Is Volatility Signalling Higher Prices?

Let’s quickly review the overall stock market and see what’s going on. We’ve had some real nice bullish action over the last week, but is it going to last?

Well the S&P 500 (SPY) has officially broken out of its consolidation from the beginning of the year. Price cleared its downtrend line and the prior high of the consolidation. This raises the probability of a new bull trend starting and lowers the probability of continued consolidation and chop. And yea, price is coming back to kiss the breakout, line but that’s just normal action. The breakout should hold.

We’re also seeing confirmation in the volatility markets with VIX (VIX) closing below its prior low put in on March 9th. You almost never see the S&P downtrending with VIX in the teens.

Oddstats tweeted a pretty cool chart of this correlation between the S&P and VIX the other day. The green and blue shading on the equity curve shows what SPX price action looks like with VIX levels of 18 or less. This makes it easy to see that low volatility = bull trends. A low VIX, means stable SPX pricing, which gives large investors the confidence they need to put money to work.

The volatility term structure has also relaxed which means stress is leaving the system. This ratio trades above 1 during times of stress and below 1 when liquidity conditions are favorable. It’s been holding levels below 1 for the last few weeks which gives us more evidence that this bull has legs. The current value is 0.92.

In just 3 months we’ve gone from hyper volatility back to 2017 style vol. This supports the theory that that the selloff we had was machine driven. It had nothing to do with the fundamentals. It was all because the auto selling from margin calls and crowded positioning that needed to be unwound. The fundies never deteriorated with the price action.

In the video above we cover market fundamentals as well. So make sure you watch it!

And as always, stay Fallible out there investors!

Will China’s Slowdown Wreak Havoc On Markets?

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

Last July, we laid out the case for why China is the most important macro factor this cycle. We talked about why it’s a debt riddled neutrino bomb waiting to go boom… But we also noted how the Chinese Communist Party (CCP) had been injecting liquidity into its economy in order to steady the boat during its all-important National Congress last year.

Our pitch was that we were tactically bullish but strategically bearish (which so far looks to have been the right call).

Well, now that the big gathering of Marx lovers is over and Xi Jinping has been anointed the Grand Emperor for life. The CCP has the all-clear to move forward with managing the country’s deleveraging and transitioning from an export economy to a consumption based one

Why does this matter? Why is China so important to global markets?

Well, it’s mainly because they are the world’s marginal buyer of commodities… by a wide mile. So when China wheezes the rest of the world (and especially emerging markets) catches cholera.

Here’s a short summary of just how important the red dragon has become.  

It’s been said that China builds a new skyscraper roughly every five days.

In the last year alone, the country has built half of the worlds new super skyscrapers (buildings with a minimum height of 656 feet). To put that into perspective, there’s only 113 buildings in New York city, total, that are over 600 feet.

That takes a LOT of steel, copper, cement and other such resources. Another fun fact that I often like to share is this mind bender: China consumed more cement from 2011 to 2013 than the US did in the entire 20th century.

China dominates global commodity consumption. They consume more than half the world’s cement, nickel, coal, copper, and steel every year (image via Visual Capitalist).

Paul Podolsky, a PM at the macro hedge fund Bridgewater, estimates that over “70 percent of the swings in the global economy are driven by swings in the Chinese economy.”

Famed short-seller and fund manager, Jim Chanos, recounted the following regarding China a while back in an interview with the FT :

This story is internally now one of our great stories.

A real estate analyst was addressing the partners and he said: ‘Currently there’s 5.6 billion square meters of high rises in China under construction. Half residential, half office space.’ And I thought for a second and I said: ‘No, you’ve gotten the American, rest of the world metrics wrong. You must mean 5.6 billion square feet. Because 5.6 billion square meters is roughly 60 billion square feet.’

And my analyst looked at me sort of terrified. He was a young analyst at the time. He said: ‘I know. I double checked. It’s 5.6 billion square meters.’ And I thought for a second and I said: ‘Well if half of that’s office space, that’s roughly 30 billion square feet of office space. And that’s a five foot by five foot office cubicle for every man, woman and child in China!’

And that’s when we all looked at each other and our jaws dropped. We realized, wow, this is a once in a lifetime kind of thing, where this whole country is in effect building itself out in a very short period of time.

So then we looked at the capital spending of their miners, and we went back and looked at a time series of those that were around from 1990 on, and once again it was just one of these hit your head kind of moments.

And with the government’s explicit backing to do whatever it takes to keep China growing faster than the rest of the world’s major economies. Right now markets believe in two things: central banks have the market’s back and China has the global economy’s back.

Those are two very, very big pillars and they’d better hold up… because everybody believes them.

This is important —> Right now markets believe in two things: central banks have the market’s back and China has the global economy’s back… One of these beliefs is going to be tested in the coming year.

Before I explain why, let me first layout what exactly makes the CCP and its leader, Xi Jinping, tick. Since they ultimately pull the levers in the country which affect the rest of the world so much.

It can be boiled down to the following: power and control.

Xi Jinping, as the leader of the CCP, cares solely about keeping his grip on power. All leaders, especially authoritarian ones, sit under a heavy sword of damocles. Xi is no different. Maintaining power and control are necessary to his survival.

