FinLight Research - Market Perspectives Apr 2014

Market Perspectives
Apr. 2014
April 3rd, 2014
www.finlightresearch.com
Caveat emptor…

“Markets crash all the time. You should, at minimum,
expect stocks to fall at least 10% once a year, 20%
once every few years, 30% or more once or twice a
decade, and 50% or more once or twice during your
lifetime. Those who don't understand this will
eventually learn it the hard way.” - Morgan Housel
2
FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation
Macro matters: While we are no longer in a recession, the
economy is still far from ideal. The market is becoming more
vulnerable as the Federal Reserve begins to adjust the monetary
policy
Many signs point to a global slowdown: China's sudden decline
in exports, downward revision to their economy's growth rate,
stalling of Europe's recovery
We continue to see the main systemic risk coming from
China.
We expect market volatility to rise over the 1-month and 3-
month time horizons.
We summarize our views as follows
3

MACRO VIEW
The Good
Fed Chairman Yellen's remarks that the Fed remains short of its employment and inflation targets
created a feeling that the Fed might taper a bit more slowly
Auto sales are strong
ISM manufacturing and service are in expansion territory
The market expects Beijing to launch a series of policy measures to stabilize growth and stop the
loss of momentum in its economy.
The Bad
Earnings warnings are at record highs
Inflation in Eurozone lowest since November 2009
Junk bond issuance is reaching record highs, while both the yields and the quality of the debt issued
have never been lower.
China's growth is slowing
Delaying the rebalancing process in China, thanks to countercyclical policy of support to growth,
increases hard landing risks in years to come
Ukraine situation remains a big concern
The Ugly
Continued weakness in China's economic numbers could offset economic gains in the U.S. and
elsewhere
4

5
Big Four Economic Indicators
The global picture is always that of a slow but consistent recovery.
The data for Feb and Mar. are back to green
Among the 4 indicators, two (Real Retail Sales and Industrial Production) have already reached their all-
time highs. Nonfarm Employment remains on a positive trend. Only Real Personal Income is still
struggling.

US Employment
Last employment data have changed nothing to the global picture: Since 2011, job gains have been
oscillating around 200K per month. This is too tight to drive real GDP above the 2-3% range
6

US Employment
US employment is experiencing a secular change
The employment-population ratio (ratio of the number of employed people to the total civilian
population age 16+) is under 59%, a level similar to that of the one-income household period in the
early 1980s
At 63%, he labor force participation rate (the number of people who are either employed or are
actively looking for work, as a percentage of working-age persons) is back to the 70s level, just
before the massive entrance of women in the labor force.
7

US Employment
We see another major shift on the employment front: The post-recession duration of unemployment
has remained very high at 35 weeks…
8

PCE & DPI
The trend in disposable personal income (DPI) and personal consumption expenditures (PCE) has
remained positive so far this year, without being particularly impressive in real terms.
9

10
Household Income
An upward trend is clearly evident in real median household income since mid 2011
However, real household incomes remain in worse shape than they were at last recession end.
In real terms, median household income almost never exceeded the purchasing power of 2000!

US PMI
ISM Manufacturing Index has now regained a part of the decline it saw from Nov. ‘13 to Jan. ‘14 (dropping
from 57.0 to 51.3)
Internals showed strength in new orders and employment
11

Factory Orders
The factory orders estimates for February were among the worst of this cycle
The last 2 years trend in factory orders does not point to any sustainable growth. We are back to levels
last seen during the first phase of the GFC
12

Real Yields & Inflation
With stable inflation expectation, the rise in government yields that started a year ago appears to be
driven by a rise in real yields.
That probably reflects the market's perception of the economy's strength.
But at -0.4%, real yields remain miserably low… Could that be a signal of improvement in economic
outlook?
13

Housing
Residential construction is clearly recovering.
Construction spending has increased by around 50% over the last 3 years
14

15
GS – Global Leading Indicator (GLI)
The GLI now locates the global
industrial cycle on the frontier of the
‘Expansion’ phase, suggesting that
growth is no longer decelerating
5 of the 10 underlying components
improved in March

US GDP
GDP ex-inventory draws an ugly picture of the US economy…
According to Alhambra IP, we are experiencing “the longest period of low non-inventory growth outside of
recession times since 1967”
16

