Gundlach Reveals His Favorite Trade For 2018

One day after Stanley Druckenmiller confessional to CNBC that as a result of central planning and markets that make no sense, the legendary hedge fund manager had a "terrible" year, and his "first down year in currencies ever" (he also said many not very nice things about bitcoin), it was Jeffrey Gundlach"s turn to confess some of his more controversial views. And so, the man who two years ago correctly predicted the Trump presidency, first discussed his best investment idea for the new year. To those who listened to his latest DoubleLine investor presentation last week, the answer will hardly be a surprise: namely commodities, because they"re "historically, exactly where you want it to be a buy."

"I think investors should add commodities to their portfolios," Gundlach says on CNBC"s Halftime Report.

Gundlach said commodities are just as cheap relative to stocks as they were at historical turning points, while the macroeconomic backdrop also supports the case for commodities; he was referring to the following chart which he highlighted last week.

Echoing his presentation from last week, Gundlach said that once "you go into these massive cycles... the repetition is almost eerie. And so if you look at that chart the value in commodities is, historically, exactly where you want it to be a buy."

Investors should add commodities to their portfolios. There is a really remarkable relationship between a market cap or the total return of the s&p 500 and the total return something like the Goldman Sachs commodities index. The cyclicality is really repettiive.

Gundlach also noted that commodities are just as cheap relative to stocks as they were at turning points in previous cycles that began in the 1970s and 1990s. The S&P Goldman Sachs Commodity Index is up 5% this year, versus the S&P 500"s 19% gain.

There is also a fundamental case for investing in commodities, Gundlach said. He pointed out that global economic activity is increasing, a tax cut could boost growth and the European Central Bank is implementing "absurd" stimulus policies in the euro zone.

Jeffrey Gundlach: Investors should add commodities to their portfolios from CNBC.

In addition to his favorite trade, Gundlach touched upon several other topics including:

What drives the dollar:

"Short-term fed moves are not what drives the dollar. It correlates much more to what the bond market thinks vis-à-vis the fed say 18 months forward. So if you actually rook at the bond market pricing for 2019 now, there’s a pretty big discrepancy between the bond market and the fed, so that’s going to be really interesting in driving the dollar, and this time i think the bond market is going to be right."

Why the markets are so calm:

"I think it’s because of central bank pegging of rates and quantitative easing going on full bore in  europe and in japan. One of the charts that i love to reference is the nearly linear rise in central bank balance sheet holdings ever since 2011, where the Fed stopped quantitative easing back three years ago, and japan and the ecb just took over the slack, and it’s just a linear rise."

 

Jeffrey Gundlach: This has been a great year for investors from CNBC.

On ECB president Mario Draghi:

"That’s going to slow things down a little bit, but the real worry from the central bank activity would be forward about a year. Because Mr. Draghi has said astonishingly that they’re going to continue 30 billion euros per month of quantitative easing at least until September and then he threw  in, just to put a cherry on top of the cake of stimulus, he said, and negative rates well past the end of quantitative easing. Which means – sounds to me you’ll have negative rates as long has Mr. Draghi is around which is a little under two years."

On tax cuts and bonds:

"If there is a net tax cut, it has to be bond unfriendly. we already have growing bond supply. we’ve been liiving in a world for the last three years thanks to quantitative easing of negative net bond supply, really, from sovereign bonds in the developing world. and that’s gonna flip because the fed is now letting bonds roll off, the budget deficit is increasing, a tax cut would increase the deficit further, and to the extent that a tax cut might be stimulative to the economy, that’s bond unfriendly, because bonds don’t like economic growth and also it’s more bonds, expanding the deficit, so even more supply."

On tax hikes and risk:

"If i"m correct and i’m going to receive a seven-point bump in my tax rate, which is actually about a 15% tax increase, i have a feeling that i’m probably going to be less able and willing to buy risky assets or buy all the other things that are bubbling up these days, and maybe that side of the narrative will start showing up."

Jeffrey Gundlach: Tax plan could have unintended consequences from CNBC.

On stimulating the economy:

"While we’re not probably going to get 3% real for the year, we’ve had it for two quarters in a row. and gdp now at the atlanta fed has been bouncing around but it’s around 3% for the third quarter. when is the last time we had something like 3% growth for three quarters in a row? it’s a long time. why would you be stimulating the economy?"

Finally on bitcoin:

Six Ways US Stocks Are The Most Overvalued In History

Submitted by Mish Shedlock

US large cap stocks are the most overvalued in history. Let"s investigate six ways.

Crescat Capital claims US large cap stocks are the most overvalued in history, higher than prior speculative mania market peaks in 1929 and 2000.

Their 25-page presentation makes a compelling case, with numerous charts. It"s worth your time to download and investigate the report.

Six Ways Socks Most Overvalued in History

1. Price to Sales


2. Price to Book


3. Enterprise Value to Sales


4. Enterprise Value to EBITDA


5. Price to Earnings


6. Enterprise Value to Free Cash Flow

Here are a few snips from the report.

Bear Market Catalysts

There are many catalysts that are likely to send stocks into bear market in the near term. A likely bursting of the China credit bubble is first and foremost among them. Our data and analysis show that China today is the biggest credit bubble of any country in history. We believe its bursting will be globally contagious for equities, real estate, and credit markets. The US and China bubbles are part of a larger, global debt-to-GDP bubble, which is also historic in scale, and the product of excessive, lingering central bank easy monetary policies in the wake of the now long-passed 2008 Global Financial Crisis. 