The same goes for the broader party and its members. The CCP fears social unrest more than anything else; lest the people take to the streets and begin to demand a voice in government. Both know that the best way to keep the peace is by keeping the engine of economic progress turning and never letting things regress, too much.

This is one of the many reasons why undemocratic systems are inherently fragile. They don’t have the shock absorbers that are organic to democracies — we can vote our frustration out.  

Question. Do you know why communism is superior to capitalism?

Answer: Because it heroically overcomes problems that do not exist in any other system.

Anyways, so Xi and fam know that they must maintain stability, both economically and politically to ensure their survival. And since their government is filled with very bright technocrats, they know that they have to deal with their debt problem. They can’t afford to keep kicking that can down the road, anymore.

In addition, communism is all about outward appearance. Dog and pony shows are extremely important in reminding the people that the communist system is really the best. Which is why the CCP’s coming centenary anniversary in 2021 is such a big deal. They need to celebrate 100 years of economic progress.

It’s very important that the Chinese economy is strong like dragon for the centenary in just three years time. The technocrats know this. And they know that if they want a strong economy in 2021 then they need to slow it down, now. This was the theory first put forth by macro hedge fund manager Felix Zulauf, which I wrote about here.

Here’s Felix’s updated thinking on this hypothesis from a recent interview he did with Real Vision (emphasis mine).

2021 is the 100th anniversary of the Communist Party… So I assume that the current president, who is now president for a lifetime, wants to have a good economy in 2021. If he wants to have a good economy then, he’s no dummy, and his experts aren’t either because I think, actually, the Chinese government has the best experts of all the governments in the world. So they have to slow down the pace of the economy in ’18-’19, and reduce some of the risks they have built up. And I think you are seeing that already.

And I think the Chinese think that the fiscal stimulus in the US could take up some of the slack. And I think it is timed that way that when the US pushes their economy a little bit further through the fiscal stimulus, that they could retreat some and it would be balanced. Of course, it will not be balanced because China’s effect and impact on the world economy today is much bigger than the US economy.

So I think the Chinese will most likely overdeliver in their restructuring efforts over the next two years, compared to what the world expects. If that is true, then we will have a stronger dollar for longer, and will have weaker commodities for longer. But once the world then gets disappointed in ’19 or whenever they figure that out– the Chinese are beginning to kick start their economy from 2020 onwards. So I think there are many cycles within these long cycle that we are in. And the mini cycle, I think, is topping.

The theory sounds solid doesn’t it?

I mean, we know the Chinese government is worried about its excessive leverage. And we know that political anniversaries and pageantry are important in their culture. And… it would be wise — and China’s technocrats are wise, if not sometimes hamstrung — for China to move aggressively in deleveraging while the US (its counterpart engine for global growth) is firing on all cylinders, with unemployment sittings at 17-year lows and capital expenditures trending towards generational highs…

But a theory is just an opinion if we can’t back it up with numbers. And as macro operators, we need to be like the late W. Edwards Deming where, “In God we trust; but all others must bring data.”

So let’s peruse the data. And since China likes to fudge the more popular datasets, we’ll look at a dashboard of more esoteric stuff that tends to fly under the radar, unmolested.

Here’s one of my favorites.

It’s the YoY change of railway freight. Remember, in our recent article, we talked about why it’s best to view data at the second derivative level. Because the rate-of-change reveals important trend changes in velocity. Well, we can see that in the chart below.

Growth in railway freight slowed, then turned negative, from 2010-14’ when China was doing its stealth tightening.

Looking at this chart alone would have tipped you off to something being amiss. You could have triangulated this with price action in commodity and emerging markets to either help you to side-step or go outright short into what became a nasty bear market.

And then in early 16’, this chart reflected the massive credit injection by the PBoC (China’s central bank) by hockey sticking upwards, which subsequently marked the nadir of the commodity/EM bear market.

Now, while growth in freight traffic is still positive. It’s slowed dramatically since its 17’ peak and looks to be decelerating further. Something we’ll have to keep a close eye on.

Now onto the second derivative of another favorite of mine… year over year Industrial Production Electricity Usage… Fun!

This one is sketching out the same pattern as railfreight traffic. Growth is clearly decelerating from its high-water mark hit last year.

Real estate, both commercial and residential, are telling a similar story.

Home prices in China’s two hottest cities, Beijing and Shanghai, are falling. And the growth in the amount of commercial floor space sold is about to turn negative for the first time in over 3-years.

Real estate plays an important role in the Chinese consumer psyche. If this trend continues it’ll make the economy’s transition to a consumption based one, that much more difficult.

Since China is such a dominant source of global commodity demand, I’ve found that tracking their imports from commodity producing countries to be a fantastic bellwether for what’s really going on in the country.

Below is a chart showing the year-over-year changes in exports to China from the countries largest commodity trading partners.

This chart, like the others, paints a picture of decelerating growth.

Our theory now looks less and less like an “opinion” and more like the word of God, doesn’t it?

But, we can go even further. Let’s look at the source of this deceleration. The supply of money (liquidity), itself.

