seen starting at about the time of past Lunar New Years.

Since China’s economy remains a major engine of growth in a growth-starved world, this is one indicator to watch carefully. The bulls can also take solace in the Hong Kong market, which formed a wedge that resolved itself to the upside recently:

In addition, Nomura believes that Chinese real estate may be in the process of forming a bottom. The firm’s analysts pointed to a positive divergence between land purchased by property developers and new construction activity:

Cautious short-term, constructive medium term
Putting it all together, what does this all mean?

My inner trader tells me that in the short-term, the rally looks overdone. Over the next few weeks, continue the strategy of buying weakness and fading strength. Indeed, Macro Story confirms a high risk level for equities by pointing out that AAII sentiment is at a bullish extreme, which is contrarian bearish.

With US equities now testing a resistance level, expect some short-term weakness but be prepared to buy the dips:

Longer term, my inner investor tells me to expect a period of sideways consolidation, likely followed by a bull phase in equities with an expected return of 5-15% in 2012 – assuming that there are no accidents.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. (“Qwest”). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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