 

These policies failed to resolve the debt-to-GDP imbalances that preceded the last crisis. Now, easy money policies have created even bigger debt-to-GDP imbalances and asset bubbles that will precipitate the next one.We are in the very late stages of a global economic and business expansion cycle with investor sentiment reflecting record optimism typical at market peaks, a sign of capitulation at the end of a bull market. Crescat is positioned to profit from the coming broad, global cyclical market and economic downturn that we foresee. We strongly believe that our global equity net short positioning in our hedge funds will be validated soon.

Cyclical PE Smoothing

It is critical to use cyclical smoothing to accurately gauge market valuations in their current and historical context when using P/E.Yale economics professor, Robert Shiller, received a Nobel Prize in 2013 for proving this fact so we hope you will believe it. 

 

The problem with just looking at trailing 12-month P/E ratios to determine valuation is that it produces sometimes-false readings due to large cyclical swings in earnings at peaks and valleys of the business cycle. For example, in the middle of the recession in 2001, P/Es looked artificially high due to a broad earnings plunge. P/Es can also look artificially low at the peak of a short-term business cycle, which can produce what is known as a “value trap”, such as in 2007 during the US housing bubble and such as we believe is the case today in China, Australia, and Canada.

 

Shiller showed a method for cyclically-adjusting P/Es using a 10-year moving average of real earnings in the denominator of the P/E. Shiller’s Cyclically-Adjusted P/E, called CAPE multiples have been better predictors of future full-business-cycle stock market returns than raw 12-month trailing P/Es. Shiller showed that markets with historically high CAPEs lead to low long-term returns for long-only index investors. Shiller CAPEs are fantastic, but they can be improved by including an adjustment for corporate profit margins which makes them even better predictors of future stock price performance and therefore even better measures of cyclically-adjusted P/E for valuation purposes. 

 

.Shiller’s CAPEs simply need an adjustment for profit margins because margins are a key element of earnings cyclicality. We can understand this by looking at median S&P 500 profit margins in the chart below. For example, even though profit margins were cyclically and historically high during the tech bubble, they are even higher today. In the same spirit of Shiller’s attempt to cyclically adjust earnings to determine a useful P/E, CAPEs need to be adjusted for cyclical swings in profit margins.

When we multiply Shiller CAPEs by a cyclical adjustment factor for profit margins (10-year trailing profit margins divided by long term profit margin), we get a margin-adjusted CAPE that is not only theoretically valid but empirically valid as it proves to be an even better predictor of future returns than Shiller’s CAPE!

 

Credit goes to John P. Hussman, Ph.D. for the idea and method to adjust Shiller CAPEs for swings in profit margins.As we can see in the Hussman chart below, margin-adjusted CAPE, shows that today’s P/E ratio for comparative historical purposes is 43, the highest ever! The 1999 peak P/E was 41 and the 1929 P/E was 40. Once again, we can see that today we have the highest valuation multiples ever for US stocks, higher than 1929 and higher than 1999 and 2000!

Margin-Adjusted CAPE

It"s easy to discard such talk, just as it was in 2000 and 2006. People readily dispute CAPE, concocting all sorts or reasons why it"s different this time. The most common reason is interest rates are low. We also hear "stocks are cheap to bonds" which is like saying moon rocks are cheap compared to oranges. I do not know when this all matters. And no one else knows either. What I am sure if is that it will matter.

How?

I don"t know when, nor am I sure "how" it happens. It could play out as a crash or stocks can decline over a period of 6-10 years with nothing worse than a 15% decline in any given year, accompanied with several sucker rallies leading people to believe the bottom is in.

History Lesson

Some might ask: If you don"t know when or how, of what use is such analysis.The answer is that history shows this is a very poor time to invest in stocks. That does not mean, they cannot go higher(and they have).

History also suggests that people who invest in bubbles, start believing in them. People believe in bubbles because they have to, in order to rationalize their investments. Others know full well it"s a bubble but they think they can get out in time. Historically, few do because they are conditioned to "buy-the-dip" philosophy, and keep doing so even after it no longer works.

Yesterday, I noted Oppenheimer Predicts PE Expansion, Most Bullish S&P Forecast Yet.So if you are looking for a reason to stay heavily invested in this market, you have one. But don"t fool yourself, this is the most expensive market in history.

 

When Will The Tesla Stock-Promote Finally Fail

Via AdventuresInCapitalism.com,

The history of industry leading consumer tech products has not been kind to investors who overstay their welcome. You need look no further than all the hundreds of notable recent failures, to realize that these companies almost always flame out. The list below (in no particular order) is a nice trip down memory lane of former favorites, that are now either bankrupt or shells of their former selves—often consumed by some other entity that fortunately put them out of their misery. Of course, the list below, is just from the past decade or two;

Palm, Gateway, Research In Motion, GoPro, FitBit, Heelys, Handspring, Compaq, BlueRay, Garmin, Delorean, Casio, Sega, Tamaguchi, TiVo, Betamax, AOL, Walkman (Sony), Set Top Boxes (Scientific American), Kodak, Atari, Napster, Netscape, Polaroid, etc.

Let’s just say, it’s hard at the top. You must guess each change in technology, each generation of improvement and design it for fickle consumers, while constantly outlaying capital for research and development that may never go anywhere. All the time, others are constantly trying to overtake you.

If you look at the lifecycles of these companies, they often follow a similar trajectory from ingenious creation with huge margins, to a few generations of new products with smaller margins, to massive competition as deep pocketed competitors and venture capitalists try and emulate your product, to missing a product cycle, to becoming obsolete. These consumer product companies rarely last more than a decade; often just a few years. In the end, consumer focused tech is vicious and Darwinian, with very few long-term competitive advantages.