China’s M1 money supply (narrow money) growth turned negative following its large upswing in 16’-17’. Here it is, charted along with the year-over-year change in industrial metal spot price index. Notice any correlations? Perhaps any leading correlations?

Hopefully, the puzzle pieces are beginning to come together for you.

China is the dominant source of global commodity demand. And liquidity (ie, money supply) drives demand. So ceteris paribus, collapsing Chinese liquidity leads to falling commodity prices.  

So this chart and the next one should have us somewhat concerned; because they clearly show that liquidity in China is rolling over.

People have been wondering why emerging market debt and currencies have dived into a hole, recently. Well, the above is why. China is deleveraging and the rest of the world is just starting to feel the affects.

Does all this mean that we should sell all our positions, convert to cash, and join a friendly prepping community?

No, not exactly…

I’m no curmudgeon or China doomsdayer. I think China will manage things just fine. But growth there is clearly decelerating. And the CCP’s actions give weight to our “slowdown into 2021” theory. So, as long as the data continues to confirm our theory, that’s the one we’ll base our assumptions off of.

I’m guessing the CCP learned its lessons from the painful economic slowdown in 14’-16’ and will proceed with more caution this time around. Taking one step back for every two forward in their move to deleverage — or crossing the debt river by feeling the stones, as Deng Xiaoping would say.

Lucky for them, the US economy is booming and will help soften the blow to the global economy. Which is why we’re not predicting fire and brimstone, just yet.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.



Review: Cameco Corporation (CCJ), Fiat Chrysler (FCAU), (YTRA)

We’ve got 3 stocks for you today that our team is bullish on — Cameco Corporation (CCJ), Fiat Chrysler (FCAU), and (YTRA).

Cameco Corporation (CCJ) is one of the largest uranium producers in the world, which makes it a great way to play the coming rebound in the uranium market. Back in 2011 the Fukushima disaster kicked off a 7-year bear market in uranium where prices collapsed 90%. But a nice bottom has been forming over the last few years and we think we’re about to get a bull again. Cameco is one of the best positioned companies to take advantage of this trend. We have a price target on it of $17, which is over a 50% increase from where it is right now.

Fiat Chrysler (FCAU) is crushing the rest of the auto industry is because of their Jeep Wranglers. While every other US auto manufacturer reported a decline in sales for April, Fiat Chrysler reported gains and smashed estimates. And it was all because of a 20% spike in Jeep sales. And that’s great for Chrysler because these are high margin vehicles which make them a lot of money. Our target for this stock is $30 dollars, which is another 30% higher from here.

Yatra Online (YTRA) is one of India’s leading online travel companies. The big reason we like Yatra is because our team is super bullish on India over the next few decades. As the indian population gets richer, they’re going to have a lot more money to spend on travel and vacations. And of course Yatra is perfectly positioned to take advantage of that. This is one of our highest conviction trades.

For more on each of these companies, make sure you watch the video above!

And as always, stay Fallible investors!

Ed Seykota’s “Fundamentals” and a Massive Pain Trade

Last week we talked about how the market derives its expectations (it simply extrapolates current data ad infinitum) along with why it’s important to view macro data at the second derivative level (the rate of change leads important inflections in the trend).

A process that looks something like this.

We used these mental models to comment on a macro development we’re tracking, which is the decelerating growth in China. As well as what this could mean for markets. You can read the piece here.

These concepts are going to be vital in understanding how markets will unfold over the coming year. And this is because we’re on the cusp of some important trend reversals that will be occuring at same time the market has become firmly anchored to the old narrative — in this game, winners anticipate and losers extrapolate.

The driving force behind this trend-change will be a strengthening dollar. And it’s likely to kick into gear a positive reflexive loop that will drive large returns for those who are positioned correctly.

This reflexive loop is centered around Soros’ idea of benign and vicious circles or what we refer to as the core/periphery model.

We’ve written extensively on this idea which you can read here. But the gist of it is that bull markets that are accompanied by a rising dollar tend to last longer than ones where the dollar is falling. That’s because there are numerous self-reinforcing processes (hence Soros’ use of the word “circle”) that drive an extended trend.

Here’s Soros on the power of benign circles (emphasis mine):

The longer a benign circle lasts, the more attractive it is to hold financial assets in the appreciating currency and the more important the exchange rate becomes in calculating total return. Those who are inclined to fight the trend are progressively eliminated and in the end only trend followers survive as active participants. As speculation gains in importance, other factors lose their influence. There is nothing to guide speculators but the market itself, and the market is dominated by trend followers.

The dollar recently broke out of a 4-month consolidation zone and is now rocketing higher; fueled by crowded short positioning and powerful fundamental tailwinds (ie, rate and growth differentials).

If this bullish dollar trend continues it’ll become the most powerful macro driver of markets over the coming year(s). Not only will it extend the duration of the current bull market but it will drastically impact market trends that have dominated over the last 2-years. We often refer to the US dollar as Archimedes’ Lever. This is now more true than ever…

The incoming data suggests this trend is just getting started (again).

US relative growth versus the rest of the world (ROW) has rebounded and is expected to accelerate in the coming quarters. Stronger relative growth means more attractive returns which draws more capital flows that in turn push up the dollar, increasing total investor returns thus making the US more attractive and giving birth to a feedback loop.

