finlight research

Market Perspectives

June 2014

June 6th, 2014

www.finlightresearch.com

Where is the vol?

“There is no doubt that corporate profitability has surged from the recessionary

lows. However, if I am correct in my assessment, then the recent downturn in

corporate profitability may be more than just due to an economic 'soft patch.'

The problem with cost cutting, wage suppression, labor hoarding and stock buybacks,

along with a myriad of accounting gimmicks, is that there is a finite limit to their

effectiveness.

While Goldman Sachs expects profits to surge in the coming years ahead - history

suggests something different.”

Lance Roberts

“The financial system responds to volatility. When volatility declines the natural

tendency is to use more leverage and concentrate risk.”

Lewis Alexander (Nomura)

2

FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation

� There are some economic grounds for optimism. But, the

conflicting signals between survey and activity data leave

economic visibility low right now

� No doubt, the world is moving out of an extraordinary period

of central bank largesse. Headwinds have to be expected to

asset prices , implying a higher volatility

� After a period of Sideway trading on equities, Bulls are

winning (thanks to BCE activism) the battle of

indecisiveness. Is that capitulation of the Bears? But the

history of market valuations still suggests a cautious

perspective.

� We expect the quiet time to end, with a break in one

direction or another.

� We continue to see the main systemic risk coming from

China.

� We summarize our views as follows �

3


MACRO VIEW

� The Good

� Forward earnings estimates rose for the sixth consecutive week

� Conference Board LEI rose 0.4%, beating expectations.

� Tensions in Ukraine and Russia are de-escalating gradually

� ISM reports were positive. The composite report seems consistent with economic growth of 4 % or

so.

� Employment showed a clear strength, although some worries are still alive (job quality, part time

jobs, participation rate…)

� The Bad

� Most housing reports are sluggish

� Existing home sales missed growth expectations.

� The pace of permit issuance for single family home construction remains depressed.

� Trade deficit was $6 billion above expectations

� Tensions between Russia and Ukraine remain high

� The Ugly

� Chinese bank loans continue to rise at a rapid pace. But lending activity is delivering less and less

growth per yuan.

� No effective monitoring of default risk from industries with overcapacity, the property sector and other

vulnerable debtors.

4


5


Conference Board LEI

� “The Conference Board LEI for the U.S. increased in April for the third consecutive month. This month's

gain was driven by large positive contributions from the yield spread and building permits”.

� “This latest report suggests the economy will continue to expand, and may even pick up steam through

the second half of the year.”

� “Despite a brutal winter which brought the economy to a halt, the overall trend in the leading economic

index has remained positive”

6


S&P500 Volatility

� Over the last 3 months, the S&P500 has traded in very narrow range (less than 5%). When the average

S&P500 intraday high/low range over a 3 month period is 13.2%

� To find a similar period in the past, we have to go back to October 2006.

Source: Bespoke Invest.

7


Big Four Economic Indicators

� The Big Four average declines after two positive months

� Most of the downside comes from Industrial Production

� Real Retail Sales is declining too

8


Personal Income

� Here is Personal Income less Transfer Receipts in real terms

� Transfer Payments consist mainly of retirement and disability insurance benefits, medical benefits,

income maintenance benefits...

� On a YoY basis, Real Personal Income less Transfer runs at the hardly exciting level of 1,7%

� Transfer Payments have been an increasing portion of Personal Income since the 60’s

9


Employment

� Nonfarm Employment for April was up by 288K, the largest increase since January 2012.

� On a YoY basis, Nonfarm Employment increased at 1.74%, a level that appears low for a typical mid-

cycle recovery

� The 0.4% decline in the unemployment rate from 6.7% to 6.3% is a good point, even if it’s mainly

explained by the decline in the Labor Force Participation rate

10


Retail Sales

� ????The Advance retail sales (headline and core) came in better than expected in March

� Is that a sign that the winter slump was weather related?

