Finlight Research - Market Perspectives - Dec 2014

Market Perspectives

December 2014

Dec. 4th, 2014

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Time for a Santa Claus Rally?

You've got to know when to hold 'emKnow when to fold 'em

Know when to walk away

And know when to run

You never count your money

When you're sittin' at the table

There'll be time enough for countin'

When the dealin's done.

-Kenny Rogers, "The Gambler"

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FinLight Research | www.finlightresearch.com

This is a big, big gamble to be manipulating the most important price in free markets, interest rates. These

purchases are canceling market signals. The bond

market and the stock market have provided wonderful

signals for many years as to potential problems. And

when you cancel those signals, you could run into a

problem. I dont know when its going to end, but my

guess is its going to end very badly.

Stanley Druckenmiller

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Executive Summary: Global Asset Allocation

We are heading towards another year of massive liquidity boost to the

financial system.

Economy is reiterating the same message of modest growth. But stocks

continue to rally thanks to the current environment of unprecedented

monetary stimulus across the globe.

U.S. economic activity is gradually improving, supported by a better job

growth, improving private sector demand and higher government spending.

Japanese growth momentum is faltering. Europe is nowhere with high

unemployment, and deflation worries.

Nevertheless, we are struck by how extreme optimism appears in

investors sentiment surveys, relative to history.

According to most measures, broad equity indices trade at valuation

above average levels, especially in the US

But expansionary monetary policies, low interest rates and abundant liquidity

are still keeping us from moving to an underweight on equities. We

remain neutral on global equities and think earnings growth should be the

only driver of markets from here.

And contrary to the common belief, lower oil is not necessarily bullish..

We remain underweight government bonds and corporate credit overall

(but with an intra-asset class preference for IG vs HY, and Eurozone non-

financials IG vs US IG), and Overweight US dollar (supported by divergence

Fed policy from that of the ECB and BOJ).

We summarize our views as follows

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MACRO VIEW

The Good US 3Q GDP was surprisingly revised higher to 3.9%. Strong ISM manufacturing (58.7) and services (59.3) survey The easy-money central bank cartel has a new member: The Peoples Bank of China has

finally joined the easy monetary policy bandwagon, by announcing a surprising rate cut. Lower oil prices is positive for consumers and growth (especially in the Eurozone)

The Bad Japan has entered its fourth recession since 2008, with year-over-year real GDP down to -1.2%

and two consecutive quarters of negative growth. Personal income, personal spending and consumer confidence have disappointingly missed

expectations Total pending home sales seem to be lethargic Lower oil prices threaten (and increase bankruptcies in) US shale plays

The Ugly Main systemic risk resides in China : Chinas economy is supported by approximately six

trillion dollars of 'shadow debt', which may eventually create major systemic issues. Last surprise easing by the Peoples Bank of China is adding to our cautious view on the Chinese economy.

We are building a boom-bust economy that is increasingly dependent on central bankers inflating policies. The end game is clear even if the timing is anything but.

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The Big Four Economic Indicators

The overall picture had been one of slow recovery, but there is no indication of a recession using the indicators monitored by the NBER.

At -0.11%, Industrial Production for Oct. 14 was disappointing again Real Personal Income less Transfer Receipts rose 0.23% and is now increasing at 2.30% YoY


Durable Goods New Orders

Durable goods new orders came in at 0.4% in October. However, we exclude both transportation and defense, the number was down -2.5% MoM (but still up 5.2% YoY)

The gap between the S&P500 and the Durable Goods New Orders is getting larger.


Wage Growth

Stagnation in real wages is one of the main features of the ongoing recovery.

The growth of inflation-adjusted wages from the start of the current recovery is the weakest in history.

Low wages are clearly weighing on personal income


PMI Data

Markit Eurozone 'Flash' PMI data points to a slowing in economic growth to its lowest level over the past 14 months. Recession is becoming a real threat to the Eurozone.

November's US 'flash' PMI also shows the slowest rise in US business activity since April. We expect a lower GDP growth over Q4-014.

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Crisis Long-Term Effect

According to researchers from theFed, 2008 recession was severeenough to leave permanenteconomic scars.

The trend of real GDP has suffereda significant drop.

The US, UK and Euro appear to beslowing down again since thecrisis, despite continual QE.