When looking at the dollar you have to analyze the US relative to Europe since the euro accounts for over 60% of the movement in the dollar on a trade-weighted basis. And on this front, the euro looks ready to kamikaze.

The improving relative US economic picture makes for more attractive return prospects in US markets as relative equity momentum picks up. This is driving speculative flows back to the core (the US) and these flows drive exchange rates.

We can see this change in flows directly in the following chart from BofA. Foreign purchases of US equities relative to eurozone equities have recently picked up, and quite significantly so.

On a forward PE basis, the eurozone is now not much cheaper than the US. While at the same time, growth expectations have strongly diverged in favor of US companies.

This dollar trend is going to affect everything from rates to commodities (think gold and oil) to EM stocks as well as specific US sectors. It’ll benefit some markets while hurting others….

There are a number of highly asymmetric trades to be made off this macro shift which we’ll be discussing in depth in our coming monthly Market Intelligence Report (MIR).

Market Wizard Ed Seykota once said that, “Fundamentals that you read about typically are useless as the market has already discounted the price, and I call them ‘funny-mentals’. However, if you catch on early, before others believe, then you might have valuable ‘surprise-a-mentals’.

The market is positioned for a weakening dollar. Everyone knows that everyone knows that the dollar is in a bear market because: the widening deficits in the US, chaos in the White House, overvalued US stocks, the technical breakdown of the dollar bull trend, USD bull cycles only last 7 years etc… This is common knowledge and is now embedded in the price. Positioning shows that this narrative has become entrenched. The market, as always, has been extrapolating the past into the future. It hasn’t realized yet that the future has changed. It’s about to be in for a surprise…

If you want to stay on top of this incredibly important shift in the macro narrative, subscribe to the MIR by clicking the link below and scrolling to the bottom of the page:

Click Here To Learn More About The MIR!

There’s no risk to check it out. We have a 60-day money-back guarantee. If you don’t like what you see, and aren’t able to find good trades from it, then just shoot us an email and we’ll return your money right away.

If the US dollar maintains trend, a seismic shift will occur in the macro landscape. The greenback is the linchpin macro asset that will affect every other asset class out there. Keeping tabs on this trend will be vital for any trader that wants to knock 2018 out of the park. By subscribing to the MIR you will have real-time monthly updates on this important trend.

Click Here To Learn More About The MIR!



From Bullish To Bearish In Gold?

Today we’re going to revisit gold. I’m going to explain what’s going on in the gold (GLD) market and what trades we put on last week in the Macro Ops portfolio to take advantage.

Earlier this month I released a video explaining why our team was bullish on this precious metal. But at the end of that video I explained that even though we were bullish, we were still waiting for price to confirm. About a week after we released that video it looked like we finally got our breakout. But we didn’t immediately put on a trade because we wanted to wait for the close to make sure it was real. And that ended up being the right move because as you can see we got a huge breakout failure. It was a bull trap.

This failure was an inflection point. Over the last year gold had everything going for it to rally, but it still failed. The dollar was down almost 15%, we had political drama everywhere, geopolitical tensions were rising from trade wars to potential nuclear strikes, and to top it off we had the rise of inflation narrative coming back front and center.

But gold still failed to breakout higher. And now conditions are actually shifting to become bearish for gold.

Last monday we saw gold break below its triangle pattern. We put on a starter position of just 25 bps to test the waters because we knew there was potential of another fake out. We were also putting on 75 bps of long dollar (UUP) positions at the same time. And going long the dollar is very closely correlated to going short gold, so we needed to size smaller when considering our total portfolio construction. By Thursday we saw the follow through in gold that we wanted and put on another 25 bips on, doubling our position. Again we sized a bit smaller because we also doubled our dollar position. And now we’re going to sit and wait for the trend to play out.

For more be sure to check out the video above!

And as always, stay Fallible investors!



A Developing Soros Style Boom-Bust

The Palindrome (Soros) once said, “The generally accepted view is that markets are always right — that is, market prices tend to discount future developments accurately even when it is unclear what those developments are. I start with the opposite view. I believe the market prices are always wrong in the sense that they present a biased view of the future.

That last part is very important. Do you know what Soros means when he says the market is wrong because it’s biased about the future?

I’ll tell you. It’s an important concept to understand. And a helpful mental model to use in today’s choppy market action.

The market is supposed to be a forward discounting machine. It’s supposed to look out into the near future and make judgements on things like revenues, margins, earnings, inflation, the discount rate, potential risks, geopolitical shocks etc… and then make bets on what the proper value (the price paid today) is for those future cash flows.

That’s no easy task… it’s a lot of things to take into consideration. The market and economy is a complex beast. There’s a lot of unknowns and unknown unknowns. And like the great sage Yogi Berra once said “It’s tough to make predictions, especially about the future.”

To top things off, we (as in, we humans) abhor uncertainty. We can’t stand it. It drives us bonkers. Especially if it’s uncertainty surrounding something that’s a strong emotional trigger — like our finances or the stock market.

