Finlight Research - Market Perspectives - Oct 2014

Market Perspectives

October 2014

Oct. 10th, 2014

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Un is not evil because he’s not Hitler […] It doesn’t have to match 1999 in order to be

madness.”

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Executive Summary: Global Asset Allocation

� The stock market is off its peak and bond yields are extremely

low, and the economy seems to be going nowhere.

� Global economic issues is the focus, and the general tone is

negative. But expansionary monetary policies, low interest rates

and abundant liquidity are keeping us from moving to an

underweight on equities

� Growth in Europe is at a great risk. Germany, which is its

economic engine, is showing increasing signs of weakness. The

odds for a triple-dip recession are still heading up.

� China’s trend growth rate has fallen and there are downside

risks from the property and financial sectors

� Like others, we ask whether major moves in bonds, inflation,

oil, and small caps (vs large caps) are canaries in the

coalmine that signal a reversal

� We remain neutral on global equities and think earnings growth

should be the only driver of markets from here. We remain

overweight commodities (but with a dispersion in views across

the sectors as individual fundamentals matter) and underweight

credit and government bonds.

� We summarize our views as follows�

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MACRO VIEW

� The Good

� Despite the lack of wage growth, jobless claims remain strong. They stand near a 14 year low. The unemployment rate fell below 6.0% for the first time since 2008

� ISM report is very positive and may points to GDP gains exceeding 4%.� There were signs of stabilization in China’s economy in September after fading momentum in

August

� The Bad

� Home prices edged lower according to the Case-Shiller index. Real prices and price-to-rent ratio have declined in July.

� Growth in Europe remains at risk of a return to recession in the near term. Eurozone economic data has been poor with sharp falls in German industrial production and factory orders and weak exports from both Germany and France

� Weaknesses in small caps are more and more obvious and may eventually bleed over into mid / large caps

� The Ugly

� Main systemic risk resides in China : China’s economy continues to be supported with credit and stimulus, strengthening the problem of excess capacity and deflating the PPI. Without this support, Chinese economy will sink. China debt crisis still remains to unfold in our opinion.

� Ebola epidemic is spiraling out of control. Economic effects have been limited so far, but the picture may get worse rapidly…

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ISM Report

� With services index at 58.6 and the manufacturing index at 56.6, the ISM report is very positive and may points to GDP gains exceeding 4%.

� The new orders component (indicator of future activity) fell to 60 but is still very strong.

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Employment

� Part time employment is on a decreasing trend. The crossover is close but the picture is still considerably different from the period before the Financial Crisis.

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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.

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GS – Global Leading Indicator (GLI)

� The Sep. GLI came in at 2.6%yoy,down from last month (3.1%).Momentum decreased to0.15%mom from last month’sreading of 0.29%mom.

� GLI places now the globalindustrial cycle clearly in the‘Slowdown’ phase (defined bypositive and decreasingmomentum)

� Only 4 of the 10 underlyingcomponents improved inSeptember

� We’ve been thinking for a while

that the current acceleration

remains quite modest for a

typical expansion phase. Moredata are needed to confirm ourfears about the current economicsituation.

Major Economies

� Schwab team’s graph summarizes the major economies as follows: US is weakening, Europe is flirting with another recession, Japan is trying to pull itself out if its long-standing bad situation, and Chinese growth is missing expectations to the downside

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Major Economies

� It is worthwhile noting that the outperformance gap between the US economy on one hand, and its developed peers(Eurozone, Japan, UK) on the other hand, is closing. The US economy is hardly doing better than other developed economies.

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Real Estate

� The Case-Shiller Composite 20 index was up 6.7% YoY in July. This is the smallest YoY increase since Nov. ‘12 .

� In nominal terms, the Case-Shiller Composite 20 Index (SA) is back to Sep.2004 levels� In real terms, it is back to Jun. 2002 levels

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EQUITY

� The weakness we have seen in stocks over the last month could have further to run in the short

term. But we still think that it’s just the start of a normal correction (off ~10%) rather than the start of a new bear phase.

� Stocks again pulled back but the uptrend is not yet broken. Stock market leadership has now shifted to defensive areas and large caps. The decline accelerated, along with a dramatic increase in volatility, at the beginning of October. The sell-off was led by the Russell 2000 and the energy and materials sectors.

� Contributing to the recent selloff was a package of weaker-than-expected economic data (decline in consumer confidence, softer housing data and manufacturing surveys) and the absence of new commitments by ECB. Stocks should keep rising on bad news because bad news implies more central bank stimulus, and more cash injection.

� We stick, however, with our view that risk-reward trade-off points to a more cautious approach

to the equity markets, at least tactically on the near term.