17
EM Growth
EM manufacturing is underperforming. Growth remains weaker in EM…

18
China’s Growth
China’s growth is slowing…
China's Markit Purchasing Managers' Index
(PMI) dropped from 48.5 in March to 48.1 in
February, an eight-month low
The official M-PMI shows 2 disturbing points:
the orders index was low at only 50
the employment index remained in
recession territories for near 2 years

Fund Flows
In EM, and after months (21 straight weeks) of outflows, this last week saw a light inflow.
Within DM equity funds, inflows continue for the 39th week in a row into Western European funds.
19

20
EQUITY
Nothing new since our last update. Markets are back to their highs…The LT structure for the S&P500
still looks very bullish.
Stocks are seen as the only asset class offering significant returns. But, market’s defensive attitude
points to a possible correction
Stocks are already discounting a benign environment and should go through a consolidation phase,
unless a true growth surprise emerges
Poor earnings revisions and rising bond yields are the headwinds we should care about.
In our March report, we have been for a replay of the Jul/Aug 2013 episode with a pull back to the Jan.
15th high at 1,851 and even a break of this resistance. But the S&P500 stopped its downside around
1850. A clear break below 1850 would change the picture…
We continue to think that any further upside on the S&P 500 should be driven by profit growth
rather than P/E expansion
Bottom line :
We remain Neutral equities.
We keep our UW on (deflationary) Europe and EM vs. US and Japan
We keep our bias to defensive high-yielding stocks. A severe unwind appears to be underway in
high-beta areas like Biotech and Social Media.

21
Market Action / Breadth
Large-cap stocks closed the month marginally higher, but US small-caps have had a hard month.
A severe unwind appears to be underway in high-beta areas like Biotech and Social Media.
On the other hand, defensive stocks remain well-bid, like USTs (despite all the talk about the end of
QE)
Market’s defensive attitude points to a possible correction
Stock market breadth is declining…
Markets appears to be driven higher by fewer and fewer stocks. Usually, this is the signature of a
major market top.
Unlike the previous rallies where participation approached 90%, less than 75% of stocks are above
their 200 day MA.
Stocks are on the high side of fair value at this point but not into bubble territory yet.

22
Earnings
S&P500 reported earnings for the trailing twelve months (TTM) show
an upward sloping structure
But earnings have continued to be revised down with the exception of
Japan.

23
Earnings
According to John Butters, senior earnings analyst at FactSet, 93 out of the 111 companies in the S&P
500 that have issued an earnings outlook for the first quarter have guided below consensus estimate.
This is the second highest level of negative guidance ever recorded (since 2006)

24
Profit Margins
Corporate profit margins are at all-time highs
Corporate profitability depends on its negotiating power in the labor market and its interest expenses
An improving labor market and rising interest rates will have a negative effect on corporate
profits and, in turn, on corporate valuations.
But the timing is harder to assess…

25
Equity Valuation
The gap between dividend yields and real bond
yields remains high, supporting the relative valuation
of equities
The valuation gap between equity and fixed
income is still balanced

26
S&P500 vs EPS
The great re-rating of stocks over the last two to three years allowed the S&P500 to catch its EPS
No further re-rating should be expected For stocks to rise further, we absolutely need progress
on the earnings front.

27
S&P500 vs Euro Stoxx
U.S. and Eurozone equity markets continue to move in sync. But Eurozone has been the lager since
its sovereign debt crisis in 2011
It’s too early to play the convergence… as least as far as the Fed tightening is not a imminent danger

28
S&P500 vs USTs
The S&P500 and UST yields moved higher in sync as long as growth expectations were good.
Divergence was driven by disappointing US data
The S&P 500 has rebounded with the data, rates have lagged

29
S&P500 – Secular Trend
Real S&P Composite regression
trendline represents an annualized
growth rate of 1.75%.
Real S&P Composite follows secular
oscillations around its trend
Except during the 2000 bubble, the
variation from the trend has rarely
exceeded 2 standard deviations
We are now close to this level, like in
2007 and 1930
If the current S&P 500 were on the
regression trendline (1 SD below), it
would be around the 1050 (500).

30
S&P500 – Secular Trend
At 25, P/E10 ratio is at the highest level since Dec. 2007.
P/E10 ratio stands above the 90th percentile of the time series since 1880!