So here we have a problem. The future is hazy. The market is complex. The future path of the stock market is hazy and complex, i.e. it’s uncertain. Humans hate uncertainty. Round peg + square hole.

But the human mind is inventive when it needs to be, especially with the right incentives. Like making a lot of money in the stock market.

So to get around this seemingly intractably uncertainty-judgement issue, the majority of market participants simply extrapolate the present into the future. They take the hard numbers; the revenue growth, margin trends, and current cash flows. And just extend them out a few years. Boom… problem solved… no more uncertain future. Good earnings today = good earnings tomorrow. Money in the bank.

This is called anchoring. It’s a cognitive bias where we overweight the first or most easily available information when making judgements. It’s a useful heuristic and works pretty well, most of the time. Especially in markets. Financial and economic data tends to trend once it gets going. Kind of like Newton’s First Law.

The problem is, markets are reflexive. Meaning, our observations of the market affect the market itself, which in turn affects our observations and so on. You smell what I’m cooking?

This manifests itself in situations like the following.

The longer we see positive earnings growth, the more market participants begin bullishly extrapolating this earnings growth into the future. This results in the buying of more stock, which drives valuations up, and thus creates a market that’s now more incentivized to maintain and propagate the bullish narrative… and more importantly slap on cognitive blinders to new info that may threaten this narrative.

And so the narrative and the market form a self-sustaining feedback loop that goes on and on. It occasionally gets tested by disconfirming evidence. Each test it survives, the stronger the reflexive relationship becomes. As each dip bought leads to more confidence that so to will the next one and the one after that. Extrapolation ad infinitum…

This is why Soros said the market is always wrong because it presents a biased view of the future. The market is always biased in the direction of the established trend. Because it utilizes anchoring and extrapolation to form judgements instead of objectively and equally measuring the weight of available information.

And like I said, this works most of the time. But when it doesn’t, it really doesn’t…

As traders we always need to be cognizant of the trend. As well as the key data points that are the foundations of the driving narrative of that trend. But we also need to objectively look out into the future to see if any freight trains are headed our way that could derail the narrative.

Just the process of gaming numerous potential scenarios is a valuable exercise as it keeps our minds fresh, open, and unwedded to a single narrative or outcome.

Market Wizard, Bruce Kovner, attributed this process as one of the main reasons behind his enormous success. He said:

I’m not sure one can really define why some traders make it, while others do not. For myself, I can think of two important elements. First, I have the ability to imagine configurations of the world different from today and really believe it can happen. I can imagine that soybean prices can double or that the dollar can fall to 100 yen. Second, I stay rational and disciplined under pressure.

What we’re talking about here is playing the game at Keyne’s second and third levels… Playing the player… Understanding what the market is focusing on and what exactly is being priced in. Then weighing that against the incoming data and gaming alternative futures to the one the market is focused on and thinking about what catalysts could trigger a phase shift.

Is this easy? No, of course not.

But there are a number of tools and models we can use to make this scenario gaming a more fruitful exercise. One of these is to focus on the second-derivative of data. That’s the trend in the rate of change instead of the trend in the absolute number.

This is important because trends lose steam before they turn. The market focuses on the growth — it wears the bullish blinders — while we want to keep our eyes peeled for a potential slowdown, or a change, in that growth. This will tip us off to a coming trend change in the data. A trend change that could destroy the narrative and cause a phase shift.

This is why we look at year-over-year data versus absolute numbers. It’s not the absolute level it’s the relative rate of change over time that matters.

And this brings us to an important point in how we should think about potential future outcomes going forward. Since it’s the relative rate of change that’s important, then the base period in which current data is measured against (the prior year in year-over-year) is pretty important. It’s essentially a hurdle. A low hurdle is easy to clear. A high one and the markets likely to trip.

We’ve benefited from having a low bar over the last few years. The goldilocks economy, of low growth and low inflation, kept expectations low which made for an easy hurdle. But with the recent tax cuts and a globally synchronized growing economy at our backs we’ve seen earnings growth, and expectations, jump.

Just look at the chart below. Consensus estimates have earnings growth peaking in the 3Q of this year.

Simply put, after this year we’re going to have a HIGH hurdle to clear. And current expectations are for this global synchronized growth trend to continue. Remember, current trend extrapolated ad infinitum… But will it?

While growth here in the US remains strong, as shown below by our composite leading indicator entering expansion territory for the first time in nearly four years. There are signs that the world’s second biggest economy is beginning to limp.

China is in the difficult spot of trying to manage a deleveraging while shifting its economy from a production centric to a consumer focused one. All while trying to maintain financial stability lest the CCP upset the apple cart and drive people into the streets demanding *gasp* freedom.

Because of China’s economic size and especially its hunger for natural resources. It’s importance on the global stage is significant, and only becoming more so.

BofA wrote in a recent letter how, “On close inspection, DM and Chinese growth are increasingly intertwined. While the two series were nearly uncorrelated in the previous cycle, their correlation has increased considerably in the current cycle. Moreover, Granger causality tests suggest that the ECI for China leads the developed-market common factor by four to five months but not vice versa.”

China matters. It sneezes and the rest of the world catches influenza…This is why we should be somewhat concerned by the recent slowdown in the rate of change in the data coming out of China.

The second-derivative shows a trend-shift occurring. Chinese liquidity has turned, as shown below by the YoY change in the M1 money supply — which tends to lead China’s PMI by 3-months. And this tightening liquidity is showing up in industrial production electricity usage. One of the few seemingly untainted data points that come out of the country.

And growth in domestic credit to households has rolled over.

Danske bank writes the following on some of the ways this could impact the rest of the world, noting:

The moderate slowdown of the Chinese economy is expected to dampen the global inflationary impact from China further over the coming year with PPI inflation declining further to around 1% by the end of 2018 down from a peak at 7.5% in early 2017. The inflationary impact of reductions in overcapacity is also set to fade, as China has already come quite far in cutting overcapacity and steel prices and other commodity prices have recovered to more ‘normal’ levels.

So here we have new incoming data that doesn’t exactly jive with the current market consensus. But it could potentially have a large impact on the dominant narrative and even cause a complete trend-shift. We have all the necessary information to game various scenarios on how this can play out.

We know that the market is still strongly positioned bullish. It’s extrapolated current trend-growth rates out to the wazoo.

We know that a combination of tax cuts and global synchronized growth last year has given us a boom in earnings this year. This earnings growth should peak in the second half, leaving us with a high hurdle and declining growth going into 2019.

We know that the market has recently anchored to the “reflation” narrative with expectations for much higher inflation becoming a consensus belief (charts below via BofA fund manager survey). As well as one of the top fears or “tail risks” on investor’s minds…

This new dominant belief over rising inflation has driven bond yields higher. And since bonds compete with equities for capital flows. And their rates are used in valuing and assigning a multiple to stocks, the high rate-of-change in yields has caused stocks to sell off.

This creates the interesting scenario — one of many possible outcomes — where a slowing China could be bullish for US stocks; over the near-term, at least. This is because a gradually slowing China (keyword being gradual) would feed into lower inflationary pressures and maybe a more dovish Fed, if not, it’d at least help put a floor under bonds.

And this outcome would then spawn a whole host of other potential outcomes.

A slowing China could extend the Fed’s rate hiking cycle and thus spur US relative market outperformance versus the rest of the world. This would put a bid under the dollar and a strengthening dollar would raise foreign investors total return outlook in US markets. Which could spark a virtuous cycle of money flowing back into the US.

Throw in the likelihood of the corporate share buyback orgy reaching new climatic heights this year and we have the makings for a core renewed driven rally. One that would have many large consequences for the dollar, gold, oil, and emerging market stocks.  

Isn’t this game fun?

If this scenario plays out, then the market will double down on its US-centric bullishness and extrapolate, extrapolate, extrapolate. While also failing to see that by doing so it sows the seeds of its own destruction. Let’s return to Soros again:

Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced.

If a self-reinforcing process goes on long enough it must eventually become unsustainable because either the gap between thinking and reality becomes too wide or the participant’s bias becomes too pronounced. Hence, reflexive processes that become historically significant tend to follow an initially self-reinforcing, but eventually self defeating, pattern. That is what I call the boom/bust sequence.

Two trends are always interacting with one another, in a reflexive loop. One trend is reality and the other is a misconception of that reality. As global macro traders we need to focus on both. And the best way to view “reality” is by measuring it at the second derivative level.

You now know what the market’s potential misconception is. As well as how growth-trends are unfolding.

There are a number of sizable trends that are about to develop… along with massively asymmetric trades that are soon going to catalyze.

We’ll be discussing all of this in our next Market Intelligence Report (MIR) that comes out next week.

Click here to secure your copy!




Yield Curve Inversion!? Flattening Yield Curve Explained

The Yield Curve Inversion Secrets! Understanding the Flattening Yield Curve is crucial for any trader or investor!

Today we’re going to talk about the yield curve. Recently the financial media has been raving about the yield curve getting closer and closer to inverting and how it’s a signal that a recession is right around the corner. In this video we’re going to go over what the yield curve is, how to use it, and what it’s really signalling about the market.

The yield curve is basically just a line that plots the yield of US treasury bonds (TLT) with different maturity dates. The curve lets you easily compare rates on short term bonds versus long term bonds. When long term bonds are yielding more than short term bonds, the line rises from left to right. And when this is the case, it’s called a normal yield curve. This is signal that the economy and market are doing okay.

When you start to see the yield curve flatten or even invert, meaning short-term rates become equal to or higher than long-term rates, and the line either becomes flat or sloped lower from left to right, then that usually signals trouble ahead in terms of a recession and lower market prices.

Two things happen for the yield curve to become like this. First, the Fed starts raising short-term rates. Based on their mandates, they may see the economy overheating and decide to raise rates to slow it down. Higher rates hurt economic expansions.

Second, investor expectations for the future become negative. And because of that, they buy up long-term bonds, lowering their yield. Those two together you a flat or inverted yield curve where short term bonds yield the same or even more than long-term bonds. And like this signals trouble ahead.

According to our analysis, yes the curve is beginning to flatten and invert, but we still have a lot of time left before this bull iis done. Make sure to watch the video above for more!

And as always, stay Fallible investors!

Tight Labor Markets Versus Crippling Debt

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

The potential for trade wars and tech regulation is increasing. And these are real market risks. But so far, it’s all talk and speculation. They remain low probability events. We need to closely monitor them but not overweight them in our decision making.

Currently, the key driver of market direction over the near-term is interest rates and thus inflation expectations. This is why we’ll need to keep a close eye on inflation indicators in the coming months.

The cyclic environment is currently supportive of building inflationary pressures. The economy is maxed out, as measured by capacity utilization and the GDP gap.

The labor market is tight and this is beginning to drive up wage pressures.

The US dollar, which has shown an increased correlation (or causal link) to inflation these last two cycles, is signalling a jump in inflation over the coming months. Lower dollar = higher inflationary pressures through the commodity price channel. Dollar is inverted on the chart below.

But on the other hand, we have disinflationary pressures coming from a deleveraging China, which is showing in falling exporter producer prices.

There’s also still the issue of a world awash in debt. And debt is naturally a deflationary force.

The developed world is only beginning to chew through the massive debt load it accrued over the previous two cycles. This is why developed market credit growth has been so anemic lately.

In my eyes, the inflation picture remains mixed.

Pressures are building in the economy which is typical this late in the cycle. But it’s to be seen whether this will be strong enough to counteract the disinflationary pressures of the global debt load and a deleveraging China in any meaningful way.

My base case is that we see inflation continue to rise modestly but not enough to make the Fed ramp up their hawkishness.

Of course, I could be wrong. I think the big tell will be the US dollar which is now at a critical inflection point. If it takes off on another leg lower then we’ll see commodities run up, giving a boost to inflation.

This would shorten the last phase of this bull market…

The primary trend in global markets remains up. But we’re likely to go through a gestation period while the last vestiges of overly bullish sentiment get washed out. This should result in continued volatile chop for some time (a few weeks to months) while a new base develops from which the market can launch its next leg up.

The key here will be managing our risk and not overtrading. We don’t want to get chopped up in the sideways action. We’ll be selectively adding starter positions in trades that have a low correlation to the broader market.


  • The inflation outlook is a mixed bag. There are inflationary pressures building from an economy that is operating at/above full capacity and an increasingly tight labor market that is slowly pushing wages higher.
  • But these inflationary pressures are being counteracted by persistently high debt levels in advanced economies and a deleveraging China, that is feeding into lower export/import prices to the rest of the world.
  • Our base case, which could very well be wrong, is that inflation will continue to firm but only modestly. Not enough to push Powell’s Fed to become more aggressive in hiking rates.
  • The big tell that we’ll have to track is the US dollar. The dollar has become highly correlated with inflation over the last two cycles. The recent fall in the dollar should put upward pressure on inflation through the commodity pricing channel. If the dollar embarks on another leg lower, that’d greatly increase the odds of us entering an inflationary regime which would translate into a violent bear market.
  • Expect equity markets to continue to chop around and go through a gestation period for a while. Overly bullish sentiment needs to be reset. Q1 earning surprises are likely to eventually drive the market on its next leg higher.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.



Let Loose The Dogs of War… How To Navigate Late-Cycle Market Volatility

Paul Tudor Jones once said, “You look at every bear market and they’ve always basically occurred because of an uptick in inflation and an uptick in interest rates.”

PTJ is right… Those of you familiar with our debt-cycle framework know that the Fed drives the business cycle by raising or lowering the cost of money (interest rates). And the Fed bases its rate decisions off of its two mandates (1) maintaining full employment and (2) and stable prices (ie, 2% inflation target).

These two mandates are intimately connected. A tight labor market drives wage pressures as businesses are forced to pay up for scarce labor. These increased costs eventually get passed to the consumer in the form of higher priced goods and services (ie, inflation).

Higher inflation leads to more aggressive rate hiking by the Fed which tightens liquidity, squeezes risk-premiums, and turns the debt cycle over into a short-term deleveraging.

The GOAT (aka, Stanley Druckenmiller) laid out in a Barron’s interview from the late 80’s exactly how this process plays out. He said, with emphasis by me:

The major thing we look at is liquidity, meaning as a combination of an economic overview. Contrary to what a lot of the financial press has stated, looking at the great bull markets of this century, the best environment for stocks is a very dull, slow economy that the Federal Reserve is trying to get going… Once an economy reaches a certain level of acceleration… the Fed is no longer with you… The Fed, instead of trying to get the economy moving, reverts to acting like the central bankers they are and starts worrying about inflation and things getting too hot. So it tries to cool things off… shrinking liquidity [While at the same time] The corporations start having to build inventory, which again takes money out of the financial assets… finally, if things get really heated, companies start engaging in capital spending… All three of these things, tend to shrink the overall money available for investing in stocks and stock prices go down…

We are now in this “late-cycle” phase of the short-term debt cycle. We call this period the ‘Overheat Phase’ as per our Investment Clock framework. This phase of the cycle is distinctly different from the previous one and thus needs to be traded and managed differently.

Where low volatility defined the prior period, this one will be marked by high volatility and greater dispersion between asset returns (ie, a wider gap between winners and losers).

Let’s run through the evidence real quick. Then we’ll talk about a unique approach we use in this type of market regime that allows up to better manage risk while still keeping our portfolio open to plenty of upside.

To start, every important macro indicator we track tells us that we’re in the late phase of the bull cycle. This phase typically lasts between 18 and 30 months and we entered this period last year. We’re closer to the middle of this phase than the end of it which is supportive of a continuing bull market.

The global labor market has become extremely tight. It’s now at levels that in the past have marked the beginning of the end for stocks…

Equity risk-premiums (the difference in earnings yield on stocks relative to government bonds) has tightened significantly but there’s some risk-premium left. The spread is still above the levels reached in 07’ and 00’. This is supportive of stocks over the near-term.  

The GDP Gap has closed and the economy is now operating at above capacity. This means that demand is beginning to outpace the economy’s ability to service it which is leading to demand-pull inflation, which we can see in the chart on the left.

This is why we recently saw the largest 3 and 6 month annualized jump in Core PCE inflation readings in over a few years.

The jump in inflation has spurred a rise in inflation expectations (a circular feedback loop is at risk of forming) which has caused interest rates to spike over the last few months.

Bond yields affect stock prices in two ways (1) they compete with equities for investor capital flows, a higher yield makes them more attractive on a relative basis and (2) higher yields (interest rates) raise the discount rate at which stocks are valued, which lowers the the present value of their cash flows.

This relationship is easily visible in the chart below.

Rising bond yields leads to a dislocation in the equity market and falling yields are supportive of risk assets. Note how the latest market sell-off that began in January was caused, not by concerns over trade wars or tech regulations, but by rising yields.

Higher interest rates are causing liquidity to shrink (ie, financial conditions to tighten) albeit from very loose levels.

And liquidity drives volatility.

Tightening liquidity leads to higher volatility and vice-versa. Higher volatility leads to more uncertainty over the future (ie, earnings forecasts) which leads to a rerating lower in valuation multiples. This works in a reflexive feedback loop as tighter liquidity leads to higher volatility leads to increasing uncertainty which leads to ever tighter liquidity and so on…

So here we are…. In the middle part of the late-cycle phase of the short-term debt cycle. Inflationary pressures are building, thus driving interest rates higher which is leading to tightening liquidity and higher volatility.

What is a trader/investor to do in this type of environment?

Our number one priority is and always should be, capital preservation. The practice of rigorous risk management is more than just preachy self-discipline. It’s to ensure our survival, extend our trading longevity, and to position us so we have ample dry powder for when highly asymmetric opportunities come along…

Thus, in increasingly volatile environments like the one we now find ourselves in. Our team at MO utilizes a method of trade construction that we picked up from hedge fund manager, Jim Leitner.

We call this our DOTM strategy which stands for Deep Out of The Money options.

We exploit a key inefficiency in the failure of long-term out of the money options to correctly price in drift (or trend). This allows us to only risk small amounts of capital while still being able to create huge convex payouts — on the order of 20x+. And just as importantly, it allows us to outsource trade management to the option — which cuts out our risk of getting whipsawed in a choppy market.

This Saturday, April 14th at 2 PM EST we’re hosting a live webinar event that will show you exactly how we implement our DOTM approach. We’ll be covering everything from the theory behind it to the exact rules we use to select the perfect DOTM option.

Click here to register for the DOTM special event!

We only do public events like these once a quarter and we don’t record them so be sure to register. You don’t want to miss how we use this vital tool to maximize risk-adjusted returns in a late stage bull market.

Click here to register for the DOTM special event!


When Is The Next Bear Market? Evaluating Risk Premium Spreads

Today we’ll measure the current risk premium in the market. We’ll take a look at risk premium spreads and see how much longer this bull has to run.

Make sure you review this video that explains risk premium spreads before continuing: 

When the Fed lowers interest rates, it affects the risk premium of every asset class. It lowers the return on bonds and widens the spread between safer assets like cash and bonds and riskier assets like stocks.

The larger spread means risk assets become more attractive relative to safe ones. And because of the lower return in safe assets, investors have to move out on the risk curve into riskier assets to maintain their returns. This causes riskier assets like stocks to get bid up, driving valuations higher. And when valuations increase, expected future returns go down.

Eventually risk premium spreads get pulled really tight together. Valuations get so high that expected returns in stocks almost equal cash… but with much higher volatility.

This happens during the late cycle phase of the short-term debt cycle. And by this point no one wants to hold stocks which is why we get bear markets as investors sell their stocks and allocate towards cash and bonds.

In the video above we’ll use GMO’s 7 year asset class real return forecast, the inverse of the CAPE minus the rate on 10-year bonds adjusted for inflation, and the rolling 5-year average annual return to equities relative to 2-year bonds to determine the current risk premium in the market.

Putting that information together we can see that we’re in the late cycle phase of this bull. But that phase lasts between 18 and 30 months. And we’re closer to the middle than the end. This puts the next bear market around 12-18 months from now.

Watch the video above for more!

And if you’re interested in learning more about risk premium spreads and our views on the current market, then check out the Macro Intelligence Report (MIR). Click here to get that report.