PAINFUL OCTOBER – FOR THE BULLS AT LEAST
It has been a painful October for the bulls as the bears sprung a 9.6% drop in the S&P500 from October 3rd all the way to the 29th before paring losses for 3 days in a row to start of November on a bright foot. This has essentially ruined the start of the “Best 6 months of the year” with October usually being one of the best performing months of the year. Well the tables have turned this time around but the bulls will be aiming for a comeback to prevent another “seasonal embarrassment”. There have been a myriad of reasons as that spurred the sell off from rising 10 year treasury yields, asynchronous growth, trade tensions and a weaker forward guidance by US corporates.
I have no complains seeing the seasonal model fail this time around as it presents an even lower risk entry point heading into the year end which will be a show of proof on if the bulls have what it takes to salvage the year. October has taught me on how a stringent risk management process can salvage the month albeit being stopped out from a few of my sector ETF positions. It took me only TWO trades to make back all my October losses and keep my portfolio in the green this year heading into the last TWO months.
Global markets are feeling the pain as well with most of them swimming in the October red, notably China, down 18.4% YTD, DAX YTD at -10.8%. DOW, NASDAQ and the S&P500 are still in positive territory YTD. If were to take a quick look below on some macro snapshots, there is an obvious slowdown but no reason to be panicking just yet as inflation and sentiment in major economies are still holding up
The IHS Markit and JP Morgan’s Global PMI snapshot is showing an expansion above 50 albeit significantly dropping from its peak.
Brazil’s GDP grew at a dismal 1.03% for Q2 2018. Brazil serves as a good proxy for an exporting emerging market economy as it is one of the BRIC economies which are deemed to be at a similar stage of newly advanced economic development. It is currently the 21st largest export economy with soybeans being its top export product, representing about 10.4% of the country’s total exports. Brazil’s main exports consist of about 45% of raw materials such as iron ore, soybeans, sugarcane and coffee. Looking at the Brazil ETF below, EWZ, shows prices challenging the 42 level after doing a beautiful double bottom in Q3. This presents good range trading opportunities even for the options aficionado, as this ETF has liquid options.
The trends in this ETF are pretty smooth and with clean moves from one $4-$5 range to the next. With its recently concluded elections, Bolsonaro’s appointment has triggered a surge of buying due to the expectations of the new administration in implementing much needed reforms in social security, expenditure controls and pledging an independent central bank.
Chile copper exports increased to $2.81B and remains on an uptrend albeit forming a lower high compared with 2011. Chile is the biggest copper producer in the world, leading China and Peru with roughly almost 6 million tons of copper annually. Copper is the global proxy for growth.
Chart shows copper futures, weekly candles for the last 3 years. Copper made its seasonal correction from May to July and is now holding above the 2.722 support. Let’s look at the whole commodity complex as a whole.
The Bloomberg Commodity Index is currently down -4.86% YTD, showing how global growth has slowed down this year and is reflected on global indices. I expect the oil complex to pick up in the current late market cycle which will prompt further rate hikes from inflationary pressures.
NOW WHAT? REVERSAL ON THE HORIZON?
The S&P500 ETF above showing daily candles is signalling a possible reversal technically, after being oversold compared with this years March drop. The 274-275 level will be a key test with the 200-day EMA hovering at. If the bears remain in control, prices may want to close the gap right to 268 and form a higher low OR may just continuously drop to potentially form a double bottom just below 265. Worst case scenario would be a break below 260. The 270 level would have to hold and will remain a key support as heavy volumes were observed just below 270 before the gap up. I am heavily hedged going long heading into November with shorts in the Yen and defensive sectors like utilities while doing a defensive arbitrage trade with longs in healthcare and real estate.
There is a 71.7% chance that the Fed will hike by another quarter basis points in their December meeting. Rates are still going up, that’s for sure. Only a matter of how much and for how long before the yield curve inverts. The precursor to more aggressive hikes down the road would be on the onus of oil – if oil indeed can break above $76 and potentially challenge double digit figures, we will see a more hawkish Fed.
There have been calls for the Fed to hold their horses in their rate hike trajectory but a correction of this magnitude is not sufficient to shake them into pulling the brakes as the economy still remain steadfast with a stronger than expected Non-Farm of 250,000 following a downwardly revised 118,000 in September and smashing consensus of 150,000. Unemployment rate remains at 3.7% while average hourly earnings are showing inflationary pressures, growing 3.1% YoY and 0.2% MoM. All these signs amidst a slowing housing market is still showing that the world’s biggest economy has a solid footing heading into Q4.
