finlight research - market perspectives - dec 2013

Market PerspectivesDec 2013

November 29, 2013

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MACRO VIEW

� The Good� There are minimal signs of business cycle risk in terms of a broad review of the latest numbers.� Two positive news on the US economy front: the 2.8% rise in (advance) GDP for 3Q13 (even if that

growth was inflated by inventory accumulation) and the addition of 204K workers in the October nonfarm payrolls report.

� Above-consensus 0.3% rise in the Index of Leading Indicators for September, with 7 out of 10 components of the LEI rose. The report from the Conference Board also shows that the 3-to-6-month outlook is accelerating.

� Consumer Incomes rose in September by 0.5% after rising by that amount in August. In October, real disposable income rose 1.3% year-over-year - the best annual income trend in four years

� Spending has rebounded. Retail sales increased 0.4% in October, surprising most analysts� University of Michigan's consumer sentiment index increased from 72.0 in October to 75.1� The news stream from the periphery of Europe has been generally favorable

� The Bad� The NFIB's Small Business Optimism Index fell to 91.6 in October from 93.9 in September. And

November consumer confidence hit a seven month low at 70.4� Europe’s earnings season’s results have been disappointing. About 50% of companies missed profit

forecasts and 2/3 have missed revenue forecasts� Euro area deflation is still a real concern as inflation remains well below its target 2%� Retail sales are bad: They dropped 0.8% in October in Germany. Consumer spending also fell in

France by 0.2%. German, as French consumers have now cut spending 4 out of the last 5 months.

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Industrial Production

� Industrial production edged down 0.1% in October after having increased 0.7% in September. Manufacturing production rose 0.3% in October for its third consecutive monthly gain. IP is back on its 2007 average level, and 3.2% yoy.

� Capacity utilization for the industrial sector declined 0.2% in October to 78.1

� The mismatch between IP and manufacturing ( a cyclically sensitive sector) is puzzling

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Employment

� New filings for unemployment benefits posted another healthy decline last week, falling 10,000 to a seasonally adjusted 316,000.

� The number of people receiving unemployment compensation also continues to decline, down by 25% yoy.

� We think that the attainment of the 7% “magic” unemployment rate, which we expect to be imminent, will give an irrational boost to the market

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Retail Sales

� Headline retail sales increased 0.4% in October, reversing September’s flat performance and rising the most since June

� More importantly, the year-over-year change in retail spending finally turned up after three straight months of decline.

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Retail Sales

� The overall YoY trend for both headline and core (Ex-Auto) has been weakening since mid-2011. October data provide the upturn needed to maintain an optimistic outlook on economic growth

� But from a longer-term perspective, sales growth is only modest and still substantially below trend

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Personal Income

� In September, personal income increased 0.5 %, as disposable personal income (DPI). Personal consumption expenditures (PCE) increased 0.2%

� In real terms, the picture is less brilliant

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Consumer Confidence

� Consumer Confidence for Novembercame in at 70.4 (bellow the expected72.6). This was the third straight monththat this report was weaker thanexpected.

� From a long-term perspective,confidence in the US is clearly in adowntrend.

� The spread in confidence betweenhigher income and lower incomeAmericans is at record highs.

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Consumer Confidence

� On the consumer confidence front, theMichigan Sentiment Index gives adifferent picture, as it improved fromOctober's 73.2 to 75.1 last month.

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Consumer Confidence

� The gains associated with the rise in home prices and from equity values (usually named “householdwealth effect”) are estimated at $8.8 trillion. This is the largest annual increase ever.

� The wealth effect is supposed to have some positive impact (estimates go from 2 to 5%) onconsumption in the following years, and a fortiori on consumer confidence.

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Durable Goods New Orders

� New orders for manufactured durablegoods in October decreased $4.6 billion or2.0% to $230.3 billion. Year-over-year neworders are up 5.3%.

� This decrease followed a 4.1% Septemberincrease.

� Excluding transportation, new ordersdecreased 0.1%, but are up 4.3% yoy

� Excluding defense, new orders decreased1.3%.

� Core Capital Goods posted the secondconsecutive negative month, down 1.2% inOctober after a decline of 1.4% inSeptember.

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US PMI

� Compared to a month ago, three of theChicago PMI's seven sub-componentsdeclined while four increased

� It is worth noting that inventories increasedfrom 48 up to 61.1. This is the highestreading for inventories since end 2006.

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Eurozone PMI

� In Europe, business sentiment declinedslightly since September

� But the broad picture remains unchangedand marked by a big discrepancy, in termsof business confidence, between Germanyand the rest of the Eurozone, speciallyFrance and Italy where sentimentdegradation is continuing.


China

� There is no room for growth to slow in Chine. 7.2% GDP growth rate seems to be the "stall speed" for the Chinese economy:� In one of the few occasions when a top Chinese official has specified the minimum level of growth

needed for employment, Premier Li Keqiang said calculations show China's economy must grow 7.2% annually to create 10 million jobs a year … That would cap the urban unemployment rate at around 4%.