31
S&P 500 – Towards a Summer Correction?
Mid-term election cycle could lead to
a market correction this summer
According to a recent study of C.
Puplava, the market has a tendency
to correct during mid-term election
years. In the chart below, the
current S&P 500 path (in black) is
compared to :
The average (in green) of last
mid-term election years during
secular bull markets (2010,
1998, 1994, 1990, 1986, 1982)
The average (in red) of mid-
term election years during
secular bear market (2006,
2002, 1978,1974)
The overall average (in blue).
This comparison suggests a market
top before end of April and a
bottoming in the summer

32
Investor Sentiment
Citi’s News Implied Sentiment Indicator (NISI) aims to capture investor sentiment via the number of
news stories on Bloomberg containing the keywords “Bullish” / “Bearish”.
The index appears to be correlated to the detrended S&P500
NISI seems near a turning point. The S&P500 should follow…

33
S&P500 – Short-Term View
Market shows signs of exhaustion
as the spot approaches 1900.
The VIX below 13.50 warns of a
move back to a more important
support
We expect a meaningful correction
lower
A clean break of the 1835 – 1850
should open the door for a decline
to 1800/1798 initially.

34
S&P 500 – The Donchian Channel
Donchian Channel is one of our favorite breakout indicators. This is a moving average indicator
(developed by Richard Donchian) that plots the highest high and the lowest low over the last period
time intervals.
According to this indicator (on Apr. 3th), a clean break below 1839 (above 1893) should be a trigger
point to put on short (long) positions.

35
EM Equities
EM stocks look linked to growth stabilization / rebound in China, and should benefit from the
countercyclical policy of Chinese authorities.
So far, EM equities are priced for weak Chinese growth

36
EM Equities
EM stocks show an attractive valuation: MSCI Emerging Markets Index’s price-to-book ratio is below
1.5
MSCI EM is 30% cheaper than the MSCI World Index. This is the biggest discount in a decade

37
FinLight Research
Risk Aversion
At -0.32, the RAI remains in neutral territories. The correction is not significant. Equity 6m-momentum
is still too high to be sustainable.

38
FIXED INCOME & CREDIT
In Govies, we keep our core strategic view for higher long-end yields going forward, especially in
US and UK.
Turmoil in Emerging Markets and geopolitical risks continued to provide support for DM fixed income
through flight to quality flows. But, we expect the selloff on Treasuries to resume very soon.
We keep our short positioning on UST
We continue to OW Eurozone vs. US and UK given disinflationary risks in Europe.
Within the Eurozone, we stay neutral Peripheral vs Core as we see lasting spread compression to be very
limited if any.
We stay neutral on TIPS but go short 5yx5y Eurozone inflation as a hedge against the risk of Eurozone
deflation.
As a tail hedge, we keep our 10y bund swap spread receiver swap

39
FIXED INCOME & CREDIT
In corporate credit, we think that investors become less risk averse and more prone to seeking out risk
on the margin. Investors continue to move down in quality in search for higher returns.
The search-for-yield is likely to remain strong and may push spreads a bit tighter over the rest of the
year. But the risk of a liquidity shock is significant.
Given the rising government bond yields, we choose to stay Neutral (but may move to UW very
soon) on credit as a whole.
Regionally, we are Neutral between the US and Europe. European credit has a much stronger
potential for returns but this is mainly due to its much higher exposure to banks and peripheral credit.
Main change in our views: On a risk-adjusted basis, we now prefer IG over HY. According to our
Fair Value Spread Model, the compensation for risk looks now more attractive for IG (versus HY)
where spreads are considerably wider than pre-GFC.
We see value in EM external debt compared to US corporate credit, especially on some single
names (Brazil, Indonesia…) that should benefit from improving macro and rotation out of Russia.
Bottom line : Still UW Govies, Neutral credit, neutral TIPS, become UW High Yield vs High Grade

40
Peripheral Europe FI
Peripheral Europe sovereign debt is outperforming BBB EM sovereigns.
Yield on Spanish debt is at parity with USTs for the first time, the least since October 2007.

41
UST Speculative Positioning
Citi’s aggregate UST net speculative positioning (10y UST equivalent), based on CFTC data, shows an
increase in overall short positioning over the last week.