Of course, Tesla (TSLA – USA) is something of an anomaly here. While the companies in the above list, all produced prodigious cash while they were industry leaders, Tesla seems to incinerate cash while in the lead—using repeated equity and now debt offerings to plug the hole. While other companies had a huge stash of cash to fall back on when others overtook them, Tesla’s cash balance leaves it only a few quarters from insolvency. Add in a host of questionable related party transactions, convoluted financial statements (what the hell is pro-forma revenue?), the inability to ever hit company guidance, deceptive disclosures and a business that seems to lose more money with each vehicle it produces, is it any wonder that Tesla is one of the most shorted large-cap stocks today? If I had to choose the most obvious pending bankruptcy of a large-cap stock, it is clearly Tesla.

At the same time, I have to give Elon Musk credit. He has created a company that is a rather successful cult, even if it is still a failing auto company. Every time that skeptics ask real questions, he deflects them with futuristic sci-fi pronouncements. What other automobile CEO is obsessed with Mars while his assembly line fumbles along? What other CEO talks of hyperloops, while his main product on auto-pilot will kill you if used as currently designed. This “visionary “status has deferred timelines and made all logical financial metrics meaningless to investors—which may be the point of all his hubristic talk in the first place. Extend, pretend, blatantly mislead investors, raise more capital. It’s the junior mining model—applied to auto production—on a scale that would make anyone in Vancouver blush.

Automobile production is a decidedly unsexy industry, with massive capital outlays, high fixed costs, huge cyclicality and low returns on invested capital throughout the cycle—the technical definition of an awful business. The leading players produce millions of vehicles a year, yet trade at mid-single digit cash flow multiples, due to how awful the industry is. Why is Tesla valued like a high-tech growth stock, where investors ignore accelerating operating losses; if the best-case outcome is that it becomes a cyclical auto manufacturer with depressing returns on capital? A new technology like electronic vehicles (EV) sounds cutting edge, but so was automatic transmission, air conditioning, power steering, fuel injection, etc. All the other auto makers copied these technologies and caught up within a few years—much like what is now happening in EV. So, how has Tesla become such an epic bubble, if it is competing (poorly) in an industry that is notorious for destroying capital? It is clearly the promotional genius of Elon Musk. Naturally, he won’t be the first or last “visionary” to have a comeuppance.

So, going back to my question, which is the genesis of this article; when will the Tesla stock promote finally implode?

Long-time readers of this site know that I no longer short companies. This was a hard-learned lesson from when I was short Research in Motion, about two years too soon and watched as it went up 3-fold on me—before ultimately collapsing as I had predicted. Unfortunately, I was not short much by the time of the collapse as a small position had mushroomed into something pretty large and I was forced to keep covering at accelerating losses—lest I be forced to sell good longs to fund the repeated margin requirements of the short. While my thesis had been right, my timing was wrong. As long as investors believed in Blackberry, it didn’t matter that Apple and Samsung were building competing products that were likely to be better. It didn’t matter that Chinese players were producing low-end models that were likely to be almost as good, but at a fraction of the cost. It didn’t matter that competition from cash rich competitors grabbing for market share would crush margins. No one on Wall Street cared—until the iPhone finally showed up and people realized it was better. Then the Research in Motion collapse began.

For the past year, Tesla was a bet on pending mass production of affordable EV cars. Earlier this summer, we saw the first of the Tesla Model 3s to be produced. Even the normally ebullient journalists struggled to hide their disappointment with the product. This is understandable, dozens of competing EV models are coming, starting as soon as 2018. Will they be better than the Model 3? Based on what we know thus far, they’re unlikely to be worse. As they continue to advance EV technology, auto companies with far greater resources than Tesla, will eventually surpass it—much like with Blackberry. Then again, Research in Motion was coining money while at the top of its game—Tesla consumes money, while racking up debt. This won’t be a game of margins and profits—all the incumbents need to do is show that they can break even producing a comparable vehicle. At that point, the funding for Tesla will subside and its debt will bury it.

I was too early with RIMM and I don’t want to be too early with TSLA. So, I’ve been patient. I’ve been waiting for the competitors to show up. They’re now coming. The Tesla Model 3 is a dud—competing products will begin showing up in 2018 and they look much better. However, I’m not going to short TSLA. I’m going to use long-dated puts—much like I’ve played all subsequent dead-man-walking companies with an uncertain mortality date.

The problem with puts, is that long-dated puts are expensive. Fortunately, there’s a way to offset this cost, the bear put spread. This is the purchase of a put and the sale of a put at a lower price. By doing this, your gains are capped by the price of the put you’ve sold, but since your cost is much lower, you get to play with many more of them. Besides, you don’t need Tesla at zero to win with these, you just need Tesla’s share price to drop materially from here. If my timing is wrong, my losses are small and I can reload when they expire. Besides, I don’t expect TSLA to be a zero immediately. It is much more likely to limp towards zero, as opposed to imploding towards zero—making the bear put spread even more attractive than straight puts. Let’s just say that for the past few months, I’ve been adding to this position. The net cost of the spread is cheap and the timing now seems increasingly pregnant.

When will Tesla’s stock promote finally implode? When people realize that it’s a cash incinerating vanity project for Elon Musk, at a time when new, better products are coming to the market. That point is coming soon. Very soon.

