27 January 2016

Cognitive Dissonance

Executive Summary

We experienced a great disconnect this month when markets continued to decline without our models showing anything untoward. Checking all the big potential risks showed that it appears much more benign than in the past. There has not been any contagion from the oil turmoil nor a larger risk aversion from the drop in the Chinese stock markets. Global volatility is slowly abating, financial risk and our Risk Matrix readings still remain positive and investor pessimism is at a high. Putting these all together shows us that the sell-off is nearly done and represents an excellent entry point for those with capital. We will be pushing out a switch and rebalancing notification through our system for investors who need to re-align their portfolios this week. Please approve it as soon as you receive it. Stay invested through these turbulent times.

Article

Since the last article we sent out at the beginning of the month, markets have continued to come under pressure. Financial markets have decided that cheap Oil is bad, and if Shanghai insiders are selling, then I should throw everything out the window as well. We faced increasing mental stress and discomfort – a cognitive dissonance. Our models showed that the risk in the market was not increasing, yet everything continued to sell-off further. How could this be, and did we fail to see something? It was highly inconsistent and felt like something was amiss. Let's go through some of the big near term risks.

Oil Again

We had to revisit the theory that the entire world could implode from the oil fallout. We wrote previously that the high yield bond market was only stressed from the energy names and there was no contagion to the other sectors. It continues to remain the same. The big US banks had publicly stated that their capital ratios were bulletproof but had to provision approximately $500-700M from any energy fallout just in case. This is a drop in the ocean compared to the over $12T in Asset Backed Securities in the financial system at the height of the subprime crisis. When we took a deeper look at oil, we found some interesting points to note. In the past, crude oil had very little correlation to the stock market.

It was only post-2009 that both had begun to move in tandem. You could probably blame central bank intervention and excess QE. In addition, big price movements in oil had always been caused by demand and supply imbalances and the latest to occur was sometime in 2014 when shale oil had a big breakthrough. Demand for oil continues to remain solid, it is just that the system is flush with such great supply that prices had to come down (Fig 1).

Fig 1: Oil Remains Correlated to The Stock Market But Is In the Midst of Bottoming Good News For Investors. Oil Price Decline Not Caused By Demand Problem But Excess Supply.

China Stock Market

The Chinese stock market continues to remain unstable. In our previous update, we showed that the A-Share market traded at a premium to the H-share market. It remains overvalued and is not as oversold as the H-share market. There should not be any surprise if there is continued downside on the mainland stock exchange. What is interesting to note is that the H-share market is now 2 standard deviations oversold, way more than A-shares. It will begin to represent an excellent buying opportunity for deep value investors, as it has approached near distressed levels (Fig 2).

Fig 2: A-Share Market Likely To Continue To Sell-Off As It Has Not Approached H-Share Levels Yet

Sovereign Wealth Rebalancing

The victims of the current oil and commodity fallout are the producers themselves. A lot of the oil producing countries have had to adjust their budget balances as they would be running big fiscal deficits selling oil at current prices. Sovereign wealth funds who have shored up reserves in good times have been selling assets since the middle of 2015 to repatriate money back home to shore up their balance sheets. Global fund flows suggest this, and a look at buying activity in the US markets also shows that countries have been pulling capital out (Fig 3). The US is not alone in being affected, as these flows have affected all major equity markets as well.

Fig 3: Foreign Wealth Especially From The Oil Producers Have Pulled Money Out of Global Stock Markets To Shore Up Balance Sheets at Home

Waterfall Effect

The question on many investors' minds now is whether we could experience a waterfall effect in the stock market where losses continue to compound and selling pressure intensifies. We do not see this happening for the time being. For one, risk in the market, especially the risk reading we are getting from our Risk Matrix, is not showing elevated levels of stress. Investors who wish to view a less black box version of our risk matrix can reference the open-source Fed's St Louis Financial Stress Index, which is showing levels of stress below previous crises (Fig 4).

Fig 4: Financial Market Stress Levels Remain Below Crisis Levels

We feel that the stock market sell-off is also in the process of bottoming. Some evidence for this is shown in the 2 indicators below. The first one shows that the global stock market volatility is slowly abating. After the spike and once volatility starts to taper off, it typically signals that the bottom is near or has been reached (Fig 5). Of course we track many more indicators to show whether a bear market is forming, but this is one useful reference point to note.

Fig 5: Global Equity Market Volatility is Tapering and Could Signal A Near Term Bottom

When you look at investor sentiment, we can see that we have reached peak pessimism in Jan 2016 (Fig 6). Typically, at such extremes, further downside in the market is limited as everyone is so bearish that they have already exited the market and there are few sellers left. Taking this into context with our other indicators, this is as good a time as any to slowly enter the market to take advantage of the oversold conditions.

Fig 6: Investor Sentiment Reached Pessimistic Extremes Just Last Week. It Usually Signals The Height of the Decline.

Earnings Season

As we start to enter the Q4 earnings season, investors are sure to focus on corporate earnings growth. Prior to this, there have been a lot of downgrades as analysts remain pessimistic on the outlook for corporate America, and the world in general. On average, around 12% of S&P 500 (more for other countries) are energy sector names which will be affected by the oil market turbulence. Apart from that, analysts were also worried about how the dollar strength would impact earnings denominated in USD especially for US multinationals. We feel that there isn't a lot to be worried about in currency terms as the dollar has been stuck in a trading range for most of 2015/16. In fact, with the Fed expected to raise rates below what has been forecast this year, the dollar strength would be slightly more muted (Fig 7).

Fig 7: US Dollar Strength Not a Worry For Earnings As It Has Been Trading Within a Range Over The Past Year

Conclusion

Markets over the past month have appeared to be unstable but we are on top of the situation and watching it for further declines. Should our indicators deteriorate, we will not hesitate to pull money out if we believe it would be getting much worse. We experienced a great disconnect this month when the markets continued its sell-off without any negative readings on our risk models. Looking at the financial headlines will make you very jumpy and unsure of what is going on in the world. However, all our data still does not show a bear market developing globally, and it appears that the rout is reaching its final stages. Continue to stay invested, especially since the current weakness represents an excellent buying opportunity for investors with capital.

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