� We continue to think that any further upside on the S&P 500 should be driven by earnings

growth rather than P/E expansion. But the return potential for equity markets looks corrupted by limited room for valuation and margin expansion.

� Given the point in the credit cycle, we favor equities over corporate bonds.

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EQUITY

� Bottom line :

� 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

� As said in our previous report, breaking through the 1900-1920 pivot area on the S&P500

would likely be the signal we wait for to go short stocks, as that could lead to a temporary sell-off in equities.

� But a clean break of 1805 (Oct. ‘11 uptrend) will give the signal of a BIG reversal on stocks.

� We keep our UW on Europe vs. US. We remain neutral to UW on Japan.

� We remain UW in US small caps vs large caps

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Earnings

� According to long-term indicators, equities look expensive. But this situation could persist as long as earnings expectations are met

� Earnings growth should be the only driver of markets from here. Earnings will

provide the reality check we need to

update our positioning on stocks

Source: JP Morgan AM

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Earnings

� Profit margins are still high but seem to have reached a plateau in all regions.


S&P 500 Sector Breadth Levels

� According to Bespoke, only 32% of stocks in the S&P 500 are currently above their 50-day moving averages.

� The most defensive sectors (Utilities, Consumer Staples, Health care) stand out as having very

positive breadth

� On the other side, Energy is suffering with only 2% stocks above their 50-days MA.

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Source: Bespoke

Small Caps Warning Signal

� The profile of small caps is starting to deteriorate in a way not seen in 2013.� Russel 2000 has broken down showing growing causes for concern.

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Small – Large Caps Divergence

� Small caps have undergone an unbelievable relative collapse

� The momentum on the Small-to-Large Caps ratio is quite negative on the downside

� The M&A cycle has slowed and small caps should benefit less as targets

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US Equities vs QE

� The correlation between QE and the S&P 500 performance has been amazingly strong since the financial crisis.

� Ultimately, less QE should weigh on stocks

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VIX

� The Volatility Index has moved sharply higher in the last few weeks as the market has had some very large moves higher and lower.

� The VIX seems to be closing the week near 19, and clearly above its 200-days A (~17.5) for the first time since Aug. ‘11

� The past two instances when this MA was breached resulted in sharp spikes.

S&P 500 Picture

� The S&P500 is ticking below its Nov. ‘12 uptrend.

� As said in our previous report, breaking through

the 1900-1920 pivot area

on the S&P500 would

likely be the signal we

wait for to go short

stocks, as that could lead to a temporary sell-off in equities.

� The 200-days MA at 1905 is the important level to watch. Closing below will probably induce an acceleration on the downside.

� A clean break of 1805

(Oct. ‘11 uptrend) will give

the signal of a BIG

reversal on stocks.

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Trading Model - SPX

� Our prop. Short-Term trading model went massively short on Aug. 18th at 1971.74 on the index, did some gamma-positive adjustments between 1940 and 1970, and finally switched to neutral on Oct.

9th close (1928)

� The model targets 1903 and 1847 on the downside and 1942-1961 on the upside

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FIXED INCOME & CREDIT

� We’ve 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.

� We are now questioning our underweight positioning, as U.S. 10-year yields are currently ticking below the 2.40-2.30 range. Below 2.25, we move to Neutral.

� Falling inflation expectations, disappointing growth and the outlook for low official rates largely explain the level of eurozone yields. While we are neutral on German yields, we think US yields are too low

for the current growth and inflation outlook.

� We continue to OW Eurozone vs. US and UK given continued policy divergence and BCE action, despite the dovish tone in the FOMC minutes. The ECB will not buy corporate bonds directly, but its purchases of asset-backed securities and covered bonds may lead to investors adjusting portfolios towards this asset class.

� Our bullish positioning on 5y-TIPS was a disaster as TIPS was the worst performer within the FI asset class (~-3%). We stop our losses on the 5y-TIPS breakeven wideners and become Neutral on

TIPS. The lack of demand could prevent breakevens from widening over the near term. Inflation expectations sit at their lowest levels since 2011

� Over 12 month horizon, we still expect 10Y HICP swaps to move up 20-40 bps. Thus, we keep our

long 10Y Euro HICP inflation swaps

� As a tail hedge, we keep our 10y bund swap spread receiver swap


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FIXED INCOME & CREDIT

� Our previous monthly reports have pointed out our caution on corporate credit as the spreads have already reached past cycle lows and credit tends to perform badly in later stages of the cycles

� As expected, the tide has begun to turn in credit and specially in high yield� Credit spreads are already pushed wider by continuing weakness in US high yield and a strong

issuance in September.

� 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

� We continue to prefer IG over HY on a risk-adjusted basis and keep our Neutral stance between

the US and Europe.