One Bank's Surprising Discovery: The Debt Party Is Finally Over

A recurring theme on this website has been to periodically highlight the tremendous build up in US corporate debt, most recently in April when we showed that "Corporate Debt To EBITDA Hits All Time High." The relentless debt build up is something which even the IMF recently noted, when in April it released a special report on financial stability, according to which 20% of US corporations were at risk of default should rates rise. It is also the topic of the latest piece by SocGen"s strategist Andrew Lapthorne who uses even more colorful adjectives to describe what has happened since the financial crisis, noting that "the debt build-up during this cycle has been incredible, particularly when compared to the stagnant progression of EBITDA."

Lapthorne calculates that S&P1500 ex financial net debt has risen by almost $2 trillion in five years, a 150% increase, but this mild in comparison to the tripling of the debt pile in the Russell 2000 in six years. He also notes, as shown he previously, that as a result of this debt surge, interest payments cost the smallest 50% of stocks in the US fully 30% of their EBIT compared with just 10% of profits for the largest 10% and states that "clearly the sensitivity to higher interest rates is then going to be with this smallest 50%, while the dominance and financial strength of the largest 10% disguises this problem in the aggregate index measures."

Another key point that Lapthorne makes, as also highlighted here back in November 2015, is that the reason for this increase in debt is largely down to financial engineering – aka share buybacks (see charts below). However the most recent data points to a significant change in this trend – with not only debt issuance in decline, but also the quantity of share buybacks.

Clearly over the long-term, this is obviously good news; borrowing money to buy back your elevated shares is clearly nonsense. However that has been the case for a number of years now. Are US corporates really waking up to the foolishness of their actions or are they constrained by their balance sheets? Or they may simply be anticipating greater clarity on Trump’s policies? Who knows! But in the short term, this does significantly reduce the impact of the biggest net purchaser of US equities, according to the SocGen strategist.

In other words, Lapthorne has found something surprising: after years of constant growth "having boomed out of control", net debt growth is rapidly heading toward zero, and perhaps even a contraction, for the first time since the financial crisis!

Needless to say, for an economy in which debt growth - either public or private - has been a primary driver of overall economic expansion, this is a stunning development. So what is driving it.

Here, Lapthorne makes several nuanced observations which have significant implications not only on future debt levels but overall equity prices and broader risk-assets:

Firstly, while the headline S&P 500 continues to move ever higher, the dynamics within the US equity market are not so encouraging. The chart below breaks down the FT US non-financial universe into top and bottom quintiles based on balance sheet strength (as measured by Merton’s Distance to Default). What is abundantly clear is that while the strongest continue to do very well, ever since the Fed surprised the markets back in February with a US rate move, stocks with the weakest balance sheets have struggled.

This goes to an observation we made last month, namely that virtually half of the S&P return has been due to a handful of high growth tech, (i.e., no debt) companies. At the same time, the average stock as measured by the equal-weighted performance, has also gone nowhere.

And here is where SocGen may have found something few have considered so far: "many are associating the surge in FAANG performance as a ‘go-for-growth’ play, but in a reality it looks like investors are running scared into cash rich companies."

Lapthorne"s conclusion: "This is not a Trump policy play, this is balance sheet risk."

Lapthorne next highlights an odd discrepancy between equity and debt: the aversion to debt "may seem a little odd given that high yield bond yields are down at historical lows and the appetite for new issuance remains strong. What drives credit is typically a mixture of leverage levels, interest rates, asset prices and asset volatility. Corporate leverage ratios are currently high, despite near record asset prices, and while interest rates are gradually rising, credit spreads on high yield bonds have plummeted. Why? Well asset volatility is very low compared to historical levels, or to put it another way, asset price confidence is high. This, coupled with the continuous clamor for yield, is helping to compress corporate bond spreads. This overconfidence may be misplaced. If equity volatility were to move higher, lower quality bonds could struggle, as firms with poor balance sheets are already in the US equity market."

The chart below plots the relationship between long/short portfolios formed on balance sheet strength (again using Merton) and high yield bond yields. That they have a strong historical relationship is not surprising as both are measures of credit risk, but as such it is interesting when they diverge. For example there are only two instances in which we saw major divergences in the chart below. The first was the original Fed tapering bond sell-off in 2013. The second is today, with equity markets clearly balance sheet risk averse and credit markets seemingly incredibly complacent.

Going back to the core point made by the SocGen strategist, namely that investors are increasingly reluctant to lend to companies that already have a sizable debt load, Lapthorne points out, as one would expect, that where he has seen the greatest aversion to debt is within the smaller cap Russell 2000 index. A long/short balance sheet strength strategy is up 20% this year – the long leg is up 7% and the short leg is off 13%. To confirm this is not all about beta or cyclicality – a long portfolio formed on just price volatility is flat this year while the short leg is off 7%.

To summarise SocGen"s unexpected finding which started by looking at debt incurrence among various "quality" strata of companies and ended up with implications for risk appetite for stocks: the strength of tech stocks (lowest amount of debt) and the Russell 2000 weakness (most debt) this year has nothing to do with Trump and everything to do with interest rate rises and balance sheet concerns.

And one final point from SocGen: "the problem with highly leveraged companies experiencing falling market caps is that it makes things worse, i.e. implied leverage and price volatility both go up!"

We wonder if Janet Yellen and her central bank peers are aware of these findings which have dramatic consequences for the Fed"s treasured "wealth effect", as they set off to not only raise rates but also unwind record balance sheets, in the process exacerbating the divergence between a handful of no/low debt companies and the rest of the public market facing increasingly higher interest rates...

Here Are The 7 Rules Bank Of America Uses To Decide When It Is Time To Sell The Market

With the Trumflation rally fizzling with every passing day, the only question asked by traders is "Is it time to sell the market?" According to Bank of America, the answer, at least for now, is no.