� When adjusted for both population growth and inflation, retail sales are now back to March 2004 level

11


Economic Data Surprise

� Economic visibility is low as recent data is

giving conflicting signals between (improving)

survey-based data (jobless claims, Markit

PMI) and (decelerating) hard activity data

(retail sales, industrial production)

� Over May, economic data has disappointed

relative to consensus, pushing JPMorgan

Economic Data Surprise Index south

12


GS – Global Leading Indicator (GLI)???

� According to the GLI, global growth

is no longer decelerating, but there

is no significant positive

acceleration.

� The May Final GLI reading and

momentum were down marginally

in May.

� The GLI continues to locate the

global industrial cycle close to the

‘Expansion’ phase (defined by

positive and increasing momentum)

� 7 of the 10 underlying components

improved in May

� We note the extreme difficulty

the GLI has to move more

decisively into expansion.

13


Real Estate

� Prices continue to rise across most of the country and significantly fewer borrowers are still underwater.

Number of underwater homes halved since 2009

� However, among the 43 Mln mortgaged homes that have positive equity, almost 25% are “under-

equitied” (with less than 20% equity)

14


Real Estate – an Alternative View

� Relationship between the trailing 12-month average of median new home sale prices and median

household income tends to show the formation of a second U.S. housing bubble!

15


Chinese Economy

� According to Chinese President Xi Jinping, the nation needs to adapt to a “new normal” in the pace of

economic growth

� A new stimulus program seems to be ruled out, because of the excess capacity already in the economy

� PPI has been deflating for the past 2 years, confirming that there is relatively weak demand and

plenty of excess industrial capacity in China.

16


Fund Flows

� In May, we’ve seen positive inflows in all fixed income funds except loan funds.

� Ytd, all US fixed income sectors have had positive inflows. Money market funds, EM debt and

commodities suffered outflows.

17


EQUITY

� After a period of sideway trading on equities, Bulls are winning the battle of indecisiveness. Is that

capitulation of the Bears?

� On the S&P500, short-term indicators are reaching levels often associated with interim peaks or

periods of consolidation. It has now been almost 3 years since the last 10% pullback!

� The first real sign of momentum loss will be a clean break below the uptrend since Nov. 2012.

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

growth rather than P/E expansion

� Bottom line :

� We remain Neutral equities. Breaking through the 1833 pivot on the S&P500 would likely be the

signal we wait for to go short stocks

� We keep our UW on (deflationary) Europe and EM vs. US. We remain neutral to UW on Japan

18


Earnings

� Based on 97.5% of the S&P 500 available data (as of May 29), reported earnings dropped to $24.79

(down 6.82% QoQ). Trailing 12-month reported earnings increased 0,57% QoQ, from $100.20 to

$100.77

� Analysts continue to extrapolate earnings growth indefinitely into the future without taking into account

long term cyclicality of earnings

� 2015 earnings are projected above the 6% peak to peak growth line!

19


Earnings

� Equity market is running well ahead of

earnings growth expected in 2015.

� Current levels in equity markets cannot be

sustainable without a substantial growth in

global earnings

� Any further upside in equities should be

driven by earnings growth rather than P/E

expansion

� Since 2009, reported EPS (up 230%) has

been completely disconnected from revenue

from sales of goods and services (up 26%

only!)… thanks to wage / labor reduction,

labor productivity increases and stock

buybacks.

� None of this could be done indefinitely

20


Equity Long-Term Valuation

� The historic P/E10 average is 16.5.

� The current ratio is at the highest level since Dec ‘07. It stands at the 91st percentile of the time series

(since 1880).

21


Equity Long-Term Valuation

� Bull markets could be decomposed into 3 phases: Skepticism, Acceptance and “Sumer will last

forever”…

� Are we in the third phase of this bull market?

22


Market Risk Perception

� Fixed income, currency and stock volatilities are all at

extreme lows that we’ve rarely seen over the last two

decades

� The steep term structure suggests investors are still

pricing in a substantial premium for longer-term risks.

� We expect an eminent sharp rise in volatility over the

next weeks

� We also expect realized correlation to pick up in the

next month.