� Bottom line : Still UW Govies, UW credit, Neutral TIPS and OW HICP Inflation, UW High Yield vs High Grade


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UST Yield Curve

� As of Sep. 30th, speculative positions on the UST curve were the shortest over the past8 years.

� Some short-covering is currently taking place, weighing on yields. We think, however, that this is more about a temporary risk-off move than a change in the underlying persistent short bias.

� Over the short term, only a material

weekly/monthly close below the 2.40-2.30

range could make us change our bearish view

on USTs.� The market remains oriented toward higher yields

over the medium term , at least in the US.



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US 10y Yields

� The downside move has already gone further than initially expected. No sign of a material bounce is showing.

� We are now questioning

our UW positioning, as U.S. 10-year yields are currently ticking below the 2.40-2.30 range.

� A material weekly/monthly close below this range would make us change our mind and move Neutral, and even OW on US Govies.


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US Inflation

� Inflation expectations have declined to their lowest levels since 2011

� This should have a dovish Fed implication


High Yield

� The correction is under way in corporate high yield…

� According to JP Morgan’s European HG investor survey, investors are the most OW credit ever in the history of the survey while cash balances are very low

� Underlying credit fundamentals are still supportive, but the very tight level of spreads makes the risk/return profile unattractive

� We remain UW high

yield.

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EXCHANGE RATES

� Over the medium term, we continue to expect the USD to strengthen against the major crosses.

� Nevertheless, it looks like the US dollar is due for a pullback.

� Despite the fact that EUR-USD underlying structure still looks very negative, EURUSD is entering a corrective phase.

� We change our positioning from UW to Neutral on EUR-USD and will remain so as long as the

pivot remains between 1.25 and 1.28.

� Additional Abenomics should weigh on JPY. But a correction is now developing on the pivot � Our previous targets of105.60 and 108 were reached. � We move from OW to Neutral on USD-JPY and wait for a break above 108 or below 106.10 before

tilting our position again by going OW or UW, respectively.


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EUR-USD

� Our first target of 1.28 was reached (and even broken) on EUR-USD.

� Nest target stands at 1.25. The break of this pivot will open the door to 1.23

� EURUSD is entering a corrective phase. We

change our positioning

from UW to Neutral on

EUR-USD as long as

the pivot remains

between 1.25 and 1.28.

� Over the long term, the picture remains very skewed towards our ultimate target of 1.20


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USD-JPY

� Additional Abenomics should weigh on JPY. But a correction is now developing on the pivot

� USD-JPY appreciated to 110 versus the but has since retreated. Is that a market reversal?

� Our previous targets of105.60 and 108 were reached.

� We move from OW to Neutral and wait for a break above 108 or below 106.10 before tilting our position again

� The next big pivot to watch is 110. Our LT target stands at 125!


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COMMODITY

� Commodity prices fell further in September, mainly because of rising US dollar, supply gains in some key commodities, and falling demand caused by reduced economic expectations around the world, in particular in China.

� Our bearishness on agriculture commos (except Cocoa and premium coffee) was justified. During the month, the wheat price fell 13.2% and is down 35% since its peak in May. Soybeans fell 10.8% and corn 12.1%.

� We have been proven right in going UW base metals : The iron ore price fell 11% and is now down 39% since the start of 2014. Nickel (-13.2%), aluminium (-6.5%), lead (-6.3%), copper (-4.5%).

� Our first target on silver at 17 was reached. The recent lows in gold (~1190) were very close to our target of 1150-1170.

� But we were completely wrong about energy.

� We continue to like owning the GSCI energy index, and to think that commodities hold value as

cross-asset portfolio diversifiers.

� While we are neutral on prices we continue to see substantially positive roll returns in many

commodities. 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).


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COMMODITY

� We maintain some of our previous views: UW on agriculture (except on premium coffee and cocoa), and base metals (we prefer Zink, Nickel and Aluminium to copper and Iron Ore).

� Without changing our MT bearish view on precious metals (targeting 1170-1150, 17 then 12.50 on silver), we move tactically OW gold and will remain so as long as the spot is above 1223. ST target ~1330

� Our dilemma is about energy, and especially crude oil!

� The drop in oil price is disconcerting as we had not foreseen it.� The current correction is impressive but still falls within the norm of recent corrections.� Breaking the $80 support zone would be a very bad signal for crude oil� At this stage, there is no sign of OPEC action to stop the bleeding

� We choose to keep our OW bias on energy as long as the $80 support zone is not clearly broken.


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Commodities

� The fall in commodity prices was obviously driven by the rise of the dollar

� We think that US dollar is due for a pullback. Commodities downward trend is expected to reverse.