That"s the conclusion of BofA"s chief investment strategist Michael Hartnett who looks at the bank"s 7 favorite, proprietary market-timing indicators, and finds that, at least based on historical patterns, the major selling is not imminent, adding that "we remain bullish risk assets; “3P’s”, Positioning, Profits & Policy, drive our tactical & cyclical views; our latest Rules & Tools piece shows Positioning has become more bullish but not yet dangerously euphoric." He finds that according to his market-timing indicators, the next step is the opposite, and the current rally will end "with one last 10% melt-up in stocks & commodities in 2017."

Here is how Hartnett lays out his "rules" to quantify market fear and greed: 

"Our rules can help identify major inflection points in market cycles. We track a broad array of positioning, sentiment, and flow data that signal when global equities are likely to peak or trough. For example, our Global Breadth Rule measures oversold conditions across global markets, and our Bull & Bear Indicator tracks 18 different indicators of flows and positioning."

Harnett summarizes the 7 rules and indicators he uses as folows (more details below):

• BofAML Bull & Bear Indicator is our broadest measure of investor sentiment; readings range from 0-10; currently at 6.1; indicator still shy of “sell” trigger of 8.0.


• Global FMS Cash Rule measures institutional cash levels as gauge of fear & greed; currently at 5.1% (above “buy” threshold of 4.5%), i.e. indicator in “buy” territory.


• Global FMS Macro Indicator augments our existing Cash Rule with a filter for macro momentum; currently in “buy” territory as macro momentum trending higher past 6 months & cash levels higher past 2 months.


• Global Breadth Rule has flipped from net 89% of equity markets being oversold in Jan’16 (“buy” signal triggered) to net 76% of equity markets being overbought today; breadth rule closest to exuberance.


• Global Flow Trading Rule uses flows to global equity and HY bond funds as contrarian indicator of risk appetite; currently neutral territory (flirted with “sell” signal in Dec’16).


• EM Flow Trading Rule uses flows to EM equity funds as a contrarian indicator of risk appetite; currently neutral.


• BofAML MVP Model is a long/short strategy that selects countries based on the three factors of Momentum, Value & Profits; currently “long” France, Sweden & UK, paired with “shorts” in Brazil, Norway & Singapore.

Harnett notes that BofA"s indicators also give tactical signals when fundamentals are silent, such as within range-bound markets or during periods when economic data paint a conflicted picture. Table 2 offers a quick summary of the latest signals & readings:

Before we dig into the details behind of the 7 indicators, here are the three take home lessons from applying the bank"s timing rules:

1. Structural market changes are more important than ever. Flow and positioning data help identify the impact of new market entrants, newly active participants (e.g. risk parity and quantitative funds), and the increasing prevalence of cross-asset mandates.


2. It’s better to be buying. Our research shows that measuring fear is easier than measuring greed, and that market tops tend to be a process, whereas market bottoms form quickly. As a result, “buy” conditions are often more visible than occasions to “sell short” in our view.


3. It’s okay to assume some normality. Measuring overbought and oversold conditions works best when markets behave in line with history. For example, our meanreverting Global Breadth Rule functions better for trading conditions within one standard deviation than with >2 deviation conditions, e.g. conditions associated with the global financial crisis.

So with that said, here are the details, together with the current reading:

* * *

BofAML Bull & Bear Indicator - Neutral

The rule:

• Sell risk assets when the Bull & Bear Indicator exceeds the “greed” threshold of 8.0.


• Buy risk assets when the Bull & Bear Indicator falls below the “fear” threshold of 2.0.

What is it?

The BofAML Bull & Bear Indicator is a proprietary cross-asset barometer that uses fund flows, positioning data & market technicals to quantify investor sentiment. The indicator is max bullish when it reaches 10 and max bearish when it reaches 0.

Latest signal

BofAML Bull & Bear Indicator climbs to 2.5-year highs (6.1 - Chart 1) as equity/credit market breadth improves & inflows return to EM debt & equity funds. But indicator is still shy of “sell” trigger of 8.0. Last contrarian “buy” signal for risk assets triggered on 6/28/16 when sentiment fell to an “extreme bearish” reading of 2.0. Global equities rallied 8.1% over the subsequent three months.

Components

• Flows: investor risk appetite as indicated by flows to EM equity funds, EM debt funds and high-yield bond funds


• Positioning: investor risk exposure as measured by long-only fund manager cash levels, equity vs bond allocation, cyclical vs defensive sector allocation and futures positioning across fixed income, commodities, FX and equities


• Price action: market technicals implied by global equity market breadth & relative performance of credit to US treasuries

* * *

BofAML Global FMS Cash Rule - Bullish

The rule

• Buy equities when the FMS average cash balance rises to 4.5% or higher


• Sell equities when the FMS average cash balance falls to 3.5% or lower

What is it?

The BofAML Fund Manager Survey (FMS) is a monthly survey of 200-250 primarily long-only investors. One of the key questions in this survey asks for cash balance as % of assets under management.

A low cash balance indicates investors are vulnerable to negative market shocks, while a high cash balance means investors could be under-invested & vulnerable to positive market shocks.

Latest signal

Cash inched higher to 5.1% in Jan’17 from 4.8% last month. Current reading remains elevated vs its 15-year history and overall FMS does not yet show “peak greed”. Rule stays in “buy” territory.

