the sorcerer’s apprentice market melt-up€¦ · 27/01/2020 · cam hui, cfa |...
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Cam Hui, CFA | [email protected] Page 1
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Quantitative & Strategy
THE SORCERER’S APPRENTICE MARKET MELT-UP
January 27, 2020
EXECUTIVE SUMMARY
Remember the story of the Sorcerer’s Apprentice from Fantasia (click link for YouTube
video)? Mickey Mouse played the role of a sorcerer’s apprentice tasked to carry buckets of
water. Instead of doing it himself, he stole the sorcerer’s hat and animated a broomstick to
carry the buckets for him. To speed up the work, he animated more and more broomsticks,
until everything got out of hand.
While we don’t claim to be a prescient genius who can see the future of the market, we
were fortunate to spot the beta chase relatively early. Bloomberg reported on December 18
that Stanley Druckenmiller had turned bullish, and Druckenmiller would not have gone on
television to proclaim his embrace of risk if he hadn’t fully entered into his entire position
yet. As Kevin Muir at The Macro Tourist pointed out, “It is also probably safe to say that
Druckenmiller, on the whole, is way ahead of most investors.” In other words, the fast
money crowd was stampeding into the reflation and cyclical recovery trade.
Nevertheless, the subsequent melt-up does feel a bit like a “sorcerer’s apprentice” rally that
got out of hand. Now the equity risk appetite seems to rolling over, and the steady advance
seems to pausing on the news of the Wuhan coronavirus, what’s next?
We believe the stock market is tactically poised for a pullback and valuation reset. However,
any market weakness should only be a hiccup. Investors should be preparing to buy the
dip, while traders should position themselves for a correction.
Cam Hui, CFA [email protected]
Table of Contents
Our Sorcerer’s Apprentice Trade .............. 2
A Melt-up Recap ...................................... 3
What’s Next? ........................................... 7
The Cyclical Trade is Still Intact ............. 11
Cam Hui, CFA | [email protected] Page 2
January 27, 2020
Quantitative & Strategy
Our Sorcerer’s Apprentice Trade
Remember the story of the Sorcerer’s Apprentice from Fantasia (click link for YouTube video)?
Mickey Mouse played the role of a sorcerer’s apprentice tasked to carry buckets of water.
Instead of doing it himself, he stole the sorcerer’s hat and animated a broomstick to carry the
buckets for him. To speed up the work, he animated more and more broomsticks, until
everything got out of hand.
While we don’t claim to be a prescient genius who can see the future of the market, we were
fortunate to spot the beta chase relatively early. Bloomberg reported on December 18 that
Stanley Druckenmiller had turned bullish, and Druckenmiller would not have gone on
television to proclaim his embrace of risk if he hadn’t fully entered into his entire position yet.
As Kevin Muir at The Macro Tourist pointed out, “It is also probably safe to say that
Druckenmiller, on the whole, is way ahead of most investors.” In other words, the fast money
crowd was stampeding into the reflation and cyclical recovery trade.
Nevertheless, the subsequent melt-up does feel a bit like a “sorcerer’s apprentice” rally that got
out of hand. Now the equity risk appetite seems to be rolling over, and the steady advance
seems to pausing on the news of the Wuhan coronavirus, what’s next?
Exhibit 1: Equity Risk Appetite Rolling Over
Source: StockCharts
Cam Hui, CFA | [email protected] Page 3
January 27, 2020
Quantitative & Strategy
A Melt-up Recap
To recap the events of the last few months, let’s go back to last August. The 2s10s yield curve
had inverted and there was widespread concern about a recession. While we were skeptical
about the recession narrative, we did expect a deeper valuation reset that did not materialize.
Exhibit 2: S&P 500
Source: StockCharts
The market eventually recovered and broke out to all-time highs in late October. On November
11 (see How Far Can the S&P 500 Rise?), we speculated about the possibility of a market melt-
up. The Street had become overly defensive in its positioning, and evidence of a global cyclical
recovery was emerging, which would lead to a beta chase stampede to buy stocks.
A more reasonable scenario is a bubbly market melt-up, followed by a downdraft, all in a 2–3 year
time frame.
On December 2, we confirmed the melt-up scenario (see Good Santa, Bad Santa):
The SPX may be undergoing a melt-up in the manner of late 2017. It is unusual to see the index
remain above its weekly BB for more than a week, which it did two weeks ago. The melt-up of late
2017 also saw similar episodes of upper weekly BB rides, punctuated by brief pauses marked by “good
overbought” conditions on the weekly stochastic. The technical conditions appear similar today, and we
are therefore giving the intermediate term bull case the benefit of the doubt.
Even though the bullish stampede was in my forecast, its sheer breadth was astonishing. In
particular, the fast money crowd had gone all-in, both on risk and leverage. The degree of
leverage undertaken by hedge funds was exacerbated by a compression in realized volatility,
which was the result of hedge fund steady buying. The compression in implied and realized
volatility served as an input to trading desk risk models, which encouraged even more leverage
Cam Hui, CFA | [email protected] Page 4
January 27, 2020
Quantitative & Strategy
to fund long positions. In other words, the sorcerer’s apprentice was animating more and more
broomsticks.