42
Eurozone Inflation
Deflation threat in the euro area is real. Similarities exist with Japan in the mid-1990s
Deflation risk could explain European stocks relative cheapness and bond yields current low level
We suggest to go short the EUR 5yx5y inflation as an effective hedge.

43
Corporate Credit
According to credit spreads, economic fundamentals appear reasonably healthy
Investment grade and high-yield CDS spreads are not very far from their pre-recession lows.
The same is true for the spread between high-yield and investment-grade CDS

44
Financials Credit
Although HY corporate credit is back at pre-crisis levels, the current level on financials shows that the
market is still demanding considerable excess premium to hold them.
iTraxx Senior Fins Index seems to price a substantially higher volatility.

45
Trend in High Yield Issuance
Junk bond issuance is reaching record highs, when both the yields and the quality of the debt
issued have never been lower.
Like in 2006, leveraged loans are becoming trendy. Their issuance volume has recently exploded and
their yields have collapsed.
Like in 2006, buybacks are surging. Corporates are issuing debt to buy back their stocks.

46
Corporate Balance Sheet
In our view, corporate re-leveraging remains the largest risk to credit quality. This risk is ignored by
the market, at this stage.
Contrary to the common thinking that "corporations hold record cash“, Variant Perception Research
shows gross debt has grown even faster than cash, and net indebtedness is at a record highs.
In their last report, they say: “Once you strip out the extremely large cash hoards of the biggest
companies, US corporate leverage is now much worse than it was in 2007. The last crisis was a
mortgage crisis, while this crisis will much more likely be a corporate debt crisis that investors are
barely focusing on.”
As an illustration, they provide a chart of the net debt per share in the US energy and consumer staples
sectors

47
CDS Positioning
DTCC data for net positioning in on-the-run CDS indices show that non-dealer positioning in the US
remains net long (selling protection) and reaches new highs this year, driving spreads lower.

48
EM External Debt
EM bonds are back in vogue!
A record $487 million poured into the world’s largest USD EM bond ETFs… An unprecedented flows

49
EM External Debt
The divergence between Barclays EM USD aggregate (sovereigns and corporates) Baa rated spread and
Barclays US Baa corporate debt spread is at a historical high
EM external debt looks attractive compared to US corporate debt.

50
EXCHANGE RATES
We keep our view for a stronger USD index in 2014 based on higher US rates and non-US
fundamental weakness
On the EUR-USD, the pull back to 1.31-1.25 we were waiting for has not materialized. We expect EUR-
USD to trade sideways in Q2. EUR depreciation requires higher relative real rates abroad. We stay
Neutral and wait for a clean break below 1.3688/1.3602 to become UW and target 1.31 - 1.28.
On the USD-JPY, we stay Neutral, watching for signs of a clean break above the area 103.93-104.34 to
become OW (and target 105.60 and 106.10)
Given fundamental trends, we stay short EM currencies (on countries with the largest current account
deficit) vs USD

51
Dollar Index
USD Trade Weighted index is expected to continue its rebound from the bottom of its multi-year
channel

52
Dollar Index
According to CFTC data (FX futures and options), the aggregate USD net positioning is now slightly
short and may drive the DXY index down.

53
EUR-USD
Yield differential between US and Germany implies a forex in the 1.20 – 1.25 range

54
EUR-USD
The president of the German Central Bank, Jens Weidman stated recently, "For now, there was no
need to act, but if the outlook for inflation changed, for example as a result of a stronger euro
exchange rate, the ECB could step in, most likely with another interest rate cut, and possibly
even QE.“
Less EU resistance to monetary easing opens the door to increased euro supply.
Better growth perspectives in the US vs EU should also favor the US dollar..

55
EUR-USD
EUR-USD is reversing back below
the downtrend from 2008 high,
opening the door to more
downside
Target ~ 1.31 before 1.28
The picture is not clear enough to
become UW again.