A critical look at the Global FMS Cash Rule

The Global FMS Cash Rule has been a reliable barometer of risk appetite since we first introduced it back in 2011. After a contrarian “buy” signal is triggered, the median return for US equities is 1.0% over the next month, 1.4% over the next two months and 2.9% over the next three months. Likewise, after a contrarian “sell” signal is triggered, the median loss for US equities is -0.5% over next three weeks, -3.5% over next four weeks and -2.6% over next five weeks. In short, the simple “buy” (>4.5%) and “sell” (<3.5%) thresholds have provided us with faithful tactical recommendations over the years.

But cash levels have remained elevated ever since the May’13 “taper tantrum” with cash rarely dipping below 4.5%. As a result, the rule has been in persistent “buy” territory since Nov’13, behaving less like a tactical indicator and more like a cyclical indicator over the past three years.

Over the past few months, we have asked survey participants for reasons why they are holding consistently higher levels of cash in recent quarters.

• On average, 53% simply cited their “bearish views on markets”


• 47% listed either structural factors (regulatory/industry changes, higher derivatives costs & margin requirements) or preference for cash over low-yielding equivalents

We believe that the May’13 “taper tantrum” has awakened investors to the risk that the central bank-induced “long duration/yield” trade is vulnerable to violent unwinds from either a “bond shock” and/or faster-than-expected policy normalization. As a result, investors are holding higher-than-normal cash as an insurance policy even though their inflation expectations are high, capex demand is strong and positioning in cyclical vs defensive sectors is rapidly improving (Chart 5)

In light of the structural/technical factors noted above, we present an alternate rule called the BofAML Global FMS Macro Indicator to complement our analysis on cash.

* * *

BofAML Global FMS Macro Indicator - Bullish

The rule

• Buy global equities when Global FMS Macro is improving and cash level is rising relative to past two months


• Sell global equities when Global FMS Macro is deteriorating and cash level has fallen by at least 50bp relative to past two months

What is it?

The BofAML Fund Manager Survey (FMS) is a monthly survey of 200-250 primarily long-only investors.

The FMS Macro Indicator is a year-on-year measure that comprises five components: investor inflation expectations, capex demand, risk appetite, cyclicals vs defensive^ sector positioning and equity vs bond positioning. ^ cyclicals = industrials, materials & tech; defensive = staples, telcos & utilities

Latest signal

The Global FMS Macro Indicator augments our existing Cash Rule with a filter for macro momentum. It is currently in “buy” territory as FMS Macro has been trending higher for the past 6 months and Jan’17 cash level is higher than it was two months ago. This is a bullish combo for risk assets because investors have been reluctant to deploy cash even though FMS Macro is positive and clearly on the upswing (Chart 6).

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BofAML Global Breadth Rule - Neutral

The rule

• Buy global equities when a net 88% of markets in the MSCI All Country World Index are trading below both their 200-day moving average and 50-day moving average.

What is it?

The BofAML Global Breadth Rule is a contrarian indicator of equity market breadth. When an overwhelming majority of equity markets around the world become oversold, we turn bullish as equities tend to trough and rebound on the back of overdone pessimism.

Latest signal

Our BofAML Global Breadth Rule shows that a net 76% of equity markets are currently trading above both their 200- & 50dma. Market breadth is at 5-month highs and edging closer to exuberance. This is a dramatic flip from Jan’16, when a contrarian “buy” signal was triggered after net 89% of global equity markets had tumbled below their 200- & 50-dma (Chart 9). Back then, global equities declined another 5.5% initially, before rallying back to +3.5% within three months.

The Global Breadth Rule is our favorite indicator for timing market-entry following a sell-off in global equities. As with most tactical trading rules that rely on short-term mean-reverting tendencies of asset markets, it would not work during sell-offs that are >2 standard deviations in nature, i.e. 2008 Global Financial Crisis.

Notwithstanding the Global Financial Crisis, we examined the return distribution of MSCI ACWI at different “buy” thresholds. Chart 10 suggests that the probability of an outsized 3-month return is much higher and the probability of negative return is minimized when at least a net 88% of equity markets are already trading below their 200dma and 50dma.

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BofAML Global Flow Trading Rule – Neutral

The rule

• Sell global equities when average inflows to global equity funds and global HY bond funds exceed 1.0% of AUM over four weeks and ISM is trending lower.


• Buy global equities when average redemptions from global equity funds and global HY bond funds exceed 1.0% of AUM over four weeks and ISM is trending higher.

What is it?

The BofAML Global Flow Trading Rule combines cross-asset flows with a validating filter for macro conditions to generate buy & sell signals for global equities. When flows into global equity & HY bond funds become overly bullish especially against a backdrop of weaker PMI, risk assets become vulnerable to short-term tactical pullbacks and vice versa. Data source: EPFR Global, which tracks institutional & individual investor flows to mutual funds & ETFs domiciled globally with $24 trillion in total assets

Latest signal

Our Global Flow Trading rule is in neutral territory as 4-week inflows to equity funds & HY bond funds = 0.6% of AUM. The rule flirted with a contrarian “sell” signal in mid- Dec’16 as 4-week inflows reached 1.0% of AUM. But ISM and PMIs globally were all trending higher (strengthening) then, allaying concerns over exuberant fund inflows. The trading rule also came very close to a contrarian “buy” signal for global equities in Jun’16 when 4-week outflows reached 0.9% of AUM (Chart 11).

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BofAML EM Flow Trading Rule – Neutral

The rule

• Sell EM equities when inflows into EM equity funds represent more than 1.5% of AUM over four weeks.


• Buy EM equities when redemptions from EM equity funds are greater than 3.0% of AUM over four weeks.

What is it?

