finlight research - market perspectives - nov 2014

Market Perspectives

November 2014

Nov. 4th, 2014

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Who will be the first to fall out of bed when rates start rising?

“Stocks have reached a permanently high plateau.”Irving Fisher (just before the 1929 Crash)

“The best way out is always through.”Robert Frost

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Executive Summary: Global Asset Allocation

� The Fed ended QE on Oct 29 as widely anticipated and, less than 2

days later, the BOJ stepped in to make sure the QE bucket remains

full.

� GDP grew 3.5% in Q3 while unemployment claims remained at a low

level, justifying the tone more hawkish than expected of the Fed

� Despite the market rally and the good US data, there are reasons

to be cautious. October was one of the most tumultuous months for

equities in several years. Europe and China are slowing, and their

troubles could drag down the market. Risk factors re-emerge, driving

market volatility higher.

� But expansionary monetary policies, low interest rates and abundant

liquidity are still keeping us from moving to an underweight on

equities. We remain neutral on global equities and think earnings

growth should be the only driver of markets from here.

� Commodity markets were mixed, Nevertheless, we still like them (for

diversification purposes and as a risk hedge) but with a dispersion in

views across the sectors as individual fundamentals matter.

� We remain underweight government bonds and corporate credit

overall (but with an intra-asset class preference for IG), and

Overweight US dollar.

� We summarize our views as follows �


MACRO VIEW

� The Good

� The average consumer's mood, appears as strong as it's been in years. Consumer Confidence, as measured by the Conference Board, just reached a seven-year high, driven notably by increased optimism about labor market conditions

� US GDP grew 3.5% in Q3, beating expectations, but it is worth noting that some of the surprise came from defense spending.

� The Bad

� Europe's economy and low inflation could eventually impact the US� Growth rate of forward 4 quarter estimate seems on a downtrend, declining from 9.1% to 7.9% � Real Retail Sales for Sep. ‘14 (-0.3% in nominal terms, and -0.4% in real terms) has

disappointed � China's PMI (down to 50.8) highlights the ongoing weakness of the economy.

� The Ugly

� Main systemic risk resides in China : China’s economy is supported by approximately six trillion dollars of 'shadow debt', which may eventually create major systemic issues.

� Ebola epidemic is still propagating. Economic effects have been limited so far, but the picture may get worse rapidly…



Big Four Economic Indicators

� The overall picture had been one of slow recovery, but there is no indication of a recession using the indicators monitored by the NBER.

� At 0.41%, real Retail Sales for Sep. ‘14 has disappointed


US GDP

� US GDP grew 3.5% in Q3, beating expectations, but it is worth noting that:

� The surprise mainly came from defense spending.

� Government spending is rising again after a long shrinkage, is rising,


Consumer Confidence

� The average consumer's mood appears stronger than it's been in years.

� The Final University of Michigan Consumer Sentiment for October came in at 86.9, a small rise fromthe September Final of 86.4. This is the highest level since July 2007.

� The Conference Board Index exhibits a remarkably similar pattern.


Business Confidence

� According to the NFIB Business Optimism Index, the mood of small business owners is also in its bestshape since 2007.


GS – Global Leading Indicator (GLI)

� GLI is back into ‘Expansion’ phase,

� 7 of the 10 underlying componentsof the GLI improved in October

� We’ve been thinking for a while

that the current acceleration

remains quite modest for a

typical expansion phase.

Available data is more indicative ofa stable macro environment ratherthan one with a growth pulse.

� More data are still needed toconfirm our fears about the currenteconomic situation.


US Inflation?

� M2 velocity is still decreasing butthe rate of decline is slowing.

� Is that an inflationary signal in

the US?

Source: St Louis Federal Reserve. % change in M2 velocity measured as

q/q change in 3-quarter moving average.


Housing

� The median price for new homes plummeted from $286,000 to $259,000. In dollar terms, it's theworst MoM plunge ever.

� Prices are falling when quantity is increasing. This is probably due to a high level of inventories,combined with the need to make big discounts


European & Chinese Economies

� China's PMI (down to 50.8) highlights the ongoing weakness of the economy. New orders declined forthe third consecutive month and new export orders declined below 50 for the first time in five months

� European growth also remained sluggish

Source: Markit


EQUITY

� October was quite a roller coaster ride for equities, but the main trend remains bullish.