The most worrying chart remainsthat for the Euro area.

Source: Federal Reserve paper Potential Output and Recessions: Are We Fooling

Ourselves?

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GS Global Leading Indicator (GLI)

GLI is back into Contractionphase, defined by positive butdecreasing momentum

6 of the 10 underlying componentsof the GLI worsened in November

Weve been thinking for a whilethat the current accelerationremains quite modest for atypical expansion phase.Available data is more indicative ofa stable macro environment ratherthan one with a growth pulse.

More data are still needed toconfirm our fears about the currenteconomic situation.

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US Real Estate Price Trends

Both US real estate indices (Case-Shiller Composite 20 Index in theupper chart and FHFA HousingPrice Index in the lower chart) arestill in uptrend mode, but theirgrowth is clearly slowing.

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Chinese Economy

Chinese manufacturing has been wavering in andout of contraction over the last 3 years

According to the HSBC/Markit flash data, Chinamanufacturing PMI and output are now back incontraction:

Flash China Manufacturing PMI at 50.0 inNovember (50.4 in October). Six-month low.

Flash China Manufacturing Output Index at 49.5in November (50.7 in October ). Seven-month low

On Nov. 21st, Peoples Bank of China decided to jointhe easy monetary policy bandwagon, by announcing asurprising rate cut.

Source: HSBC Markit

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EQUITY

At these levels, the stock market is clearly not the economy!

End of November, weve seen another central bank-driven rally fueled by the surprise easing by China and the positive commentary from Draghi . But, defensive sectors, Small Caps, Treasury yields, high yield are still not confirming the excitement in equity indices

At current valuation levels, the risk-return profile for equities appears less attractive and should imply some cautious. Rationally, the upside on stocks is exhausted by a limited multiple expansion and margins being at peak levels. But the current environment of unprecedented monetary stimulus across the globe is making rationality irrational.

We are also struck by how extreme optimism appears in investors sentiment surveys.

We are still puzzled by the incredibly high correlation between Treasuries and the S&P 500, mainly explained by the belief that lower rates are good for stocks. We should keep in mind that lower rates could also be a translation of faltering growth and lower inflation expectations. And this is hardly good for equities.

Thus, we remain Neutral equities. At this stage, expansionary monetary policies, low interest rates and abundant liquidity are keeping us from moving to an underweight on equities. Even bad news for the economy (in Europe, Japan and China) appear as good news for stocks, as they allow for further stimulus.

We think it is wise to incrementally "de-risk" your portfolios by focusing on higher quality / more defensive / more favorably priced companies.

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EQUITY

Assessing the effects on growth of the lower oil prices is more tricky than most people think. Lower oil is not necessarily bullish. If the collapse in crude were bullish, we should see small-caps outperforming large-caps. Is that the case?

No doubt, the sharp decline in oil prices will give a strong boost to consumers (especially in the US). BUT, even we forget about all the state budgets that rely on a minimum level of crude, it creates bankruptcies in shale plays, killing growth from that sector, increasing instability in connected sectors and increasing global risk aversion. It also intensify the disinflationary pressure in the eurozone.

Bottom line : We remain Neutral for the moment. We will revise our view to OW after a clean break of the 2075-

2100 range (threshold moved 35pts up because of BoC surprise easing) on the S&P500, and to UW below the trend from Nov. 12 lows

We move from UW to Neutral on Europe vs. US, as ECB eases further. We look for the ECB to introduce purchases of corporate bonds in Jan. 14 and sovereign bonds in Q2-2014.

We remain OW on Japan (always on an FX hedged basis) on the back of an aggressive BoJintervention, a weaker yen and good earnings growth.

We remain UW in US small caps vs large caps

The coming rate hikes (probably in Q2-2015) will depress all asset prices for at least part of next year, in our view

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Earnings

The blended earnings growth rate for Q3 2014 is 8%, up from 7.3% last month

Of the 495 companies that have reported earnings to Nov. 28th, for Q3 2014, 77% have reported earnings above the mean estimate and 59% have reported sales above the mean estimate.

