25 August 2015

What Goes Up… Must Come Down

Executive Summary

The media headlines seem to suggest that something has gone terribly wrong in global markets. But if you were to look at the economic data, nothing fundamental has changed – global growth is still present but at slower levels and the market is taking a technical “time-out”. Equity risk premiums still remain attractive, forward earnings growth is still positive (except for commodity related sectors), but panic is nearing an all-time high. Financial stress is not elevated yet which leads us to believe that this is part of a normal market correction. However, our technical models are indicating a poor environment and should they deteriorate further, we could be at the start of a bear market scenario. Our risk matrix has flashed a red warning signal today (25 Aug) because of this. As such, we are getting ready to sell out the majority of the equity positions in most portfolios to preserve capital should the signal be maintained.


Market pessimism has finally given way to a broader global correction in the stock markets. However, looking at the fundamental picture, nothing has changed. We had highlighted in previous updates that global growth was slowing down, and that there was no cause for worry unless it breached important support levels. Markets had been largely flat for the year, with consolidation occurring over the past few months. Technical indicators showed that markets had been weak during the June Greek debt debacle. Our own Risk Matrix flashed a red signal on Tues 25 Aug following the recent declines. When deconstructing that signal, we note that financial stress continues to remain at benign levels and the signal was triggered from the technical decline of the market. As such, whilst we view this as part of a market correction, should the sell-off intensify, then we could likely be looking at the start of a bear market. We are getting ready to reduce equity positions across all portfolios.

Yuan Devaluation

The Chinese Yuan devaluation in mid-Aug shocked markets into thinking that global growth was much weaker than what it seemed. Whilst the weaker Chinese economy and trade growth could have played a role in the devaluation, it was more likely that the PBoC wanted to move to a more market driven rate which would lead to the Yuan’s inclusion into the IMF’s SDR (Special Drawing Rights) reserve currency basket. Weakening the Yuan does nothing for Chinese trade, with net exports declining since 2009. In addition, the Chinese economy is undergoing a rapid rebalancing from manufacturing to a service driven one (Fig 2). As such there are greater considerations at play and it is no surprise that the Chinese want to become a significant player in the global financial arena, with the status and power associated with the Yuan becoming a reserve currency. It is interesting to note how little the devaluation is compared to a lot of other currencies versus the USD over the past 12 months (Fig 2).

Fig 1: Chinese Economy Restructuring from Manufacturing/Export Led to Domestic and Service-Oriented

Fig 2: Yuan Devaluation Compared to Other Currencies (all versus the USD)

Commodity Weakness

We have been negative on commodities since the beginning of 2015 and nothing has changed our view. We are in the midst of a dying/dead commodity super-cycle and no commodity is able to escape the gravitational pull of the bear. At present, we view the downturn in commodities as part and parcel of a typical market cycle. Of course, the question is whether the weakness in commodities is a result of a global recessionary environment. Whilst some arguments could be made to support this stand, the majority of the data suggests otherwise. The least of which is China’s restructuring from an investment-led economy as well as generally slower growth (but not a recession) globally. Within commodities and especially oil, it is likely that we have not seen a bottom in prices just yet. Despite expectations that supply would taper off in tandem with the drop in prices, it has actually increased, contributing to the weakness in prices (Fig 3). In general, with the exception of agriculture, the commodity sector is experiencing a large supply overhang which will continue to negatively pressure prices downwards and which will take quite some time to balance out. The media has also been quick to pounce on the commodity decline story, thus dominating headlines. However, commodities had already been in a decline since peaking in 2011 (4 years ago!) in line with weakness in China and we do not see this trend reversing anytime soon (Fig 4).

Fig 3: Mismatch in Supply and Demand of Oil is Contributing to Collapsing Prices

Fig 4: Multi-year Commodity Decline Underway. The Key Takeaway is to Avoid Commodity Producers and Commodity Related Currencies.

Fight or Flight

These last few days have shown that investors preferred flight than staying and fighting, selling out equity positions especially in Emerging Markets and Asia. However, we note that this institutional shift out of EM positions to higher quality developed markets have been occurring for some time as evidenced in the latest BofA ML fund manager survey. In addition, we can see that institutional investors are extremely negative on EM and commodity sectors which have been experiencing capital outflows, and thus exacerbating the negative price action (Fig 5).

Fig 5: Fund Managers Extremely Negative on Commodities and Emerging Markets and Have Been Allocating More to Developed Markets

When looking further into investors’ positioning and sentiment, we can see that investors have been bearish for quite some time judging by the higher than average cash levels (Fig 6) and pessimistic sentiment (Fig 7). With such negative positioning, it is likely that this global sell-off will wash out the remaining bulls and be nicely set-up for a short term bounce. In addition, the sell-off in the US on Friday triggered short term oversold indicators which are typically contrarian bullish signals (Fig 8).

Fig 6: Institutional Investors Holding Higher than Average Cash Levels is a Contrarian Bullish Indicator

Fig 7: Developed Market Equity Investors at Extreme Pessimism Levels is a Contrarian Bullish Signal

Fig 8: US Market Sell-Off Has Triggered Short Term Oversold Signals

Is it still worth investing in equities?

With the wall of worry facing investors, are equities still worth investing in? If faced with a sharp global slowdown we should see a drop off in forward earnings for corporations. Whilst we had a hiccup in the beginning of the year, recent data does not portend anything sinister yet (Fig 9). With the recent sell-off, we have also seen some flight to safety with money flowing to bonds, pushing yields down. This has been compounded with fears over deflation caused by the growth slowdown and weak inflation from commodities. As a result, equity risk premiums continue to be attractive with bonds remaining overvalued compared to stocks (Fig 10).

Fig 9: Forward Earnings for S&P 500 Corporations Continue to Rise

Fig 10: Equity Risk Premiums Still Attractive Implying a Better Risk/Reward Ratio for Holding Stocks

Risk and Positioning

Our risk matrix has flashed a red signal on Tue 25 Aug, mainly caused by the deterioration in technical factors. For the time being, financial risk remains at relatively benign levels (Fig 11) which seems to suggest that the market action is part of a normal correction process and not a larger bear market for the time being. Many EM and commodity related markets are already in a bear, but have a smaller impact on global averages due to the relative size of their markets. As such, we still hold the overall view that this is still a larger bull market until proven otherwise. Nonetheless, markets have a way of feeding on itself and we cannot remain oblivious to such strong market action signals. The latest technical decline has already caused our risk matrix to flash a red warning signal, and as such, we must be prepared for a possible bear market. In view of this latest signal, we are preparing to reduce all risky positions. Later, should market fundamentals prevail and sanity returns, we need to also be just as adept to buy back into the markets. Hence our latest notification (that is in the process of being sent out to you right now) is for you to approve our recommendation urgently to act on reducing equity positions as well as to get back into the markets.

Fig 11: Both the STLFSI and ECB CSI Show Below Average Financial Stress Readings for the Time Being

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