� Extremely low volatility encourages leverage and

risk concentration

23


Market Risk Perception: Risk Concentration

� US household assets are now more concentrated in equities than ever… except during the tech bubble

24


Market Risk Perception: Risk Concentration

� Retail investors maintain

full investment even

through corrections. The

last time they did that was

at the end of 2007.

� Assets in Rydex bull-

oriented funds relative to

bear or money market

funds is at the highs last

seen during the tech

bubble.

25


Market Risk Perception: Leverage

� Investors are deploying higher leverage than ever before. Margin debt exceeds that reached in 2000 and

2007 on an absolute and relative basis

� Decline in leverage should precede a decline in equity prices. Is that really the top?

26


Market Sentiment

� Large speculators and hedge funds are the most net short futures on the Russell 2000 since July 2008.

� According to BoA Hedge Fund Monitor, speculators have moved to a net short position in the S&P 500.

� According to the commitment of traders report, commercials (“smart money” ) are the most bullish they

have been in years. Commercials have had a tendency to increase their net long exposure to the Dow

and the NASDAQ at market bottoms � bullish sign?

27

FIXED INCOME & CREDIT

� In our central scenario we continue to see higher intermediate-duration yields, lead by a rise in

the US and UK, and marginally tighter peripheral spreads vs. Germany.

� Nevertheless, we keep our short positioning on UST and expect 10-year yields to reach 2.90%-

3.20% by mid-year

� We continue to OW Eurozone vs. US and UK given disinflationary risks in Europe and BCE activism.

� An improving Eurozone growth outlook and ECB credit easing measures should induce further

Peripheral-Core spread convergence. We remain, however, neutral Peripheral vs Core as we see

lasting spread compression to be very limited.

� We are now more bullish on TIPS breakevens and hold 5y-TIPS breakeven wideners

� We remain 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


28

FIXED INCOME & CREDIT

� In corporate credit, investors appear to be seeking out risk on the margin, moving down in quality in

search for yield, encouraged by low default rates and benign event risk

� 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.

� We think that rising Treasury rates would be disruptive to high yield technicals. Such a move would

slow the high yield market advance in the second half of 2014, even if default rates remain contained.

� We expect erosion in returns on 2H-14 to be more effective in high yield than investment grade, due to

the progressive deterioration in new issue quality.

� We choose to stay Neutral (but may move to UW very soon) on credit overall. We are clearly less

constructive over the medium-term.

� Regionally, we keep our Neutral stance 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.

� the growing yield differential between EUR and USD high yield should induce some reallocation

back into dollars, given the low cost of hedging the forex.

� On a risk-adjusted basis, we continue to prefer IG over HY.

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


29

US Treasuries

� In contrast to our strong expectations for

higher yields, we’ve rather seen sideways

move in Govies and even an acceleration to

the downside

� The rally in May was different from that in

January. It was led by lower real rates, with

TIPS breakevens actually rising and the

curve steepening � Is market pricing in a

more dovish Fed action?

� In our last report, we expected the range low

(~ 2.60) to hold but we instead witnessed a

brief excursion to the 2,40 level. We are now

back to the old range support after a clear

rejection of the 2.40 support.

� Thus, we stay near term bearish

� Breaks through 2.825% would put our

original outlook back on the table


30

Inflation Linked

� At this point, the economy is still showing only nascent signs of growth. 5y and 10y US TIPS

breakeven rates remain stable.

� We are now more bullish on TIPS breakevens, for several reasons: strong demand for TIPS (TIPS

ETFs are in their 5th week of inflows), a improving labor market and still a positive carry.

� Hold 5Y TIPS breakeven wideners.


31

Investment Grade

� Should interest rates stabilize around this level, credit spreads

could tighten further by 20bps. This is now our view.

� We expect interest rates to go up, inflows in IG to go down

and spread volatility to go up.

� Given the limited upside and the higher risk in IG spreads, we

move back to Neutral on IG.

� Itraxx Main shoud outperform CDX IG because of BCE action

and its higher exposure to banks.


32

High Yield

� The success of credit investing in attracting

capital over the last 2 years was triggered by

low return volatility and attractive volatility

adjusted returns.