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Gold

� Like in Jan. ‘14, Gold seems to be ready for a bounce (preceding the final leg down)

� momentum is starting to turn higher from extremely oversold levels

� Without changing our MT bearish view (targeting 1170-1150), we move tacticallyOW gold and remain so as long as the spot is above1223. ST target ~1330


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Crude Oil

� The current correction is impressive but still falls within the norm of recent corrections.� Breaking the $80 barrier would be a very bad signal for crude oil

Energy Sector

� The S&P 500 Energy sector has experienced a breakout back below its 2007 highs, and is now breaking below its 2 year uptrend line.

� The next uptrend line to watch is that initiated at 2008 lows.

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Source: Bespoke

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Commodity Performance

� Speculators


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ALTERNATIVE STRATEGIES

� Within the hedge fund complex, we’ve been OW Equity Market Neutral, CTA, Global Macro and Vol

Arb.� Two months ago, we decided to move from OW to Neutral on Event-Driven, as M&A activity was

calming down, volatility was expected to bounce, and geopolitics were threatening…� Most of our bets have paid off handsomely in September :

� The HFRI Macro Index gained +1.8% for the month, led by contributions from Multi strategy (+1.8%), Systematic Diversified/CTA (+2.6%) and Currency (+1.3%) sub-strategies

� Long Term CTAs were among the best performers during the month as they made money out of their long rates (still long govies, despite a reduction in the past few weeks), short EUR/USD and aggressively short commodities.

� CTAs and Equity Market Neutral are now the best performing strategies on a YTD basis, thanks to a strong Q3

� HFRI Event Driven Index declined -0.95%, when Equity MN was flat on the month. � HFRI Macro: Discretionary Thematic Index is -0.2% on the month. The strategy was hurt on its long

exposure on commodities, as well as on their short U.S rates. These losses were mitigated by the gains on their short EUR exposure.

� According to HFR “The Macro resurgence accelerated in September, leading industry performance as equities, bonds and other hedge fund strategies declined. Macro hedge funds, including both trend following, quantitative as well as fundamental discretionary strategies, have re-emerged recently as powerful, uncorrelated exposures as US stimulus measures are wound down and the US economy continues to proceed toward interest rate normalization,”


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ALTERNATIVE STRATEGIES

� 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 � CTA’s 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.


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Are US Pension Funds getting out of Hedge Funds?

� CalPERS’ decision to get out of the hedgefund universe has raised concerns amongother investors.

� According to a recent Prequin survey,however, more US-based public pensionfunds than ever before are allocatingcapital to hedge funds.


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CTA

� The main driver of CTAs returns was the

commodity sell-off. CTAs have been increasing their commodities shorts since the summer.

� CTAs also made money out of their still long positions on Govies and shorts on EUR vs USD

� On the other hand, CTAs generated losses on long positions on equities


Bottom Line: Global Asset Allocation

� The stock market is off its peak and bond yields are extremely

low, and the economy seems to be going nowhere.

� Global economic issues is the focus, and the general tone is

negative. But expansionary monetary policies, low interest rates

and abundant liquidity are keeping us from moving to an

underweight on equities

� Growth in Europe is at a great risk. Germany, which is its

economic engine, is showing increasing signs of weakness. The

odds for a triple-dip recession are still heading up.

� China’s trend growth rate has fallen and there are downside

risks from the property and financial sectors

� Like others, we ask whether major moves in bonds, inflation,

oil, and small caps (vs large caps) are canaries in the

coalmine that signal a reversal

� We remain neutral on global equities and think earnings growth

should be the only driver of markets from here. We remain

overweight commodities (but with a dispersion in views across

the sectors as individual fundamentals matter) and underweight

credit and government bonds.

� 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.

About Us…

� FinLight Research is a research-centric company focused on Asset Allocation from a top-down

perspective, on Portfolio Construction, and all related quantitative aspects and risk management issues.

� Our expertise expands along 3 axes:

� Asset Allocation with risk control and/or risk budgeting techniques

� Allocation to alternative investments : Hedge funds, rule-based strategies (momentum, value, carry, volatility), real assets (real estate, infrastructure, farmland, timberland and natural resources). Private equity and venture capital should be the next step…

� Allocation with a factorial approach built on the understanding (profiling) of the risk/return drivers of the different asset classes

� FinLight Research is an innovation-oriented company. We target to fill the gap between the academic research and the investment community, especially on real assets and alternatives. We survey on a continuous basis the academic literature for interesting published and working papers related to quantitative investing, non-linear profiling, asset allocation, real assets...

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Finlight Research - Market Perspectives - Oct 2014

Economy & Finance

Transcript of Finlight Research - Market Perspectives - Oct 2014