Exhibit 3: Hedge Funds Are All-in on Leverage and Risk
Source: Morgan Stanley QDS
The slower moving institutional investors were also buying into the cyclical recovery trade. The
BAML Global Fund Manager Survey showed a spike in global expectations that began late last
year.
Exhibit 4: A Spike in Growth Expectations
Source: BAML Global Fund Manager Survey
Equity positioning, however, was not as extreme as hedge funds. Readings are only in neutral
territory and nowhere near crowded long levels. By contrast, the 2017/18 melt-up episode
Cam Hui, CFA | [email protected] Page 5
January 27, 2020
Quantitative & Strategy
began with global institutional equity positioning already bullish, and readings then surged to a
crowded long.
Exhibit 5: Equity Weights Rising, But Not at Crowded Long Levels Yet
Source: BAML Global Fund Manager Survey
Another difference between the current melt-up and the 2017/18 experience is the lack of
participation by retail investors. The TD-Ameritrade Investor Movement Index, which tracks
the custodial position of the firm’s clients, shows that while individual investors did buy into
the rally, their level of exuberance was nothing compared to the last melt-up episode.
Cam Hui, CFA | [email protected] Page 6
January 27, 2020
Quantitative & Strategy
Exhibit 6: TD-Ameritrade Investor Movement Index
Source: TD-Ameritrade
Cam Hui, CFA | [email protected] Page 7
January 27, 2020
Quantitative & Strategy
What’s Next?
So where do we go from here?
The fast money crowd front ran the institutional cyclical recovery trade, and hedge funds are
now in a crowded and leveraged long on risk. Market valuation became extended. The stock
market is now trading at a forward P/E of 18.6. The Rule of 20, which flashes a warning
whenever the sum of forward P/E and inflation rate exceeds 20, is warning of a market
pullback.
Exhibit 7: The Rule of 20 Flashes a Warning
Source: Yardeni Research, Inc.
The cyclical recovery narrative is also showing some cracks. In the U.S., the relative performance
of cyclical groups is mixed. Semiconductor stocks are still on fire. Industrial stocks have been
soft against the market, but much of the weakness is attributable to the well-publicized problems
at heavyweight Boeing. An equal-weighted analysis, which reduces the effects of Boeing, shows
that the sector is performing reasonably well. However, homebuilding stocks were
underperforming during a period when the cyclical recovery theme was dominant, though they
have since begun to rise again and remain in a relative uptrend. Transportation stocks, on the
other hand, have done nothing except lag the market during this entire period.
Cam Hui, CFA | [email protected] Page 8
January 27, 2020
Quantitative & Strategy
Exhibit 8: Cyclical Stock Leadership Wobbles
Source: StockCharts
In Europe, the rally of the cyclically sensitive has paused. Industrial stocks did stage an upside
relative breakout, but they have paused and begun to move sideways. Similarly, the financial
sector broke out of a relative downtrend, but is also consolidating sideways. By contrast, a
defensive sector like consumer goods is bottoming on a relative basis and is starting to show
signs of life.
Cam Hui, CFA | [email protected] Page 9
January 27, 2020
Quantitative & Strategy
Exhibit 9: European Cyclical Theme Takes a Pause
Source: StockCharts
As the European markets have begun to take on a defensive tone, bond yields have fallen (and
bond prices have risen). Falling bond yields are detrimental to European banking profitability,
and it is therefore no surprise to see European banks start to underperform. The recent price
recovery of the Austrian century bond is an example of the shift in risk appetite.
Cam Hui, CFA | [email protected] Page 10
January 27, 2020
Quantitative & Strategy
Exhibit 10: Austria’s Century Bond
Source: Bloomberg
Normally, at this point we would turn to an analysis of China and Asia’s markets for
completeness. However, the recent panic over the Wuhan coronavirus makes analysis difficult.
It’s all noise until we get more clarity on the situation.
Cam Hui, CFA | [email protected] Page 11
January 27, 2020
Quantitative & Strategy
The Cyclical Trade Is Still Intact
In summary, the market is tactically poised for a pullback. Valuations are extended and fast
money positioning is too bullish. But that doesn’t mean the bull is dead once we see a valuation
reset. All fundamental and macro signs show that the cyclical recovery trade is still alive.
From a top-down perspective, the Citi U.S. Economic Surprise Index (ESI), which measures
whether economic releases are beating or missing expectations, is rising and indicating that the
cyclical recovery is showing strength.
Exhibit 11: U.S. Economic Surprise Index
Source: Refinitiv Datastream
G10 ESI is also showing a similar pattern of strength.