12m-Volatility Adjusted Returns

Annualized Volatility

33

High Yield

� The success of credit in attracting capital over the

last 2 years was also strengthened by:

� low default rates

� An attractive upgrade to downgrade experience

� Current levels are similar to those of end of 2006


34

High Yield Extension Risk

� Higher Govies rates would negatively affect

both callable and bullet bonds, but callables

are more exposed due to the extension risk.

� Higher government yields make embedded

calls less worthy and bonds longer and more

sensitive to credit risk � negative convexity

� Convexity for High Yield Market is close to

its post-crisis lows.

� Further yield increases induce additional

market losses, duration extension and thus

an acceleration in losses


35

High Yield vs Investment Grade

� We expect erosion in returns on 2H-14 to be more

effective in high yield than investment grade, given the

sharp tightening seen in HY and the progressive

deterioration in new issue quality.

� On a risk-adjusted basis, we continue to prefer IG

over HY.


36

EXCHANGE RATES

� We keep our view for a stronger USD index in 2014 based on higher US rates and non-US

fundamental weakness

� The ECB’s dovish rhetoric and action should finally diminish support for the Euro.

� The ongoing deterioration in Japan's current account deficit , combined with the rise in US yields, should

drive USDJPY higher

� As the Fed continues to taper, we expect many EM currencies to remain under pressure versus USD

� On EUR-USD, our previous monthly report states “We remain Neutral and wait for a clean break below

1.3675 to become UW and target 1.31 - 1.28”. So, we are now UW and target 1.34 - 1.31 - 1.28.

� On the USD-JPY, the corrective phase has been well supported so far. The rally of the USD should

resume shortly. Our previous target on the downside was not reached, but we decide to wait for a last

pullback before switching our view to OW again. We remain UW but move our stop loss down to

103.50.


37


EUR-USD

� Medium to long-term picture of

EUR-USD looks heavy.

� In our last report, we were expecting

an exhaustion pattern, coupled with

a lack of momentum. We also said:

“In order for our EUR bearish view

to realize, the spot should hold

below the trend across the highs

since Feb. 2012”. This was the case

as we saw a near double top just

below the psychological resistance

of 1.40

� On EUR-USD, we remain UW and

target 1.34 - 1.31 - 1.28.

38


EUR-USD

� Yield differential (definition on next slide) between US and Germany implies a forex in the 1.20 – 1.25

range

� After reaching a top last month, the gap is diminishing again

39


EUR-USD

� Till mid-2013, EUR-USD were highly correlated to an equally weighted basket of German/U.S 2, 5 and

10y-spread

� This spread has clearly broken the primary uptrend from Jun. ’99.

� The next big pivot should be around -115bps � EUR-USD has some room to go down…

40


USD-JPY

� In our last report, and given the “on

hold” status of BoJ QE, we decided

to become UW, to target 99.50 and

to use the area 103.93-104.34 as a

stop loss.

� The corrective phase has been well

supported so far. The rally of the

USD should resume shortly.

� Technically, the picture is not

easy to interpret.

� JPMorgan interpretation (which we

like) is that this is a triangle

consolidation that began at Jan. 2nd

peak. We can wait for a last

pullback into the middle of the range

before switching our view to OW

again.

41

COMMODITY

� The return picture in commodities is currently a more mixed one than was the case for most of Q1

� We remain UW on the short run, and expect fundamentals (idiosyncratic supply and inventory cycles ) to

re-emerge as the main driver for prices.

� Over the short run,

� We remain Neutral (to a light OW on contracts in backwardation such the Brent / WTI) on

Energy. Crude oil prices could be driven to the upside by an already tight supply and demand

balance, low inventories and a higher summer oil consumption.