� The most recent rally has been nearly as violent in terms of speed and magnitude as the one we saw in Mar. 2000 (14.4% in 7 days to get to the 1,553 top on 3/24/2000)

� The BoJ stimulus announcement added more fuel to that pattern. But, defensive sectors and Treasury yields have not confirmed the excitement in stocks

� Over the course of the past five years, the S&P has advanced five times faster than GDP. We

think this is hardly sustainable.

� Bottom line :

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

likely be the signal we wait for to go short stocks, as that could lead to a temporary sell-off in equities � We’ve got it!

� In our Oct. report, we also said : “But a clean break of 1805 (Oct. ‘11 uptrend) will give the

signal of a BIG reversal on stocks.” � This break down hasn’t occurred as the S&P500 bounced violently on our threshold.

� Thus, we remain Neutral equities. At this stage, expansionary monetary policies, low interest rates and abundant liquidity are keeping us from moving to an underweight on equities. Even bad news for the economy (in Europe, Japan and China) appear as good news for stocks, as they allow for further stimulus.


EQUITY

� Bottom line :

� We keep our UW on Europe vs. US. We move to OW on Japan on the back of an aggressive BoJ intervention, a weaker yen and good earnings growth.

� We remain UW in US small caps vs large caps

� In our equity bucket, we favor the most defensive, high-dividend stocks (Utilities, Healthcare, and Consumer Staples)

� The coming rate hikes (probably in Q2-2015) will depress all asset prices for at least part of next year, in our view


Earnings

� Forward earnings estimates decline further. The blended earnings growth rate for Q3 2014 is 7.3%.

� Q4 Earnings Guidance are negative for 72% of the 64 companies in the index have issued EPS guidance for the fourth quarter. This percentage is above the 5-year average of 67%.

� Analysts are cutting earnings estimates for future quarters

� As of Oct. 31st, the 12-month forward P/E ratio is 15.5.


S&P500 Sector Breadth

� As of Oct. 31st, 71% of stocks in the S&P 500 are above their 50d MA

� Defensive sectors (Utilities, Consumer Staples, and Health Care) have the highest breadth.

� This behavior is usually present

in the latter innings of a bull

market.

Source: Bespoke


S&P500 – A Long-Term Perspective

� We watch 4 long-term indicators : 2 P/E ratios and Q Ratio through their deviation to their arithmeticmeans and the inflation-adjusted S&P Composite deviation to its exponential trend.

� Based on the average of these indicators, the market looks 70% overvalued, suggesting a cautious

long-term outlook


S&P500 – A Long-Term Perspective

� The real S&P Composite monthly averages of daily closes is still 5% below the tech high.

� Thus, based on the real S&P500, the March 2009 low cannot (not yet) characterized as the end of asecular bear market and the beginning of a secular bull.


S&P500 & QE Ending

� Equities have tended to underperformTreasuries post QE programs ending.

� Will this time be different as ECB andBoJ are stepping in to make sure the QEbucket remains full?

� As learned from the recent history of quantitative easing, the ending of QEs has had a boost effect on volatility


S&P500 – The Sell Signal to Come…

� Using a monthly MACD on the S&P500 could be a way to avoid downturns. A cross between theMACD lines seems possible in the months ahead. This cross would give the first sell signal since2011.

S&P 500 Picture

� From our previous report: “A clean break of 1805

(Oct. ‘11 uptrend) will give

the signal of a BIG

reversal on stocks.”

� The break down hasn’t occurred and the S&P500bounced up right above the trend across the lows since Oct. ‘11

� The index is now moving back towards the prior high at 2,019 and the probability of making a new high is clearly increasing.

� We stay Neutral for the

moment. We will revise our view to OW above 2040-2060, and to UW below the trend from Nov. ‘12 low



Trading Model – S&P500

� Our prop. Short-Term trading model went modestly short on Oct. 24h at 1964.58 on the index� The model targets 1962, 1903 and 1847 on the downside and would stop its losses at 2041-2062

23

FIXED INCOME & CREDIT

� We’ve been UW on 10y-UST for a while now, expecting 10-year yields to reach 2.90%-3.20% over next months, because of sustained US growth, increasing US inflation. As said in previous reports, only a material weekly/monthly close below the 2.40-2.30 range could make us change our mind.

� Since last month, we’ve been questioning our underweight positioning, as U.S. 10-year yields was ticking below the 2.40-2.30 range. We’ve decided to move to Neutral each time the 10y yield

goes below 2.25. We actually did that for a few days around Oct. 15th. But we moved UW since then

� The FOMC’s hawkish tone supports our view that the Fed will indeed start tightening from Q2-2015 and will hike rates more than is currently priced in.

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

for the current growth and inflation outlook.