56
USD-JPY
Fundamentally, we still look for a
weaker Yen as further lifting from
BOJ is expected to counter the
economic deteriorating data
We stay Neutral, watching for
signs of a clean break above the
area 103.93 – 104.34 to become
OW (and target 105.60 and
106.10)

57
EM Forex
After the significant adjustment experienced in
2013, EM FX are now very attractive on a valuation
basis.
Fed’s tapering effect is already priced in EM
currencies.
Source: Barclays
* “Vulnerable 5” are TRY, ZAR, INR, IDR and BRL; FX
value is calculated using Barclay’s real effective FX
rates; the overall score is the average of the z-scores for
all 5 currencies from 2004 to present

58
COMMODITY
Last month, we’ve decided to move commodities from OW to UW on the short run. We keep this
view.
We still see significant downside potential for gold (due to rising real interest rates), copper and iron ore
(due to increasing supply), and upside potential for soft commodities (coffee and cocoa)
Over the short run,
We remain Neutral on Energy. Crude oil prices remain well supported by tight supply in the near term
We are Neutral to moderately UW on Agriculture (because of higher supply) except premium coffee
and cocoa (where we are OW)
We are UW on base metals because of overabundance of supply, especially for copper
We stay UW precious metals (targeting 1180-1150 on gold and 17 and then 12.50 on silver)
because of rising real interest rates and strengthening of the dollar.
Reaching a base will give a buying signal not only on physical gold but also on gold miners.
Over the MT, we stay UW copper, despite the strong sell off in copper last week . The downside risk
due to increasing supply is too significant to be ignored. We target 6600, and ultimately 6000.

59
Commos
A perfect environment for commodities would be a combination of:
high inflationary expectations
pickup in demand

60
Crude Oil
Oil prices remain well supported by tight supply as inventories appear very low.

61
Gold
Diminishing fears and stronger macro data should make gold re-converge with commodity prices,
probably lower

62
Gold – Short-Term View
Gold is now stuck in between 1297-1312
and 1272-1262
Price action over the last year held below
the 38.2% of the decline from Nov 2012,
implying a bias to the downside.
We should keep an eye on 1262 level. A
clean break of that level should drive the
gold back to 1180.
The market appears ready for its final leg
down.

63
Silver – Short-Term View
Silver is now contained in a triangle pattern
Breaking through the bottom of this pattern
would drive the spot down to 12.5!
Any gains will be corrective and limited to
20.75 resistance. From there we expect the
long term bear trend to resume, with long
term targets seen to 12.50.

64
Gold – Fair Value Price
Our theoretical price (implied by US$, sovereign CDS and Real Rates) stands now at 1150 (as of Mar
31st ), versus a market price at 1287. Our fair price should continue its downward movement as soon
as the US$ and real rates resume their move to the upside.

65
CFTC Data
According to CFTC data, WTI longs reached new local highs.
On gold, last week data showed some unwinding of the long positions

66
Soft Commos
Soft commodities see a strong quarter as weather and lower supplies fuel higher prices.

67
ALTERNATIVE INVESTMENTS
We are always OW on AI as we expect a 10% return in the coming year versus 5% on a traditional
balanced portfolio (stocks + bonds+ cash).
Our remain OW on Commercial Real Estate
We are still OW Equity long-short market-neutral, Convertible arbitrage.
In spite of their poor performance YTD, we keep our OW on CTA’s and Global Macro as a diversifier and
tail hedge

68
HF Industry
Top performers in Feb. 2014: Event Driven +2.63%, Distressed +2.61%, Equity Long/Short +2.54%, Multi
Strategy at +1.62%.
Bottom performers: Dedicated Short -4.24%, Equity Market Neutral +0.96%, Fixed Income Arbitrage
+1.07%.

69
HF Performance
Event Driven and Market Neutral funds performed the best in Q1, up 3.11% and 2.46% respectively,
when the S&P500 was up 2.01%.

70
HF Positioning
According to BoA regression model, Macros funds:
decreased (very marginally) their long exposure
to S&P500 and NASDAQ.
Increased their long exposure to US Dollar, EM
exposure and commodities
covered their short exposure to 10y USTs.
HF long positions, as measured by GS Hedge Fund
VIP Basket (equity HFs), fell sharply in March

Bottom Line: Global Asset Allocation
Macro matters: While we are no longer in a recession, the
economy is still far from ideal. The market is becoming more
vulnerable as the Federal Reserve begins to adjust the monetary
policy
Many signs point to a global slowdown: China's sudden decline
in exports, downward revision to their economy's growth rate,
stalling of Europe's recovery
We continue to see the main systemic risk coming from
China.
We expect market volatility to rise over the 1-month and 3-
month time horizons.
We summarize our views as follows
71

FinLight Research - Market Perspectives Apr 2014

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