Merry “Beary” Christmas

Santa’s On Vacation, Bonds & Disinflation

It feels good to be back after a long absence from writing. My last post was about a suspect sell-off which was not justified from the macros perspective. This time around – the bond markets gyrated and spreads widened during a weak November where the SPX fell 6% from peak to through and then briefly recovered till early December and then resuming the downtrend and broke below a key 2630-2640 support level.

Macros are effective here in the sense that for a normal onlooker – prices were just trading in a range but to the professionals, this is what they saw (pictures below) and how I wished I had written this post earlier to make this call – well I was just too busy and did not have the time. To be honest, would I have taken the short? Probably not because I would be trading against seasonal factors and it made me slightly uneasy to take the trade since there is a divergence between technicals and macros although the flattening (and partial inversion) yield curve and the widening credit spreads could give some reason to take the short. Moreover, I was not in my best mental state due to work stress and lack of exercise which reduced my mental flexibility to seize this opportunity. Okay, enough justifying – lesson learned and to move forward in 2019.

Note the price volume divergence (red line) when trading in the range.  Volumes were higher when prices went down to support. This would be the first indication.

 

Note how much the bond spreads deteriorated even though the market rallied from 19th November till early December. This is the second sign. Also, note the double bottom on AAA-BB spreads which then points to a possible near top of the rate hike cycle before any further hikes will start to topple the economy.

Neutral rates are clearly lower this time round with the yield curve still inverted on the short-end (1st chart below). If were to look at the past 2 cycles, the top end of rates has been decreasing by around 1.25% and it is still heading downwards. This is attributed to several factors:-

  • Baby boomers are retiring from the workforce and are being replaced by lower waged younger workers
  • Technological advances have boosted productivity and improved price competition
  • The last recession was highly deflationary. Look at how much cheap money was fed into the economy and yet growth and inflation was subdued for several years. It took 3 QE’s and USD4.5 trillion worth to ONLY enable the Fed to raise rates late 2015. Look at current times, rates are only at 2.5% and the yield curve is already susceptible to a 2-10 inversion anytime. So, take away all that money and just see how will US fall into a deflation. Glorious era of bonds coming up?

 

Note below how disinflationary it is post The Great Inflation Era of the 1970’s as below. Inflation will remain within a range as technological advancement further causes disinflation but will be balanced by demographic shifts as the current Gen Y and Z will drive consumption as living standards improve along with wages. Gen Y will start to overtake the Baby Boomers in 2019  as chart below.

 

 

The MMI Indicator

I have recently developed a very simple qualitative indicator to gauge on what strategy could be more effective and also how much risk I can take on a trade and on my portfolio at any single time. This is a very personal indicator and only incorporates what I sense is vital on what moves the market and how do I adjust to the dynamics based on my own style. It is separated into Macroeconomics and Market Cycle (Seasons and Cycle) where each factor has an equal weighting – which I agree in that it makes my indicator bias and inflexible since markets are constantly changing. However, by observing the colors, I can better gauge on if the market is evolving and at a particular inflection point, which would better prepare my mindset to be more flexible on how I should approach trading the new market scenario. I believe that this will only get better with time as I improve on this with experience and help from others. This indicator is not backtested and is mainly used for qualitative analysis only.

The MMI is currently showing 0.44 which is slightly bearish on the scale of 0-1. Most indices have experienced their “death crosses” and certain macro data points have slightly weakened after topping out in previous months. Clearly some divergence since the macro data points are still solid. I would put more weight on the yield curve and the credit spreads though and I agree that leading indicators should have more weight in the calculation since I would prefer this to be forward looking. Currently, I will be looking at technical shorts if weakness persists and also on the medium term to look for a reversal at support with candlestick patterns. Clearly once the reversal is in place and macro data points don’t deteriorate, seasonal portfolios can be on the horizon as well to pick up some beaten down stocks.

 

Based on the MMI, I am not bullish (more bearish in fact) in the short term as prices are still in no man’s land. I will evaluate candlesticks and volumes when deciding on either shorting rallies, resistance or longing supports with macros as my signal to vary my risk per trade. I will trade where and when the market tells me to. I will share my trading plan in the upcoming weeks.

Over and out,

Ramone Kok

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