On a weekly basis we analyze data on total flows into and out of EM long-only funds and ETFs. Flows tend to coincide with (rather than lead) performance and are therefore well-suited for use as a contrarian indicator. When investor flows into EM funds become overly bullish, EM equities become vulnerable to short-term tactical pull-backs and vice versa. Data source: EPFR Global, which tracks institutional & individual investor flows to mutual funds & ETFs domiciled globally with $24 trillion in total assets.

Latest signal

Our EM flow trading rule is also in neutral territory as 4-week inflows = 0.3% of AUM. It last triggered a “buy” signal for EM equities on 9/3/15 when 4-week outflows reached 3.0% of AUM (Chart 12). MSCI EM fell another 2.5% initially, before rallying 5.6% on an 8-week basis.

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BofAML EM Flow Trading Rule – Neutral

The rule

• Sell EM equities when inflows into EM equity funds represent more than 1.5% of AUM over four weeks.


• Buy EM equities when redemptions from EM equity funds are greater than 3.0% of AUM over four weeks.

What is it?

On a weekly basis we analyze data on total flows into and out of EM long-only funds and ETFs. Flows tend to coincide with (rather than lead) performance and are therefore well-suited for use as a contrarian indicator. When investor flows into EM funds become overly bullish, EM equities become vulnerable to short-term tactical pull-backs and vice versa. Data source: EPFR Global, which tracks institutional & individual investor flows to mutual funds & ETFs domiciled globally with $24 trillion in total assets.

Latest signal

Our EM flow trading rule is also in neutral territory as 4-week inflows = 0.3% of AUM. It last triggered a “buy” signal for EM equities on 9/3/15 when 4-week outflows reached 3.0% of AUM (Chart 12). MSCI EM fell another 2.5% initially, before rallying 5.6% on an 8-week basis.

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BofAML MVP Model

The model

Our new long/short BofAML MVP model selects equity markets based on the three factors of Momentum, Value & Profits (Chart 14). We believe a long/short strategy targeting minimal market risk (beta), lower drawdowns & higher risk-adjusted returns can outperform in a world of low expected returns. For more details on backtest results & methodology, please see link for the launch report.

Latest signal

On a 1-month basis, our BofAML MVP model recommends going “long” an equalweighted equity basket of France, Sweden & UK paired with “shorts” in Brazil, Norway & Singapore.

Model framework

Universe

Our model is based on a 16-country universe comprising MSCI US, Canada, Germany, France, Italy, Spain, Netherlands, Switzerland, Sweden, UK, Norway, Brazil, China, Australia, Japan and Singapore. The 16 countries are chosen based on data availability.

Factors

• Value is represented by price-to-book value from MSCI. Book value is lagged by a month to ensure data availability and the most recent month-end market values are used to compute the ratios.


• Momentum is measured via country flows, a derived dataset from EPFR Global that estimates the overall money flow into different countries by multiplying the net flows for a given fund by the fund’s country allocation. The process is repeated across all funds with relevant investment mandates and then aggregated into a final number. Country flows are lagged by a month due to data availability.


• Profits are proxied by Purchasing Managers’ Indices (PMI) from Markit Group & the ISM, both of whom track sentiment among purchasing managers at manufacturing firms. The index is based on five major indicators: new orders, inventories, production, supply deliveries and employment environment. PMI data are lagged by a month to ensure data availability.

Momentum x Value x Profits

It is well-documented1 that “Factor Investing” – namely, Value, Growth, Size & Momentum – can capture risk premia and outperform the broad market over long periods. But less appreciated is the cyclicality of factor returns to different phases of the business cycle. It is therefore unreasonable to expect a single factor (say high bookto- market ratio) to generate persistent excess returns across the business cycle. We focus on the synergy that exists between Value and Momentum, whose negative correlation with each other acts as a natural buffer against “value-traps” and abrupt “mean-reversions.”

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And two extra bonus long-term market timing signal:

BofAML Global Financial Stress Index

What is it?

The BofA Merrill Lynch Global Financial Stress Index (BofAML GFSI™) and its constituent indices are designed to be a comprehensive measure of financial stress, covering: 1. cross-asset risk measures of volatility, solvency and liquidity (the Risk Index); 2. hedging demand implied by equity and currency option skew (the Skew Index); and 3. investor risk appetite gauged by trading volumes and flows into equities and high yield bonds and out of money markets (the Flow Index). The GFSI and its 11 sub-indices can be followed daily on Bloomberg using the code: GFSI<GO>.

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Sell Side Indicator – Neutral

The rule

• Bullish signal: when Wall St is bearish…Sell Side Indicator >1? below the mean


• Bearish signal: when Wall St is bullish…Sell Side Indicator >1? above the mean


• Index target: the indicator can be used to predict +12-month S&P 500 total returns and is one of five input models used by our US Strategy team for their S&P 500 target

What is it?

Our US Equity & Quant Strategist Savita Subramanian’s Sell Side Indicator is based on a survey of Wall Street Strategists that submit asset allocation recommendations to us and/or Bloomberg. The indicator shows the average recommended equity weighting in a balanced fund. A contrarian Buy (Sell) signal is triggered when the indicator is more than 1 standard deviation below (above) its mean on a rolling 15-year basis.

Latest signal… equity sentiment was unchanged in January

In January, the Sell Side Indicator is unchanged at 52.8, staying in “Neutral” territory for a second consecutive month. This follows the biggest two-month increase in optimism since 2013. While sentiment has improved significantly off of the 2012 bottom — when this indicator reached an all-time low of 43.9 — today’s sentiment levels are still below last summer’s high of 54.0 and where they were at the market lows of March 2009. The recent inflection from skepticism to optimism could be the first step toward the market euphoria that we typically see at the end of bull markets and that has been  glaringly absent so far in the cycle.