Of the 95 companies that have issued EPS guidance for the Q4. 76 (or 80%) have issued negative EPS guidance

Analysts are still cutting earnings estimates for future quarters

Q4 earnings are currently projected to grow at 4.2%, which seems quite low for this early in the estimate game,

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Earnings

According to Thomson Reuters, the forward 4 quarter earnings estimate for the S&P 500 stands at $126.15 (down from previous week: $126.48)

S&P 500 trades around 16.1x its forward earnings. This is historically a high P/E multiple. S&P 500 may rise to 2100 over the next 12 months, but P/E expansion phase seems over (but

we do not exclude a pick around 17x) We expect S&P500 P/E multiple to start contracting, probably with Fed hikes in Q2 or Q3-2015

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Profit Margins

S&P 500 net profit margins have expanded to 9%, mainly driven by the IT sector (with its 17% margin)

Current net profit margin are at record historical levels.

From here we expect profit margins to stabilize before contracting, when consensus expects expansion to 9.8% in 2015.

IT sector should remain a key driver of S&P 500 net profit margins over a 12 month horizon.

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QE and Equities

QE has been pushing stockshigher

Wealth creation throughrising equity share priceswas one of the mainpurposes of Fed balancesheet expansion.

Ben Bernanke was rightwhen he said Theproblem with QE is that itworks in practice, but itdoesnt work in theory.

Relative to the U.S. andJapan, the European equitymarket is a rally waiting forignition.

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Investors Sentiment

Different sentiment indicators show that investors across the board are extremely optimisticabout U.S. equities.

Advisory sentiment (IIS Index) shows 43% gap between bulls and bears (96th percentile). Individualinvestors sentiment (AAII index) is at its 90th percentile. Active investment managers (NAAIM) arereporting high exposures to equities (92nd percentile).

On average, such an extreme sentiment points to flat returns on over the following 12 months

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S&P500 A Long-Term Perspective

We watch 4 long-term indicators : 2 P/E ratios and Q Ratio through their deviation to their arithmeticmeans and the inflation-adjusted S&P Composite deviation to its exponential trend.

Based on the average of these indicators, the market looks 80% overvalued (the highest level outside theTech Bubble, up from last months 70% overvaluation), suggesting a cautious long-term outlook

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S&P 500 A Long-Term Perspective

S&P 500 CAPE ratio points to a forward 10-year total return around 5% p.a.

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S&P 500 A Short-Term Perspective

All exhaustion patterns have been ignored to date.

Technically, the S&P500 seems to be forming a mega-phone pattern

At this stage, we favor a top formation within the 2075-2100 range

Our view will prove wrong if the uptrend going through the highs since mid-2013 (~2100) is clearly broken.

A similar pattern is forming on the Dow.

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Eurostoxx 50: A Short-term Perspective

Since April 14, the Eurostoxx 50 has consolidated below 3248.

The main levels to watch are 3248 3300-3325 (April highs)

Breaching these levels up would drive the spot to 3600 (downtrend from March 2000)

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US Stocks vs Global Peers

U.S. stocks have outperformed their global DM peers by more than 60% over the past 5 years.

Does that mean that the U.S. economy is going to decouple from the rest of the world ?

From our point of view, decoupling is an unrealistic hypothesis in the global economy we live in Expect re-convergence (one way or the other)

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US Stocks vs Govies

We are still puzzled by the incredibly high correlation between Treasuries and the S&P 500, mainly explained by the belief that lower rates are good for stocks.

It looks like weve switched to a new regime at the end of 2013.

We should keep in mind that lower rates could also be a translation of faltering growth and lower inflation expectations. And this is hardly good for equities

Source: Danske Bank & Macrobond Financial. G3 = US, Germany, Japan

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US Stocks vs High Yield Credit

Divergence between US stocks and US High Yield is getting wider. The HY yield is ticking higher like it did before June-July and the Sept-Oct pullbacks.

Risk-seeking behavior is clearly less visible in HY than in equities. This is puzzling given the global bullish sentiment. Should us take it as a warning signal?

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Trading Model S&P500

Our prop. Short-Term trading model went modestly short on Oct. 24h at 1964.58 on the index, and reduced its position just above 2050

The model is still modestly short and targets 2062-2042-1962 on the downside and may review its position at 2082 and 2103.

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FIXED INCOME & CREDIT

Nothing new compared to our previous reports. We still look for the bear market on USTs to resume.