Exhibit 12: G10 Economic Surprise Index
Source: Refinitiv Datastream
Calculated Risk reported that the Chemical Activity Barometer, which is a leading indicator of
industrial production, is turning up.
Cam Hui, CFA | [email protected] Page 12
January 27, 2020
Quantitative & Strategy
Exhibit 13: Chemical Activity Barometer Leads Industrial Production
Source: Calculated Risk
Renaissance Macro Research also pointed out that the word count of “weak” and “slow” are
falling in the latest Fed Beige Book survey, which is another sign of cyclical strength.
Cam Hui, CFA | [email protected] Page 13
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Quantitative & Strategy
Exhibit 14: Signs of Improvement from Beige Book
Source: Renaissance Macro Research
From a bottom-up perspective, consider the latest excerpted comments from The Transcript,
which is a summary of company earnings calls:
Business sentiment is improving
“We see some resolution to those issues and that combined with continued consumer strides, leads us
to expect to see businesses continue their solid activity and we’re hearing more optimism.” – Bank of
America (BAC) CEO Brian Moynihan
“There’s no question in the fourth quarter the environment improved. Based on the data or information
we can see across activity and dialogue with clients, I would say that it’s improved in the fourth quarter
and the trends that we’re seeing early into 2020 are a little bit more positive.” – Goldman Sachs (GS)
CEO David Solomon
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January 27, 2020
Quantitative & Strategy
“the fourth quarter definitely, I would say, stabilized. Things trade certainly stabilized. Things, broadly
speaking, stopped getting worse and so, we saw sentiment improve a bit” – JPMorgan Chase (JPM)
CFO Jennifer A. Piepszak
Manufacturing seems to be turning a corner
“last year we did see a little bit of weakness in manufacturing, but we’re starting to lap that and we’re
starting to see some positive momentum coming out of that sector. So generally, we’re seeing some very
good signs from our corporate.” – Delta Air Lines (DAL) President Glen Hauenstein
” For most of calendar year 2019, the weakness in global manufacturing was exacerbated by the
inevitable inventory destocking that companies undertook in response to the weak demand
conditions…As we enter 2020 however, we are seeing signs of an improvement.” – Schnitzer Steel
Industries (SCHN) CEO Tamara Lundgren
Significantly, the US consumer is doing fine
“our results continue to reflect the strength of the U.S. consumer in the biggest economy in the
world…We also continue to see healthy consumer trends in spending and asset quality. ” – Bank of
America (BAC) CEO Brian Moynihan
“Our outlook heading into 2020 is constructive, underpinned by the strength of the U.S. Consumer.”
– JPMorgan Chase (JPM) CFO Jennifer A. Piepszak
China headwinds are moderating
“In Europe, growth continues to remain relatively low given manufacturing weakness. However in
China trade headwinds appear to have moderated with both monetary and fiscal stimulus supporting
growth estimates of nearly 6%” – Goldman Sachs (GS) CEO David Solomon
Across the Atlantic, the latest flash PMI release shows signs of green shoots in manufacturing.
Manufacturing PMI edged up, and the new orders/inventory ratio rose strongly, indicating that
the inventory de-stocking cycle is over.
Exhibit 15: Eurozone “Green Shoots”
Source: IHS Markit
Cam Hui, CFA | [email protected] Page 15
January 27, 2020
Quantitative & Strategy
As well, the latest ZEW survey from Germany rose unexpectedly. While ZEW is a sentiment
survey, it has historically led eurozone GDP growth by about 12 months.
Exhibit 16: A Spike in ZEW
Source: Nordea Markets
In conclusion, the stock market is tactically poised for a pullback and valuation reset. However,
fundamental and macro indicators all point to a continuation of the global cyclical recovery.
We have pointed out before that the highly reliable long-term monthly MACD buy signal for
the S&P 500 remains in play.
Exhibit 17: A Long-Term S&P 500 Buy Signal
Source: StockCharts
Cam Hui, CFA | [email protected] Page 16
January 27, 2020
Quantitative & Strategy
Similarly, the buy signal for non-U.S. markets is also still valid.
Exhibit 18: A Long-Term MSCI World xUS Buy Signal
Source: StockCharts
Any market weakness should only be a hiccup. Investors should be preparing to buy the dip,
while traders should position themselves for a correction.
Cam Hui, CFA | [email protected] Page 17
January 27, 2020
Quantitative & Strategy
Disclaimer
I, Cam Hui, certify that the views expressed in this commentary accurately reflect my personal views about the subject company (ies). I am
confident in my investment analysis skills, and I may buy or already own shares in those companies under discussion. I prepare and edit
every report published under my name. I depend on my colleagues for constructive criticism on my research methods and conclusions but
final responsibility is my own.
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this commentary.
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contain statements and projections that are forward-looking in nature, and therefore subject to numerous risks, uncertainties, and
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the information contained in this note.
This information contained in this commentary has been compiled from sources believed to be reliable but no representation or warranty,
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This article does not constitute an offer or solicitation in any jurisdiction.
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