� The GSCI agricultural index is up around 20% year to date. We remain moderately OW on

Agriculture, especially crops (Negative weather effects and concerns about the geopolitical

situation in the Black Sea) but we expect lower prices in the next quarter or so, because of the

supply response from US and Europe. We remain OW premium coffee and cocoa

� We remain Neutral on base metals as prices seem to stabilize in the short term, but we think prices

could slip further in the months to come, especially for Copper and Iron Ore

� We stay UW precious metals. We expect gold to resume its downward trend (targeting 1180-1150

on gold and 17 and eventually 12.50 on silver) as central banks move from ultra-accommodative

towards tighter monetary policy

� 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. The downside risk due to increasing supply and a lower Chinese

demand is too significant to be ignored. We target 6400 (Q3-2014), and ultimately 6000.


42

Commodity Performance

� The performance picture in Q2 was more mixed than the one we saw in Q1, when commodities were

clearly outperforming the other asset classes.

� In May, Precious Metals prices were under pressure due to signs of improving US economic data

and easing tensions in Ukraine.

� Industrial Metals performed well due to the increase in China’s PMI in May

� Agricultural commodity prices declined on forecasts of better weather conditions.

� Energy was mixed with Crude prices going up and Natural Gas going down.


43

Commodity Performance

� The China MSCI Index tends to be a leading indicator for the CRB raw industrials.

� It’s down 8% Ytd, has been trading sideways since 2011, and seems to predict a near end to the

rebound in commodities. � We remain UW on the short run


44

Precious Metals

� Many have called the bottom for gold as being the 2013 June

low of $1180 which is something that we remain skeptical

about.

� A re-test of the June lows now looks highly plausible

� We still have a LT bullish view on precious metals, but prefer

to wait for this bear phase to exhaust itself.

� On Silver, absent a break above the 50dma around 19.5, the

downside should dominate: technical targets17.44, 16.33 and

12.50.


45

Precious Metals – Spec Positions

� Large speculators decreased gold and silver longs


46

ALTERNATIVE STRATEGIES

� 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).

� We still prefer risk diversifiers to return enhancers

� We keep our OW on:

� Equity Market Neutrals despite its disappointing performance over the last 3 months

� Event-Driven, as M&A activity is heating up and Event-driven strategies continues to maintain

momentum.

� CTA’s and Global Macro as a diversifier and tail hedge. Both strategies recovered a little during

May.

� We are now OW on Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all

regions). This strategy has shown a great ability in terms of protecting capital during adverse periods, and

a volatility that compares favorably with the hedge fund industry.


47

Hedge Fund Performance


� Based on Credit Suisse HF Index estimates for May

‘14, top performing strategies were Managed Futures at

+3,10% (we were OW), LS Equity at 1,60%, Emerging

Markets +1,53%, Event-Driven 1,19% (we were OW),

Global Macro 1,11% (we were OW),

� The worst performing strategies were ConvertArb at -

0,30% (we moved Neutral last month) and Equity MN -

0,29% (we remained OW!)

48

Hedge Fund Performance


� Based on universe of 3850 funds aggregated by Citi, the dispersion within alternative strategies remains

the rule

49

Volatility Trading / Arbitrage


� Despite the extremely low-vol environment, May was a good month for the Volatility Arbitrage

program., as it took advantage from the mismatch in implied vs realized volatility.

� Implied volatilities across most markets continued to post historically low levels.

� But, at the same time, realized vols have begun to drop sharply in most markets, going ahead of the

implieds that are a bit sticky to the downside

� Two reasons to be OW on Volatility Arbitrage:

� Given the wide gap between implied and realized volatilities, the Vol. Arb. strategy is making

money in this low-vol environment.

� In addition, this strategy is normally designed to act as a tail-risk hedge.

Bottom Line: Global Asset Allocation

� There are some economic grounds for optimism. But, the

conflicting signals between survey and activity data leave

economic visibility low right now

� No doubt, the world is moving out of an extraordinary period

of central bank largesse. Headwinds have to be expected to

asset prices , implying a higher volatility

� After a period of Sideway trading on equities, Bulls are

winning (thanks to BCE activism) the battle of

indecisiveness. Is that capitulation of the Bears? But the

history of market valuations still suggests a cautious

perspective.

� We expect the quiet time to end, with a break in one

direction or another.

� We continue to see the main systemic risk coming from

China.

� We summarize our views as follows �

50


finlight research - market perspectives jun 2014

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