Weve been UW on 10y-UST for a while now, expecting 10-year yields to reach 2.90%-3.20% over next months, because of sustained US growth, increasing US inflation. As said in previous reports, only a material weekly/monthly close below the 2.40-2.30 range could make us change our mind.

Since end of Sep. 14, weve been questioning our underweight positioning, as U.S. 10-year yields was ticking below the 2.40-2.30 range. Weve decided to move to Neutral each time the 10y yield goes below 2.25. We actually did that for a few days around Nov. 28th. But we moved UW since Dec. 2nd.

Falling inflation expectations and disappointing growth largely explain the level of Eurozone yields. We expect the coming ECB QE in government bonds to keep German bond yields at very low levels.

While we are neutral on German yields, we think US yields are too low for the current growth and inflation outlook.

We have been OW Eurozone vs. US and UK for a long time now. We are aware that the ECB is probably planning to buy government bonds during 2015. But given the record levels reached by yield gap between Treasuries and Bunds, we prefer to change our position to Neutral.

We expect the Fed to start tightening from Q2-2015 and will hike rates more than is currently priced in: The markets are still only pricing in about one hike from the Fed next year. Based on Feds speech, we expect 3 or 4 hikes instead. Thus, the re-pricing of Fed expectations is likely to take place very soon in the short end of the curve.


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FIXED INCOME & CREDIT

While US yields in the short end are expected to go higher, the medium to long end of the curve will be supported by abundant liquidity. We expect a significant flattening of the US yield curve.

High Yield has fared poorly relative to most other areas of the investable landscape. We see investors moving up the quality spectrum, selling high yield bonds and growth sectors and getting into investment grade bonds, govies and defensive sectors. This is probably a sign we are moving into the final stage of the bull market and economic expansion

The ECB is probably planning to buy corporate bonds directly, but even if not, its purchases of asset-backed securities and covered bonds may lead to investors adjusting portfolios towards this asset class

We remain UW on corporate credit, due to valuation, to position within the credit cycle, to the expected rise in government bond yields and given the weak total return forecast

Within the credit pocket, we now prefer Eurozone corporates (especially IG and non-financials) to US corps, because of the coming ECB massive QE

We continue to prefer IG over HY on a risk-adjusted basis as we expect higher volatility on spreads

We remain OW on HICP breakevens (through forward 1yx1y for example) given the potential for a sovereign bond QE

Bottom line : Still UW Govies, Neutral Eurozone vs. US Govies, Long flatteners on the US yield curve, UW credit, OW Eurozone credit vs US credit, Neutral TIPS and OW HICP Inflation, UW High Yield vs High Grade, Neutral on EM corporates


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10y US Treasury Yields

Government bonds have continued to fool all of us, as inflation slumped below predictions But, like many others, we still expect higher interest rates over a 12 month horizon.


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10y US Treasury Yields

For the last 3 months, weve been questioning our underweight positioning, as we saw U.S. 10-year yields ticking below the 2.40-2.30 range. As explained in a previous report, we decided to move to Neutral each time the spot goes below 2.25.

We still think that the structural channel that has been in place since the late-80s will be broken to the upside over the next few months.

We will feel more comfortable with our UW position if the 10y UST yield goes above the important resistance at 2.35 and 2.47.

The risk is that the 10-year yield eases to 2.13%, and possibly to 2.06% in the period ahead


Source: CQG

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Treasuries vs Bunds

The yield gap between Treasuries and Bunds is at record levels, as the 10y Bund yield hit a record low of just 70bp

We decide to switch from OW to Neutral on Bund vs. USTs


Source: Goldman Sachs

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US Credit

The spread widening on US High-Yield is still underway. Its now drive by the fear of more defaults in the energy sector (US HY carry a big exposure to that sector) after the sharp drop in oil prices.

As expected US High-Hield has continued to underperform US Investment-Grade


Spread between US HY and US IG

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US Credit

The US HY underperformance since end of Oct. was mainly due to the energy sector. In the US, energy (mainly shale oil & gas) represents 15-20% of HY benchmarks.

According to a GS analysis, the cumulative 3y energy default rate may reach 8% if the WTI stays below $75/Brl and even 25% if the barrel stays below $65.


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Eurozone Credit

ECB has already started buying ABS and covered bonds.