US jobs growth still looking solid
U.S. consumer spending grew 0.4% MoM
U.S. personal consumption expenditure grew 2.0% MoM
NO THERE IS NO RECESSION. JUST NOT YET…….
Will this be the start of something more sinister?
Spreads between the 10 and 30 have widened in recent weeks, much more than the 5 and 10. Visually, the curve still looks flatter compared with Q4 2017. With the 2 year being around 2.9%, will just be a matter of time when the curve severely flattens and inverts.
The 10y and 3m spread has hit lows since the post subprime, staying below the 1.0% line. This would foretell on how growth in the US will stagnate and that the prospects of an economical cycle top is on the horizon. Jobs data, wage growth and unemployment are already showing a tightening labor market, just that how much slack left is unknown. Companies are still capable of expanding capacity and consumption may remain robust so I would say there is still room for the economy to overheat. The million dollar question would be how long can the US economy endure before toppling over. I would watch closely how real assets perform in this cycle as commodities are a powerful cyclical indicator.
The top chart shows high yield spreads still hovering below the 4% line. Any break above this level would indicate troubling times ahead like how flat and volatile 2015 and 2016 was. Qualitatively, the BBB spread in the lower chart above widening and possibly challenging the June 2018 high of 1.63%. The widening of this spread is something to note of but without panic as it’s divergent with other data.
I’ve always like this spread between junks and investment grade corporate as the peaks and valleys are straightforward – below 2% in a late cycle macro scenario shows a healthy bond market.
Real interest rates are still positive with the FFR and 10y spreads narrowing. The Leading Index is still above 1% and the Fed is nowhere near its neutral 3% target, As such, I do not see any recessionary risks for the next 6 months to 1 year.
Unemployment remains at 47 year highs with capacity utilization still on the rise, together with inflation expectations. Inventory to sales ratio remain on the downtrend. All these signs are pointing to a sustaining bull market. To be honest, it’s rather tiring to keep reporting an intact bull market month after month. Nonetheless, I will go where the macros point.
Just a quick one on earnings as of 4th November. For Q3, 78% of S&P500 companies have reported an EPS beat while 61% reported a revenue beat. The current earnings growth rate is at 24.9% while revenue growth is at 8.5%, which is currently the 2nd highest growth rate since Q3 2010. On the flipside, 46 companies have issued negative EPS guidance while only 24 have issued positive EPS guidance. The recent gyrations we have seen since the start of earnings season was attributed from analysts lowering earnings estimates for Q4. The bottom up EPS estimate dropped by 1.1%, which is not significant as compared to the 5,10 and 15-year averages at 1.6%, 2.1% and 1.6% respectively. Utilities (-4.4%) and Industrials (-4.1%) led this decline while Energy (+5.4%) was the only sector to guide its forward estimates higher – a bullish scenario for oil.
Double digit earnings growth are led by Energy, Financials and Communication Services while double digit revenue growth is seen in Energy, Communication Services and Real Estate. The Consumer Discretionary sector is reporting largest upside difference between actual and estimates, for example, Under Armour ($0.25 vs $0.12), Amazon ($5.75 vs $3.08) and General Motors ($1.87 vs $1.22). Analysts are still projecting earnings growth of around 15% for Q4 with revenue growth at 6.8% but for Q1, the figures are expected to drop to 6% EPS growth with 6.6% revenue growth which is more than a 50% drop of earnings growth. Energy (+26.8%) is expected to see the largest price increase due to the largest upside difference between the bottom up target price and the closing price. Energy sector also has the highest percentage of buy ratings at 63%. For Q4 earnings, Energy is expected to outperform the rest in terms of earnings an revenue growth. This analysis coincides with my sector rotation model and also the tendency of oil to pick up during late market cycle.
In a nutshell, I see the recent drop as a low risk entry point to build long positions heading into the best 6 months of the year. I do not deny some divergences especially with the BB spread widening. Personally I will be long out of my eyeballs heading to the year end but would not hesitate to hedge or even reverse if macros turn for the worst. I will continue building oil and energy positions heading into the year end alongside the SPY. I would not hesitate to short bonds at resistance and even the Japanese Yen.
Over and out,