� We continue to OW Eurozone vs. US and UK given continued policy divergence, BCE action and the more hawkish than expected Fed. The ECB is probably planning to buy corporate bonds directly, but even if not, its purchases of asset-backed securities and covered bonds may lead to investors adjusting portfolios towards this asset class.

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24

FIXED INCOME & CREDIT

� We see investors moving up the quality spectrum, selling high yield bonds and growth sectors and getting into investment grade bonds, govies and defensive sectors. This is probably a sign we are

moving into the final stage of the bull market and economic expansion

� We remain UW on corporate credit, due to valuation, to position within the credit cycle, to the expected rise in government bond yields and given the weak total return forecast

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

the US and Europe.

� We closed our OW in EM corporates, given the tightening move we’ve seen overs the past 3 months, and our view on the approaching Fed tightening (which will probably raise concerns about EM vulnerability again)

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


25

10y US Treasury Yields

� For the last 2 months, we’ve been questioning our underweight positioning, as we saw U.S. 10-year yields ticking below the 2.40-2.30 range. As explained in our previous report, we decided to move to

Neutral each time the spot goes

below 2.25.

� We actually did that for a few days around Oct. 15th. We’ve been UW

since Oct. 23rd.

� The technical rejection of the new lows tested during Oct. 15th (~1.87) is very positive for 10y UST yields. The next levels to watch closely are 2.35 and 2.47. Above that point, we will feel more comfortable with our bearish view on US treasuries.

� We still think that the structural

channel that has been in place since

the late-’80s will be broken to the

upside over the next few months.


26

US Credit

� High-yield bond spreads have tightened back, but are still wider than where they bottomed in late June.

� We also expect higher credits to continue outperforming lower credits, especially in Europe where ECB may start buying (Q1-2015?) senior non-financial IG corporate bonds

� We continue to believe that equities should outperform credit given the point where we stand within the cycle


27

US Credit

� The credit risk premium (spread needed to compensate for expected losses due to default), as calculated by Citi, is near all-time lows

� We remain UW credit overall, and continue to prefer IG over HY on a risk-adjusted basis


28

EXCHANGE RATES

� Signals we watch argue for further USD strength to develop in time

� In our previous monthly report, we said that the US dollar was due for a pullback. This correction took place but was short lived.

� The EUR-USD underlying structure still looks very negative. Our ST target of 1.25 was finally reached. The break of this pivot will open the door to 1.24, and ultimately to 1.21-1.20. Thus, we remain

UW EUR-USD as long as the pivot stays below 1.25

� As expected, additional BoJ intervention has weighed on JPY. � We are again OW on USD-JPY as the pivot broke above 108. We target 119.30 and ultimately 124-

125


29

EUR-USD

� The corrective phase we’ve mentioned on EUR-USD, in our last report, was short lived.

� Our ST target of 1.25 was finally reached. The break of this pivot will open the door to 1.24, and ultimately to 1.21-1.20.

� We remain UW EUR-USD as long as the pivot stays below 1.25


30

USD-JPY

� BoJ final move pushed the JPY down the road. USD-JPY broke above 108 and even 110, making us OW again.

� The next big levels to wait for / watch are 112.40 and 119.30 (Q2-2015)

� Our ultimate LT (medium-term?) target remains at 124-125!


31

COMMODITY

� 2014 has been a year of extremes for commodity markets: after outperforming other assets over H1, the commodity complex has experienced the steepest price drop since 2008

� Over October, commodities reported negative returns as Energy, Precious Metals and Livestock sectors declined, while Industrial Metals and Agriculture advanced

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

cross-asset portfolio diversifiers.

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

commodities. We remain OW commodities but with a dispersion in views across the different sectors. At this stage, individual fundamentals matter a lot!

� We continue to favor commodity futures with steep backwardation (for positive carry).

� Our bearishness on agriculture commos (except Cocoa and premium coffee) was a very bad deal: Grains have rallied 15% in October despite markets entering peak Northern Hemisphere harvest

� We have been proven right in going UW precious metals and base metals. But our bet against Copper was bad: We saw a sharp short covering rally in copper prices, after the better than expected Chinese September industrial production data, and rumors of copper purchasing by China’s State Reserves Bureau. Aluminium (one of our favorite metals) prices increased for demand-supply imbalances.

� But we were completely wrong about energy, as crude continued its slide breaking down $80


32

COMMODITY

� We remain UW on agriculture (except on premium coffee and cocoa), and move to Neutral on base metals (we prefer Aluminium and copper to Iron Ore).