ECB seems to be considering buying : sovereign bonds, but how to do that legally? corporate bonds directly, but how to manage the underlying

valuation and risk issues? At this stage, weve seen nothing about the Bundesbank point of

view.

Anyway, the market seems to have started to speculate that corporate bonds would be included into the ECB purchase program

We now prefer Eurozone corporates (especially IG and non-financials, as financials will be hardly included in such a purchase program) to US corps, because of the speculation about the coming ECB massive QE

Our strategy will be buy the rumor, sell the news. I will get out as soon as the information becomes official.


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EXCHANGE RATES

Policy divergence between the US on one hand, and Japan and the Eurozone on the other, should create an environment supportive of the dollar

We continue to expect the USD to strengthen against the major crosses, especially EUR and JPY

Things are going very fast. Our targets on EUR-USD and USD-JPY have been already reached. On both pivots, a short-term consolidation is getting more plausible, but without changing anything to our

bullish views on USD Additionally, the expected EUR1tn balance sheet expansion of the ECB should lower euro ~10%!

The US Dollar Index (DXY) continues to consolidate just below 88.70, and may enter a corrective phase bringing it to 84.80

The EUR-USD underlying structure still looks very negative. Our ST target of 1.24 was finally reached. The break of this pivot will open the door to 1.21-1.20. Thus, we remain UW EUR-USD as long as the pivot stays below 1.25 and move Neutral above to play the correction towards 1.30

BoJ intervention has weighed (more than expected) on JPY. Our target of 112.40 was reached. We are now very close to our following (medium-term) target of 119.30. We remain OW as far as the pivot stays above 116. We still target 124-125 over the medium-term

Being OW USD-JPY is a good manner to gain exposure to the lack of economic direction in Japan till the coming lower house election.


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EUR-USD

Our ST target of 1.24 was finally reached.

EUR-USD has some difficulty to go through 1.2395.

The break of this pivot will open the door to 1.21.But A correction phase is becoming plausible.

We remain UW EUR-USD as long as the pivot stays below 1.25 and move Neutral above to play the correction towards 1.30

Our long-term view remains biased towards a strengthening of USD (target ~ 1.10 then parity)


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USD-JPY

Things are going very fast. Our target of 112.40 was reached. We are now very close to our following (medium-term) target of 119.30.

The resistance around 119.30 may hold for a moment and a consolidation towards 117-116 seems possible .

But we are biased towards the view that the USDJPY will break out of the 119.30 threshold before the coming election (mid December).

A clean break of this resistance will push the pivot to our medium-term target of 124-125.


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COMMODITY

Over November, the biggest development has been a breakdown in oil prices and a sharp drop in precious metals

A strong USD is also a big headwind to commodities We continue, however, to like owning the GSCI index, and to think that commodities hold value as

cross-asset portfolio diversifiers.

We remain OW commodities but with a dispersion in views across the different sectors. At this stage, individual fundamentals matter a lot!

We continue to favor commodity futures with steep backwardation (for positive carry). Unfortunately, roll returns have turned negative as many commodity curves have already moved into contango.

Bottom Line :

Demand for base metals globally eased significantly in 2H2014 and has not yet recovered. We remain Neutral on base metals (we prefer Aluminium, Zinc and Nickel to Copper), as US Dollar strength and the Chinese slowdown is weighing on prices, and because of weaknesses in construction / housing sectors in major economies (mainly affecting Copper and Nickel).


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COMMODITY

We anticipate that agriculture prices will revert to 2009 levels. We remain UW on agriculture (except on cocoa), as we think supply will continue to grow relative to demand

Precious metals are suffering from a stronger dollar and higher US rate rise expectations Our target on gold (1170-1150) was reached. We will move Neutral on gold below 1150 and switch

progressively to OW (accumulate) as the spot slides down towards 1000-980, which is probably the final leg down.

Our first target on silver (~17) has been reached. The spot has been very close to our second target at 14.70. We still think that Silver is probably ready for its final leg down towards 12.50. At current levels, we move Neutral but, like for gold, we will switch progressively to OW (accumulate) as the spot breaks the first material resistance around 14.70 and slides down towards 12.50

Weve decided to keep our OW bias on energy as long as the $80 support zone is not clearly broken by the WTI. But it was. Weve stopped our losses and moved to Neutral, waiting for a clean break above $80 to switch back to OW. We will move UW if the 59.5-60 band is breached down. Is the OPEC going (early next year) to decide to stop the bleeding?