Carlson Capital: Border Adjustment Tax Would Lead To "Global Depression"

In their latest quarterly letter, Carlson Capital"s Black Diamond Thematic Fund (which was up 9.27% in Q4 and up net 19% in 2016) portfolio managers Richard Maraviglia and Matt Barkoff, who unlike Carl Icahn, Stanley Druckenmiller, Dan Loeb and most of the market, turned rather bearish weeks into the Trump victory, warn that “we may be looking at the grisly spectacle of stagflation”, echoing ongoing warnings from virtually all major banks that the market is wildly overpriced:

If the economy slows down against expectations it will have little effect on the upward direction of inflation. The rationale of inflation was cost-push and supply side constraints not demand side stimulus. Thus, we may be looking at the grisly spectacle of stagflation with the equity market on the highest cyclically adjusted valuations ever.

The two PMs are especially concerned about an imminent stagflationary episode, coupled with a concurrent recession, for the following reasons:

"Based on rising commodity prices and the more than one hundred percent year-on-year increase in crude oil, also an (OPEC) supply issue, we expect inflation to rise quite sharply perhaps as high as five percent over the next year. Anytime over the last thirty years that oil has risen one hundred percent year-on-year and long end interest rates are up one hundred percent year-on-year with a strong dollar, the US economy has slowed down often into recession. It squeezes consumer real purchasing power, slows real consumer spending at a time when export growth could slow given uncertainty over new, undecided policies and a less competitive currency. This is a global phenomenon; Japan has an extremely low unemployment rate too. The Eurozone and UK CPIs are destined to accelerate also."

Needless to say the fund is bearish, and here is the reason why in its own words:

Politics and history feature heavily in our thinking as we begin the year. We see a variety of factors that could cause macro deceleration just at the moment when investors have been dragged kicking and screaming into cyclical positioning, a place in which they are not truly comfortable. We further see much more dramatic risk from China. The combination offers attractive optionality to defensive positioning that is now under owned and attractively priced. As it relates to the Trump rally, we could argue that there were several drivers. The first was seasonality into year end. The second was the enforced bond-equity rotation which we suspect could be over in the short term. Third, fourth and fifth would be policy themes: corporate tax reform, infrastructure spending and broad deregulation. It was notable that in his first press conference there was no mention of any of these but rather unprompted criticism of the pharmaceutical industry.

Setting aside intra-market rotations, we note that hedge funds are really long the market right now. Recent CFTC data showed large US futures buying by hedge funds. Net futures positioning is now above the 80th percentile. Recent prime brokerage data showed net leverage +6.5 percent above the trailing twelve month average and is now close to a twelve month high.

In short, euphoria: "Sentiment is bullish; inflation is deemed to be a good thing despite the points we have made here. The Merrill Lynch Survey shows that we are in the euphoria stage:"

As it remains a constant topic du jour the hedge fund also touched on China, saying "monetary policy is tightening as interest rates in China have risen by almost one hundred basis points since the US election. Rising interest rates have caused a slowdown in corporate bond issuance. We would expect that Chinese New Year starting on January 27th will cause a further spike in rates.

Due to the pressure that rising interest rates will have on GDP given China’s leverage will reach three times GDP by 2018.

Thus, if China remains committed to a stable currency, it means tighter economic policy and downside to data now that government fixed-asset investment has begun to fall back to pre-February 2016 stimulus levels. The simplest way to observe this is through Shanghai house prices, which have just turned negative.

Carlson also has some thoughts on the current rate hiking cycle, which it views as further justifying the fund"s bearish posture:

Prior letters have been focused on the Fed and the implications of the rate hike cycle. These implications have not gone away, but have perhaps been forgotten and the path will be difficult to reverse. Regardless of current opinion, the truth is that tightening cycles almost always cause multiple contractions. The only exception was a six month period at the beginning of the chart below in 1987…

Next, some market observations: "we note that the market is rising on ever-decreasing breadth. In the second week of January when the averages made new highs, only 3.5 percent of securities closed at a fifty-two-week high. This was one of the smallest readings in decades. The average over one hundred years is almost fifty percent. The last two times breadth was this weak was in July 1999 and March 24, 2000."

Unlike Horseman, which suffered a big drop in the last two months of 2016, Carlson is boasting with a nearly 19% return for 2016 despite "a short beta position of 34.5%."

The fund remains short. We produced a return of 18.95 percent net of all fees in 2016 despite averaging a short beta position of 34.5 percent on average throughout the year by capturing important rotations based on our macro analysis. This amounted to a 3.34 Sharpe ratio for the fourth quarter and 1.64 for the year. We see more of these alpha transitions to come going forward but expect that we can also capture beta at some point in the first quarter of 2017. Volatility is here to stay and we also expect to be somewhat volatile and accept it as a cost of doing business and will attempt to control risk as much as possible while expressing our views.

Finally, and as the title suggests, the biggest risk according to Carlson"s PM is the US trade deficit, and specifically how the proposed Border Adjustment Mechanism would impact both the global economy and stocks:

We cannot overstate the impact of a declining US trade deficit and this is why we spent a large part of the letter discussing it. If the border adjustment mechanism is implemented as proposed we think it will cause a global depression and a major equity market decline. It is still unclear whether it will happen but at the very least we expect that US trade policy will put downward pressure on global growth. When this becomes apparent commodities will correct meaningfully and we will reinvest in inflation beneficiaries. Until then we are short cyclicality with what we assess to be tremendous risk-reward optionality through semiconductors, industrials and miners.

Full letter below: