Finlight Research - Market Perspectives - Sep 2015

Market Perspectives
September 2015
Sep. 4th, 2015
www.finlightresearch.com
When China sneezes, the world just might catch a cold…

“Every single major global recession in the last
50 years has started in the United States. The
next global recession will be made in China.”
– Ruchir Sharma - Head of EM for Morgan
Stanley IM (July 2015)
“The crisis takes a much longer time coming
than you think, and then it happens much faster
than you would have though.”
– R. Dornbusch
2
FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation
As trumpeted for months now, Chinese economy was the eye of the
storm. Concerns about its growth and fears of global
recession/deflation triggered the panic on the global capital markets
The deflation and growth scares morphed into a vicious cycle over the past
few weeks.
Our sentiment is that the risk-off tide is rising. The market sharp sell-off
suggests that something big is unfolding. The bull market is probably not
broken but seriously damaged.
The long-awaited (10-15%) correction on stocks has finally occurred. But we
still believe that equity markets are living on borrowed time
The last time markets experienced the type of volatility that we are currently
witnessing across all asset classes was in 2008. The volatility regime
switching we’ve been signaling for months is finally confirmed.
Anticipation of rising interest rates will contribute to fear and volatility in the
stock market. The last payrolls report keeps a September hike on the table
We maintain our view that commodities will underperform, US$ will continue
its rise, and volatility will remain high.
A confluence of forces are converging to disrupt global equity and debt
markets.
We reiterate our view: A perfect storm is building… It combines historically
overvalued stocks with stretched government bonds and corporate credits.
Unlike previous storms (2000, 2008), investors would be left with almost
no place to hide
We summarize our views as follows
3

MACRO VIEW
The Good
The second revision to US Q2 GDP growth came in surprisingly strong at 3.7% vs a previous
2.3%.
Consumer confidence is very strong according to the Conference Board survey.
US employment improved by most measures
The Bad
At 0.2% (and 1% core) the Eurozone's inflation rate is far away from the 2% ECB target.
Japanese economy is contracting again (-0.4% in Q2-2015)
Chinese growth is slowing. China's manufacturing PMI came with its worst reading in three
years (49.7 vs. 50.0 in July). Turmoil in China's equity market has reached extreme levels.
August manufacturing PMI has disappointed everywhere, except in Germany
US productivity is anemic. Over the past 70 years, its growth has never been weaker except
in the 1976-82 period.
The Ugly
Main systemic risk resides in China: The Chinese debt burden is extremely high and the
credit cycle is probably starting to turn. We are probably in the early stages of a bursting credit
bubble.
The fixed-income / credit edifice is highly vulnerable to China’s need to liquidate Treasury
reserves in order to maintain its currency peg, as capital outflows increase and market widely
expects further devaluation in the USD-CNY
4

5
The Big Four Economic Indicators
The current picture is characterized by relatively strong Employment and Income, a weak Industrial
Production and an erratic to weak Real Sales.
The average of these indicators suggests that the economy is still trending sideways. But setting a new
high still seems possible over the short term.

6
US Employment
US employment has been falling
steadily by most measures.
Wage gains were 2.2% on a year-
over-year basis.

7
US productivity
The disappointingly-slow pace at
which the US economy is growing
may be explained by the sharp
decline in productivity
Over the past 5 years, productivity
has increased by 0.54% per year on
average, a very weak growth rate
similar to the one experienced during
the 1976-82 period!
The declining productivity is the
natural result of reduced investment
and a general aversion to risk-taking

8
GS – Global Leading Indicator (GLI)
The Aug. Final GLI came in at
1.3%yoy. Its MoM momentum is
down to 0.11%
According to last estimates, GLI
has crossed the border from the
Expansion phase to the Slowdown
phase, since June
Four of the ten underlying
components of the GLI improved in
August. Most manufacturing
subcomponents, including the
global PMI declined over the
month.
We continue to think that the
acceleration we’ve been
witnessing since Jan. ‘15 is quite
modest for a typical expansion
phase

9
Chinese Economy
Chinese growth has been slowing
since 2010
Two (electricity consumption
and rail car volumes) of the 3
indicators we usually use to
assess the economic health in
China have declined during H1-
2015 . Only bank lending continues
at the same pace.
The official 7% GDP growth is
clearly outdated. The economy has
been probably flat over the quarter!

10
EQUITY
Is the long-awaited correction over? We think that a new test of recent lows is very likely…
The S&P500 has been rangy for most of the year. At the top of the range, 2130 is probably the level that
will make or break the market over the short-term.
If the S&P500 was going to move higher (breaking the 2130 ceil), it probably would have done it
by now. Given the weakness in the transports and Russell 2000 (and other market breadth
weaknesses), we view the bias to the downside and think that the top is already in place (80% chance).
At this stage, the bullish trend has been definitely damaged, as the S&P500 breaks its trendline
across the lows since Oct. ‘11 at around 2000
Recent data shows more evidence of lower productivity, lower potential GDP growth and (later)
higher inflation risk. This is a bad scenario for stocks
We still believe that equity markets are living on borrowed time because…
Earnings season hasn't provided the catalyst needed for the breakout to the upside
Valuations are well above historical norms, especially when we take into account the slower
revenue growth, the lower margins and the starting wage pressures
With the market already lofty, a 1.5% revenue increase (for Q2-2015 on S&P500 excluding energy)
doesn't give a lot of upside room.
The coming rate hikes will depress all asset prices for at least a part of next year
The market wild moves during August suggest that something big is indeed unfolding.

11
EQUITY
Bottom line :
For months now, we’ve been asking our clients to incrementally "de-risk" their portfolios by
focusing on higher quality / more defensive / more favorably priced companies.
We moved from Neutral to UW equities the S&P500 broke its trendline across the lows since
Oct. ‘11 at around 2000
We may revise our view to Neutral if the S&P500 breaks above 2000-2050, and to OW after a
clean break of the 2070-2130 range.
Other markets (FX, credit, commos, volatility) suggest stocks are still the odd man out. The
risk/reward remains in favor of waiting, rather than being fully invested, until there is more clarity
We stopped our (FX hedged) OW and moved to Neutral (vs US) on Japan as the behavior of
the Nikkei around the important level of 21 000 was deceiving, and our toppish view on USD-JPY
was confirmed. Japanese equities were the worst performing DM market driven by the proximity to
EM Asia. Weak demand from China is expected to continue to weigh on Japan's production.
We remain Neutral on Europe vs. US despite the policy divergence between the Fed and the
ECB. According to the 12 month forward P/E, Europe is trading at 15 year highs, relative to the
US
We remain UW in US small caps vs large caps.

12
US Earnings
For Q3 2015, 77 companies have issued negative
EPS guidance and 30 companies have issued
positive EPS guidance
The 12-month forward P/E ratio for the S&P 500 now
stands at 15.3, down from 16.5 last month, but still
above historical averages: 5-year (14.0), 10-year
(14.1)
For Q2 2015, earnings growth stands at -0.7%. The
last time the index reported a YoY decrease in
earnings was Q3 2012 (-1.0%, the Fed came with
its QE4 later that year).
Of the 495 companies that have reported earnings
to date for Q2 2015, 74% have reported earnings
above the mean estimate and 51% have reported
sales above the mean estimate. This is below the 5-
year average (57%).
Most of the deterioration in earnings momentum
for the S&P 500 is due to the Energy sector
If the Energy sector is excluded, the earnings
growth rate would jump to +5.7%

13
US Equity – Insiders Buying
The ratio of buyers to sellers
among corporate insiders is
heading north, crossing the LT
average of 0.5 for the first time
since 2012.
We look for an inflection point in
this ratio before hoping a bottom
formation in equities.

14
US Equity Volatility
The connection between implied volatility and stock prices has been extremely strong over the last
months. This is probably due to hedging activity (option writing) and systematic strategies (trend-
followers, risk parity portfolios)

15
Equity Volatility / Correlation
Implied S&P 500 volatility, skew and correlation are pointing to extreme market conditions.
Implied S&P 500 volatility spiked to extremes. And so did the vol skew!
Implied S&P 500 stock correlations surged to its historical highs.

16
US Equity – Margin Debt
We look at margin debt (as a % of GDP) as a warning flag.
At $464 billion in April, the margin debt is at its all-times highs, and represents 2.78% of the US GDP.
Similar extreme levels have never been reached except twice: in Mar. 2000 (2.78%) and in July 2007
(2.62%).
We seem on the verge of a “nervous breakdown”

17
S&P500 – A MT Perspective
Weekly and monthly S&P 500 charts
show a loss of momentum. New
market lows are plausible..
On monthly basis, the MACD breaks
through the zero line
In the past, this has been a very
good indicator of very important
market inflection points

18
S&P500 – A Medium-Term Perspective
As said in our previous report, we
interpreted the material break below
2000 (trendline across the lows since
Oct. ’11) as a signal that the underlying
trend is definitely damaged.
We moved UW stocks on Aug 21st,
and we will stay so as long as the
trendline across the lows since Oct. ‘11
is not broken to the upside.
We would start to get uncomfortable if
the S&P500 goes above 2030-2050
The next level to watch is the 2009
uptrend around 1700.

19
Equity Volatility – Regime Switching Confirmed
On Oct 13th, 2014, our regime
switching model pointed to a
major shift in the S&P500
volatility regime
Since then, the VIX index has
left the “Low Vol” regime, and
started to migrate between the
“Medium Vol” and “High Vol”
regimes
The last time we’ve seen a
similar behavior on the VIX
was in July ‘07.
The last turmoil provides an
additional support to this
hypothesis

20
Chinese Stocks
The Shanghai Composite Index
reversed sharply higher on its Aug 26
bottom.
But despite the corrective rally
underway (with a plausible target at
3700 - 4000, the downtrend is still
preserved. We keep our negative
bias on Chinese equity.

21
S&P500 – A Short-Term Perspective
As of Sep 4th , our prop. Short-Term trading model is flat on the S&P500 (@1921.22).
Out of the 5 active systems, 3 are long with 1961 and 2041 as targets. The other 2 are short with a
target at 1903
The model has been in drawdown since Aug 20th, as it was massively long when the sell-off
occurred. It became almost flat at the close of Aug 26th (@1940.51) making up its losses partially.
The model has boosted its return generation since Oct. ‘14, exhibiting a pattern similar to the one
we’ve seen after Jun. ’07. Even the last drawdown is similar to that started on Jun 6, 2008

22
FIXED INCOME & CREDIT
We still believe the Fed is on track for a September rate hike (the stronger than expected US labor
market report supports this view), when the market continues to price such a scenario very partially.
UST yields remain underpriced relative to this scenario.
The dovish rhetoric from the ECB tends to put more probability on a QE extension in either October
or December
The recent decline in US nominal yields is largely due to a downward revision of inflation expectations.
Nevertheless, inflationary signs should be watched closely as they will foreshadow a steepening
decline in govies.
We expect negative total returns on USTs. We still look for the bear market on USTs to resume.
We remain Neutral on USTs as far as the 10-year yield stays below 2.30. We wait for a material
break either above 2.35 or below 2.00 to change our positioning
Our ultimate target on 10y yields stands at 2.75 by end of 2015.
On German Bund, we remain Neutral. as long as the 10-year yield stays above the 0.45 – 0.50 area.
We will switch to UW again as the 10-year yield breaks above 0.80-0.90
Inflation breakevens have risen since the start of the year. We remain OW HICP Inflation through 5y
inflation swaps (long HICP inflation breakevens = receiving HICP vs payind fixed rate) as we expect
a steady pick-up in HICP inflation over 2H15
We expect TIPS to underperform as energy prices continue to decline and Fed tightening tends to
push real rates up in the absence of accelerating inflation.

23
The Chinese turmoil and expectations of substantial IG supply have weighed on corporate spreads
over the past 2 months.
Credit quality further deteriorates in Q3, both in IG and HY, as the releveraging continues to rise at
a sustained pace (especially in HY space)
August has not been kind to the HY market. With the Chinese hard landing fears resurfacing,
pressure resumed on commodity prices, pushing down credits in the Energy, Metals & Mining sectors,
especially in US HY
We feel more cautious about EUR HY despite the prospects of further easing by the ECB. Next QE
should drive a rally in European credit over the near term, but long positioning is getting crowded and
liquidity scarce
We remain UW on corporate credit, due to valuation, to rising corporate leverage (specially in the
US), to rising volatility, to position within the credit cycle and given the weak total return forecast
We still prefer IG over HY on a risk-adjusted basis as we expect volatility on spreads to remain
elevated and we believe IG corporates better positioned to absorb the impact of rising rates
Within the credit pocket, we remain Neutral on USD vs. EUR HY spreads, but we prefer USD on a
total return basis, despite its higher beta to energy sector
We still prefer US IG over Eurozone.IG, as we think that more attractive spread valuations and
higher carry should fuel a stronger bid for US credit.

24
Bottom line : UW Govies, Neutral US vs Eurozone Govies, remain long flatteners on the US yield
curve and short duration in 2y USTs, UW credit, Neutral Eurozone vs US HY credit, UW Eurozone vs
US IG credit, Neutral TIPS and OW HICP Inflation, UW High Yield vs High Grade, Neutral on EM
corporates

25
US Govies – 10y UST
Last month, we decided to switch
from Neutral to UW 10y USTs and
moved to 2.30 the threshold below
which we become Neutral again.
We keep this same positioning rule
Tactically, we are now Neutral
again, waiting for a break either
above 2.50 or below 2.00 to
change our positioning.
We think that the risk is still
biased to the upside on the 10y
yield.
A better labor market would
translate into higher inflation
expectation later this year (or in
2016) and higher LT yields.
In order to confirm our bearish
view, a clean move above 2.40-
2.50 is needed..

26
Government Yields
Despite the risk-off dominant
behavior, government yields
increased over the past 2 weeks
One possible explanation resides
in the “Chinese Effect”: China
needs to liquidate Treasury
reserves in order to maintain its
currency peg, as capital outflows
increase and market widely
expects further devaluation in the
USD-CNY
5-year Bund Yield

27
US Credit
IG spreads have reached a 3-year peak, driven
by heavy supply and concerns about commodity
prices.
With the Chinese hard landing fears resurfacing,
pressure resumed on commodity prices,
pushing down credits in the Energy, Metals &
Mining sectors, and putting pressure on HY
bond prices
We still prefer IG over HY (both in US and
Eurozone) on a risk-adjusted basis as we
expect higher volatility on spreads and we
believe IG corporates better positioned to
absorb the impact of rising rates

28
European HY
Investors’ interest in the asset class is clearly calmed down by:
Two concerning metrics: net leverage and interest coverage
Significant outflows and rising supply
Higher proportion of issuance (37%) used for M&A and share buybacks, which is considered as
“credit negative”.
Net Leverage
European High Yield
Interest Coverage Ratio

29
Credit – Any Warning? Credit vs Equity
During normal market conditions, the correlation between the S&P 500 and HY spreads is negative.
Since 1997, this correlation has averaged -75% and has been in negative territory 86% of the time.
Currently, this correlation stands at extreme positive levels (+60%), higher than those seen in
2000 and 2007. This is probably the signature of the next crisis to come.

30
Credit – Any Warning? Swap Spreads
2-yr swap spreads acted as an advance warning of widening risk in HY spreads and fundamental
deterioration in the broad economy
At this stage, swap spreads are trading around 20-30 bps. No risk is seen on the horizon
yet!

31
EXCHANGE RATES
The dollar rally is not over. We reiterate our bullish view on USD over the medium-term and expect a rival
of the appreciation cycle of the '90s
Historically, USD cycles have been persistent, lasting 5-6 years in the appreciation phase. We thus see
further medium term USD gains against the major crosses (especially EUR and JPY) and expect a
cyclical low in EUR/USD somewhere in 2016 (with the ECB tapering)
But over the ST, and without a September hike, the uptrend on the US dollar may be damaged
seriously.
The line in the sand for the DXY index is provided by the lows of May and June. A clean break below
would derail the strength phase.
Our positioning on USD is driven by (almost) the same trading rules:
We are now Neutral on EUR-USD, as it stays between 1.1080 and 1.12. We will move to UW
again if the spot breaks below 1.1130 with 1.08 as a target, and to to OW above 1.12
On USD-JPY, we remain Neutral for the moment, as the spot failed to hold a break above 124-125
resistance
We remain short EM and Commodity FX

32
EUR-USD
The 6-month correlation between EUR-USD and the spread between 2-year swap rates in EUR and
USD, is back to its highest levels (around 55-60%) of 2015
China unexpected currency devaluation sent a negative message on the global growth and
raised speculation about Fed delaying its interest rates move Decline in US$

33
EUR-USD
EUR-USD has broken above
its July ‘14 downtrend (around
1.10).
During the month, we moved
UW as the spot broke below
1.1040 and reached our first
target around 1.08.
As said in our previous Monthly
Report, we moved from UW to
Neutral as the spot broke above
1.1080 and then to OW above
1.12
We are currently Neutral, and
prefer to keep our bearish
bias.
We will move to UW again if the
spot breaks below 1.1130 –
target = 1.08

34
COMMODITY
The picture remains bearish in commos. despite the sharp reversal in prices (led by energy and
base metals) we’ve seen recently, and which is more about technicals than fundamentals.
Commodity weaknesses (supply glut in oil, slowing growth in China, precious metals loosing their
luster as a safe heaven…) are likely to continue.
The expected Fed rate hike would put more pressure on the asset class as higher interest rates put a
higher cost on holding commodities
The next leg up in the US$ will put more pressure on commodity prices
We remain neutral-to-bearish across all complexes in the near term. To mid-2016, return
forecasts are negative for commodities as a whole.
We still think that it is still too early to get in the “reflation trade” of a weaker dollar and higher
commodity prices
We remain UW commodities. We continue, however, to like owning the GSCI index, and think
that commodities hold value as cross-asset portfolio diversifiers and as an inflation hedge.

35
COMMODITY
Bottom Line :
Base Metals: Base metals don’t appear to be stabilizing yet. We remain Neutral on base metals given
the current weaker demand environment.
On the MT, we do not like holding Copper (even if it could go higher over the ST) as it appears
highly overvalued relative to the dollar, the global growth and the Chinese demand.
Producers should cut existing production and future projects before we can expect a sustainable
reversal in prices.
We expect base metals to trade lower for longer in order to match supply with demand.
Agriculture: GSCI Agri posted -2.57% in August. We remain Neutral
Energy: We remain of the view that the oil market is oversupplied, still think it is too early to expect
major upside for the price and that the risks remain substantially skewed to the downside. The rising
Middle East production (Iran would double its oil exports to 2.3M barrels a day) and the seasonal dip in
refinery crude runs should add pressure to the market.
We moved from UW to Neutral, as the spot dropped below 42.
We will move to UW again if the WTI goes above 56.5 and to OW if the it breaks above 63

36
COMMODITY
Precious Metals: As expected, the Gold broke below its March lows and headed towards our target
(980-1000), before rebounding on the 1080 level.
We change nothing to our view on precious metals. The stimulus provided by the ECB & BoJ is
already factored in gold prices. Precious metals are vulnerable to higher US real yields,
stronger dollar and weaker gold flows to Asia We maintain the view that Q3 15 is likely to be
the weakest quarter for gold
Applying our trading rule, we decided to switch from UW to Neutral at and below 1150, and to
move progressively to OW (accumulate) as the spot slides down.
We are OW gold. The impulsive rebound we’ve seen in August is probably the signature of a base
formation around 1080 (to be checked), and the beginning of a corrective rally
We will significantly increase our OW if the spot breaks above the 1150-1160 area (target 1210 and
higher)
A clean break below 1120 would open the door for testing recent lows again. We will increase our
OW below 1060.
We still think that Silver (like gold) is probably ready for its final leg down towards 12.50.
We are OW (accumulate) on Silver as the spot broke below the 14.70 resistance and moved
down towards 12.50.
We may increase our OW if the Silver breaks above 16.7-17 or below 13.5

37
Crude Oil
From looking at the strong rally the crude has experienced during the last days of August, short
squeeze and other technical factors seem to be the most rational answer.
We see no fundamentals behind this move. We expect a consolidation to the downside.

38
Crude Oil – Tech. Perspective
We moved UW on July 2nd.
expecting WTI to retrace its recent
lows of $45/bbl by October. But
our target level has been reached
earlier.
In our Aug. Report, we decided
to go Neutral again around 42
and wait to see how the spot
behaves near the previous lows.
Since then, we are Neutral
crude. We were proved right
given the sharp rebound we’ve
seen at the end of August.
A base formation seems
underway.

39
Gold – Tech. Perspective
According to our trading rule
(please see our previous reports),
we decided to switch from UW
to Neutral at and below 1150,
and to move progressively to
OW (accumulate) as the spot
slides down towards 1000-980.
We are OW gold. The impulsive
rebound we’ve seen in August is
probably the signature of a base
formation around 1080, and the
beginning of a corrective rally
We will significantly increase our
OW if the spot breaks above the
1150-1160 area (target 1210 and
higher)
A clean break below 1120 would
open the door for testing recent
lows again. We will increase our
OW below 1060.

40
ALTERNATIVE STRATEGIES
The HFRI Fund Weighted Composite Index fell 1.87% in August (+0.2% Ytd). August was the
worst monthly performance since May 2012. Nevertheless, the FWC index outperformed the S&P 500
by over 4% over the month (and +3% YTD). Losses were widely distributed across HF strategies. Best
performers were low-beta strategies (Macro, Arbitrage, Market-Neutral Equity). The HFRI Macro:
Systematic Diversified/CTA Index declined by -1.9%
The weak performance of Macro managers was mainly due to long positions in equities and USD.
Long exposure to US rates proved rewarding but the gains were more than offset by losses on long
positions in European rates.
Long-term CTAs suffered from the collapse of equities given their long exposure. They also posted
losses on their long exposure to rates and were penalized by their short exposure to energy.
We stick to our preference for risk diversifiers (pure alpha generation strategies) over return
enhancers. Our strategy has been clearly rewarding during the last market turmoil.
We believe that diversifying portfolios with an increased allocation to alternatives is particularly
attractive at this stage of the cycle.
We are not changing our recommendations on alternatives which we consider to be suited to current
market conditions. We maintain our OW positioning on:
Equity Market Neutrals both for their “intelligent” beta and their alpha contribution.
CTA’s and Global Macro as a diversifier and tail hedge. These strategies should outperform as
FX and commodity current trends are likely to persist.
Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all regions). This is our
way to take advantage from the higher volatility regime.

41
CTA Funds
CTAs remain our favorite HF strategy over the mid term as they provide adequate
diversification benefits, and despite the fact that their current positioning (neutral to short equities,
long govies, long USD and short commodities) is vulnerable to a market rebound.
This strategy is well designed for the current context of aging bull market for both equities and
bonds.
Source: Attain Capital

Bottom Line: Global Asset Allocation
As trumpeted for months now, Chinese economy was the eye of the
storm. Concerns about its growth and fears of global
recession/deflation triggered the panic on the global capital markets
The deflation and growth scares morphed into a vicious cycle over the past
few weeks.
Our sentiment is that the risk-off tide is rising. The market sharp sell-off
suggests that something big is indeed unfolding. The bull market is probably
not broken but seriously damaged.
The long-awaited (10-15%) correction on stocks has finally occurred. But we
still believe that equity markets are living on borrowed time
The last time markets experienced the type of volatility that we are currently
witnessing across all asset classes was in 2008. The volatility regime
switching we’ve been signaling for months is finally confirmed.
Anticipation of rising interest rates will contribute to fear and volatility in the
stock market. The last payrolls report keeps a September hike on the table
We maintain our view that commodities will underperform, US$ will continue
its rise, and volatility will remain high.
A confluence of forces are converging to disrupt global equity and debt
markets.
We reiterate our view: A perfect storm is building… It combines historically
overvalued stocks with stretched government bonds and corporate credits.
Unlike previous storms (2000, 2008), investors would be left with almost
no place to hide
We summarize our views as follows
42

43
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…
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perspective, on Portfolio Construction, and all related quantitative aspects and risk management issues.
Our expertise expands along 3 axes:
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carry, volatility), real assets (real estate, infrastructure, farmland, timberland and natural resources).
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