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Commodity Indices Performance

In total return terms, commodityindices are roughly back on theirlevels in Dec. 08

We switched from UW to OW oncommodities in early H2-2014. Itwas hardly a brilliant decision!

The poor performance of the assetclass since Jul. 14 is mainly due tothe energy pocket and to the USDrally.

We keep our OW stance as we see the drop inoil prices as overdone

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Crude Oil - WTI

We were right on the big level wementioned in our previous report:74.95-73.75.

Breaking this level down willdrive the spot to 64.25, the spikelow from 2010. Below there, the$59.50-$60.00 band should slowthe descent.

However, given the speed of thedescent, we favor a correctivebounce from 64.25, back to 73-75.

We remain Neutral, waiting for a clean break above $80 to become OW.

We will move UW if the 59.5-60 band is breached down.

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Crude Oil - WTI

oil was still up as much as 40% as recently as this past summer. The decline in the oil price overthe last few months has certainly closed this performance gap in a hurry. Oil is simply catchingdown.

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Gold

Our first target on gold (1170-1150) was reached.

We keep the view expressed inour last report

Current levels should bewatched closely as we canwitness a powerful break below1170-1150 towards 1000-980. Inthat case silver will drop to 12.50

We move Neutral on goldbelow 1150 and switchprogressively to OW(accumulate) as the spotslides down towards 1000-980

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ALTERNATIVE STRATEGIES

Within the hedge fund complex, weve been OW Equity Market Neutral, CTA, Global Macro and VolArb.

Global macro and trend following strategies were the best-performing hedge fund subsets in November. The HFRX Macro/CTA index was up 1.7% for November, when the broader HFRX Global Hedge Fund index gained 0.3%

Global Macro continues to post losses on (reduced but still) short Fixed Income positions in the US. These losses were offset by long positions in Eurozone FI and US dollar

CTAs are firing on all cylinders! CTAs generated money on short commodity exposure (especially in energy), long positioning on equity, fixed income and US dollar.

We maintain our previous positioning: While preferring risk diversifiers to return enhancers, on a risk-adjusted basis, we keep our OW on: Equity Market Neutrals both for their intelligent beta and their alpha contribution CTAs and Global Macro as a diversifier and tail hedge. Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all regions). This strategy

has shown a great ability in terms of protecting capital during adverse periods, and a volatility that compares favorably with the hedge fund industry.


Bottom Line: Global Asset Allocation

It looks like we are heading towards another year of massive liquidity boost to

the financial system.

Economy is reiterating the same message of modest growth. But stocks

continue to rally thanks to the current environment of unprecedented

monetary stimulus across the globe.

U.S. economic activity is gradually improving, supported by a better job

growth, improving private sector demand and higher government spending.

Japanese growth momentum is faltering. Europe is nowhere with high

unemployment, and deflation worries.

Nevertheless, we are struck by how extreme optimism appears in

investors sentiment surveys, relative to history.

According to most measures, broad equity indices trade at valuation

above average levels, especially in the US

But expansionary monetary policies, low interest rates and abundant liquidity

are still keeping us from moving to an underweight on equities. We

remain neutral on global equities and think earnings growth should be the

only driver of markets from here.

And contrary to the common belief, lower oil is not necessarily bullish..

We remain underweight government bonds and corporate credit overall

(but with an intra-asset class preference for IG vs HY, and Eurozone non-

financials IG vs US IG), and Overweight US dollar (supported by divergence

Fed policy from that of the ECB and BOJ).

We summarize our views as follows

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Disclaimer


This writing is for informational purposes only and does not constitute an

offer to sell, a solicitation to buy, or a recommendation regarding any

securities transaction, or as an offer to provide advisory or other services

by FinLight Research in any jurisdiction in which such offer, solicitation,

purchase or sale would be unlawful under the securities laws of such

jurisdiction. The information contained in this writing should not be

construed as financial or investment advice on any subject matter.

FinLight Research expressly disclaims all liability in respect to actions

taken based on any or all of the information on this writing.

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Finlight Research - Market Perspectives - Dec 2014

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Transcript of Finlight Research - Market Perspectives - Dec 2014