� Precious metals are suffering from a stronger dollar and higher US rate rise expectations

� We are close to our target on gold (1170-1150). We will move Neutral on gold below 1150 and switch progressively to OW (accumulate) as the spot slides down towards 1000-980, which is probably the final leg down.

� Our first target on silver (~17) has been reached. Silver is probably ready for its final leg down towards 12.50. At current levels, we move Neutral but, like for gold, we will switch progressively to OW (accumulate) as the spot breaks the first material resistance around 14.70 and slides down towards 12.50

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

� The current correction is impressive but still falls within the norm of recent corrections.� Breaking the $80 support zone would be a very bad signal for crude oil, unless the OPEC decides to

stop the bleeding� We’ve decided to keep our OW bias on energy as long as the $80 support zone is not clearly broken.

But it was. We stop our losses and move to Neutral, waiting for a clean break above $80.



Crude Oil - WTI

� WTI seems to be finally breakingdown our important support of 80.

� The rebound we’ve been waitingfor hasn’t occurred

� The next big level to watch downcomes at 74.95-73.75.

� A very similar pattern is alsodeveloping on the Brent


Gold

� The Fed hawkish statementcoupled with a strong Q3 U.S.GDP, pushed up the dollar andrate rise expectations � Interestin gold was shaken a littlemore...

� On the other hand, goldcontinues to be stronglycorrelated to JPY (throughUSD).

� Our bullish view on USD-JPY

is thus coherent with our

bearish ST view on gold. Our

target of 1150 seems now at

hand.

� But what is next?


Gold

� In our last report, we thoughtthat a bounce was forming ongold around 1190

� We ‘ve proven wrong. That wasa false bounce similar the onewe’ve seen near 1520-1530 �Is the gold ready for a last legdown?

� Current levels should bewatched closely as we canwitness a powerful break below1180-1150 towards 1000-980

� We move Neutral on gold

below 1150 and switch

progressively to OW

(accumulate) as the spot

slides down towards 1000-980


Copper

� Since end of July ’14 (level ~ 7100), we’ve been UW Copper, targeting 6400 in Q3 and ultimately 6000. The spot reached the 6600 – 6550 range but now seems ready for a bullish reversal.

� We move Neutral on Copper

and wait for a break of 6960 (trendline since the highs of Feb. ‘13) to become OW.

37

ALTERNATIVE STRATEGIES

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

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

calming down, volatility was expected to bounce, and geopolitics were threatening… The share of M&A deals withdrawn or terminated has sharply increased this year.

� Our bets have paid off handsomely except for Global Macro

� We maintain our previous positioning: While preferring risk diversifiers to return enhancers, on a risk-adjusted basis, we keep our OW on:� Equity Market Neutrals both for their “intelligent” beta and their alpha contribution � CTA’s and Global Macro as a diversifier and tail hedge. � Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all regions). This strategy

has shown a great ability in terms of protecting capital during adverse periods, and a volatility that compares favorably with the hedge fund industry.



Event Driven

� The share of M&A deals withdrawn or terminated has sharply increased this year.

� We stay Neutral and wait for a softer flow of negative announcements .


CTA and Global Macro

� Unlike Global Macro managers, CTAs are still long rates which have proven profitable over the month.

� CTAs held short positions in commodities, making significant gains over the recent months.

� The erratic trends on rates and FX have induced losses for CTAS and Global Macro.

Bottom Line: Global Asset Allocation

� The Fed ended QE on Oct 29 as widely anticipated and, less than 2

days later, the BOJ stepped in to make sure the QE bucket remains

full.

� GDP grew 3.5% in Q3 while unemployment claims remained at a low

level, justifying the tone more hawkish than expected of the Fed

� Despite the market rally and the good US data, there are reasons

to be cautious. October was one of the most tumultuous months for

equities in several years. Europe and China are slowing, and their

troubles could drag down the market. Risk factors re-emerge, driving

market volatility higher.

� But expansionary monetary policies, low interest rates and abundant

liquidity are still keeping us from moving to an underweight on

equities. We remain neutral on global equities and think earnings

growth should be the only driver of markets from here.

� Commodity markets were mixed, Nevertheless, we still like them (for

diversification purposes and as a risk hedge) but with a dispersion in

views across the sectors as individual fundamentals matter.

� We remain underweight government bonds and corporate credit

overall (but with an intra-asset class preference for IG), and

Overweight US dollar.

� We summarize our views as follows �


41

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.

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

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finlight research - market perspectives - nov 2014

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