22 April 2016

So, Should I Be Bearish or Bullish?

Executive Summary

Overall, the weight of the evidence shows that there is underlying strength in the recent rally off the Feb lows. What makes us bullish for the year is that a decent majority of the technical models are showing that this strength can continue in the medium term. In addition, a vast number of central banks are still very accommodative. What makes us slightly bearish and take a pause is that valuations appear full. We will need a great increase in corporate earnings to push some price ratios down. However, we do not see a bear market in the near term as a recession appears unlikely at least for the next 1 year. In addition, our risk signals and components within our Risk Matrix have slowly been improving. We recommend all our investors to remain invested, but we would slowly start trimming positions within the next few months to neutralise the portfolios as we expect some volatility going into the US presidential elections.

Article

There is no easy answer to the title question above, but taking the weight of the evidence across all our data, we are leaning slightly bullish for now. Markets have somewhat recovered from the hysterical sell-off of Jan/Feb 2016 and if you had stayed invested or had the courage to allocate more capital during that period, congratulations! Essentially we see little has changed to sway us from our views in Feb and March but lets refresh some of that data.

Bull Case - General Market Trend

It may not be that apparent yet, but the technical momentum of the market has resumed its bullish tilt (Fig 1). Whilst it is not an outright extremely bullish signal, the mildly bullish signal now just shows us that we could be in a positive trending market. And as they say dont fight the trend, so remaining at full allocation appears to be the best course forward for now.

Fig 1: Market Momentum Has a Bullish Tilt Now, Which Mean Some More Upside In the Near Term.

Bull Case - Market Breadth

Recent market breadth readings have provided signs that the market rally off the recent lows is much healthier than in Sep 2015 (Fig 2). In fact, such positive breadth readings have not been seen since the beginning of 2014. This means that there have been more stocks participating in the rally compared to the past year where only a few big names performed well. This is a sign of a healthy market.

Fig 2: S&P500 Market Breadth

Bull Case - Fed Is Still Dovish

The Fed is still sending very accommodative messages to the market with regards to interest rates. For now, there is a strong likelihood that the first rate hike for 2016 will occur in June. Even with one or two hikes this year, Fed funds rates would still remain at very low levels of under 1%. As such, it is hard to be bearish especially if the Fed wants to inflate the price of assets. By keeping rates at this level, the majority of stocks in the S&P500 have higher dividend yields than 10 year treasuries (Fig 3). From a risk/reward perspective, it still makes sense to hold stocks at the current levels of bond yields.

Fig 3: Many More Stocks Give Higher Dividends Than 10Yr Treasuries Making It More Attractive To Hold Risk Assets

Bull Case - Commodities Still Bad But Stabilisation Provides Relief

There is no doubt that the commodity sector is still in a bear market. The recent rally in oil back to around $40 per barrel has brought some relief to investors and lowered the correlation of all risky assets. There is also less talk about $20 oil as the bearish commentators retreat to the sidelines. The chart below carries two different key messages (Fig 4). In the left clip, it shows that the current oil price decline has already surpassed the mean historical declines both in terms of price quantum and duration. This could mean that oil could already have bottomed at $26 in Feb. As for further price increases, the right clip shows that the shale oil producers in the US will come back into play as soon as prices reach around $60. This provides an implicit near-term ceiling on prices and just shows that oil could be stuck in a trading range for some time.

Fig 4: (Left Clip) Oil Likely Bottomed at $26 in Feb. (Right Clip) Oil Has A Price Ceiling of $60 as Shale Producers Are Profitable Around That Price And Will Restart Operations Adding to Supply.

Bull Case - More Global Markets Participating In the Recovery

One should not focus solely on the developed markets, but also look at Asia and EM. These markets suffered since the Aug 2015 sell-off with extreme negative sentiment led by the commodity decline. They have since participated quite broadly in the recent rally (Fig 5). The fact that some markets have also broken through some short term resistance levels bodes well for general risk taking.

Fig 5: Breakouts in Quite A Number of Asia and EM Bodes Well for Risk Taking

Bear Case - Stocks Are Not That Cheap

Current valuations of the market could provide some headwinds to big gains from stocks. However, from the chart below, note that periods of overvaluation can persist for many years, similar to the late 90s all the way to the mid-2000s (Fig 6). We would need a big rally in earnings to bring some of these overvaluations down, but for the meantime we could be looking at a fairly valued market (on an index basis).

Fig 6: Markets (like the US) Are Currently Fairly Valued From an Overall Index Basis. This Could Limit Upside Gains.

What We Are Looking Out For - Negative Yield Curve

What could make us turn very bearish? In addition to our Risk Matrix flashing RED, we are also watching some leading indicators which can foretell an upcoming recession. Why worry about a recession? Because in a recession, the bear market and losses on risky assets are extreme and the time to recovery is much longer. A good leading indicator despite recent central bank intervention, is the yield curve (Fig 7). A negative yield curve is a sign of an overheated economy which is a precursor to a recession. Currently, all sectors of the treasury yield curve are not at dangerous levels yet.

Fig 7: Treasury Yield Curves Not Forecasting A Recession Yet

What We Are Looking Out For - US Presidential Election

History has shown that the stock market is quite apolitical. However, the market does not like uncertainty and has generally tended to perform more poorly when there was a closely contested election rather than a clear cut race. The historical chart on the 4 year Presidential Election Cycle (data from 1900) shows that the typical election year is range bound until a clear sign of who the next President will be emerges (Fig 8). It also does not help that the elections are always held in Nov, which is preceded by the weak sell in May and go away months.

Fig 8: Historical Presidential Year Cycles When Compared With The Current Stock Market Template Shows That The Market Could Be Range Bound For a Few More Months

The Most Risky Asset? Reach for Yield Has Stretched Bond Valuations

We want to end off this piece with two charts on what we feel is the most risky asset class currently and that is fixed income. With rates around the world going into negative territory, investors have been desperate for yield and have been crowding into higher yielding fixed income. This presents two problems. First, the extremely long 30 year bull run in bonds appears close to running its course and can only reverse from here. Next, inflation is actually picking up in some areas of the market, more so in the US although investors have turned a blind eye to it. An inflationary environment is negative for fixed income investors and as the asset class becomes more illiquid, a flight to safety in the event of bond losses will magnify the effect.

Fig 9: Fixed Income Both Short Term Overvalued and Looking Negative From a Long Term Secular View

Fig 10: Long Term Chart on Asset Class Trends Shows That Fixed Income Is Near The End of Its Very Nice Bull Run

Conclusion

To sum up, we recommend that investors do not panic at small events but rather take a big picture view. We see both reasons to be bullish and bearish, but for now are leaning more bullish as the weight of the evidence pushes us to be so. However, we are watching out for certain key indicators as well as for the deterioration of our Risk Matrix which would necessitate a reduction in risky assets. For now, we will stay invested to ride this current uptrend. We will soon be sending out a notification to renew certain mandates for asset allocation which we have not fully executed during these few months, so please approve it as soon as you receive it.

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