� As China's recent growth has been mainly driven by unsustainable government lending and investment, it is not so easy to reconcile the 7% growth floor with the last CCP’s communique stating that market forces should play a "decisive role" in allocating resources going forward

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GS - GLI

� The November Final GLI locatesthe global industrial cycle on theborder between the ‘Expansion’and the ‘Slowdown’ phase

� 5 of the 10 underlying componentsimproved in November

� the GLI continues to signal solidactivity growth, but with no clearevidence of further acceleration atthis stage

� Bottom line: positive outlook forglobal growth but acceleration isprobably behind us.


EQUITY

� U.S. stocks rose as an unexpected drop in jobless claims and better-than-forecast confidence data indicated the economic recovery continued

� No doubt, QE explains a part of the bullish sentiment. But there is a also a good correlation between the S&P 500 move off its low and the simultaneous rise in S&P 500 earnings

� However, insider selling and sentiment numbers are flashing warning signs, and negative divergences are present in a lot of indicators

� The obvious weakness in demand makes us skeptical of the rally in European stocks (as in EUR-USD)

� After more than 35% rally without any correction, the drawdown risk becomes omnipresent. According to our short-term trading model, there is 80%+ probability to see a drawdown of a magnitude of 5 to 10% over the next 3 months.

� The year-end rally is becoming very consensual

� Bottom line:

� We keep our bet on a limited correction, with a test of 1700 - 1650 level on the S&P 500

� We continue to like Europe and EM which we overweight vs. the US.

� We prefer more defensive high-yielding stocks. We take our profit on the technology sector.


Earnings

� The S&P 500 rally is coherent with the rise in its earnings. Between its lows in March 2009 and the current 1800 level, the S&P 500 has risen 165%. Earnings are on track to grow 140 - 145% from the low of $50 in 2008.

� Analysts target $122 on 2014 EPS, implying around 10% growth off 2013 EPS (expected around $110)

� Keeping S&P 500 earnings growth moving forward requires, at least, continued U.S. GDP growth (with the needed consumer confidence) and stability in Europe


Earnings

� This amazing chart from Morgan Stanley shows the earning forecast on the S&P500 since 1985, as squiggles starting when the first prediction is done and going till the final report for the corresponding earnings year.

� Is that enough to say that analyst estimates tend to be too optimistic?


Earnings

� From Deutsche Bank Asset & Wealth Management report (CIO View, October 2013):

� “The average price-to-earnings (P/E) ratio of the S&P 500 Index is 15.9 and approaching the 10-year average of 16.4. The S&P 500 Index could climb to around 1,800 points in the next 12 months, spurred on by continued profit growth, and we expect the profits of S&P 500 Index companies to increase by 7%. Including dividends, investors in U.S. blue chips could achieve a gain of around 10%.”

� Shiller P/E gives a completely different picture. The ratio stands at 25.5, or 52% above its historical mean of 16.5 .


US Equities

� From a long-term perspective, the current market rally is no way spectacular…

� From Chart of the Day, we note the following commentary on bull market advances and duration for the Dow:

� “As it stands right now, the current Dow rally that began in March 2009 (blue dot labeled you are here) would be classified as well below average in both duration and magnitude. However, the magnitude of the current post-financial crisis rally has now reached median status -- its magnitude is greater than six and less than six Dow rallies since 1900.”


US Equities

� Quality stocks (S&P500 Low Volatility) began the year on a strong note. But since April (when the tapering talk started), the market rally has been driven by the most speculative stocks (S&P500 High Beta)

� The same phenomenon appears when we compare the Goldman Sachs Weak Balance Sheet Basket (including companies that rank the worst in the S&P 500 Index in terms of probability of corporate default) with its over +42% for the year, to the Strong Balance Sheet Basket with its “meager” +22% return


US Equities

� The overlay of durable goods new orders and the S&P 500 shows the market pulling away from the durable goods reality over the last year. The picture looks less diverging when produced capital goods (ex-aircraft) are used for the comparison.


US Equities

� The chart of stocks versus Govies shows that investors are more and more confident about future economic outcomes. As complacency reigns, fear retreats.


US Equities

� Upon this recent advance, the ratio of insider sellers to buyers is becoming extremely bearish.


US Equities

� Stock market capitalization relative to GDP has moved back up to multi-decade highs


US Equities

� Little cash is waiting on the sidelines to be invested


US Equities

� The current reading of 16.86 on the average price is within the top percentiles and is typically associated with major market tops.


US Equities

� the current reading of the S&P500 to Sales ratio is at its highest level since 2000

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SPX

� S&P 500 is pushing into its upper 52-week Bollinger band. The higher-odds outcome here is a pullback. The lethargic VIX finally started to move again… upward

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Japanese Stocks

� The link between Japanese stocks and yen is the strongest on record, based on data compiled by Bloomberg since 1978. There is an obvious tendency for Japanese equities to rise when the yen weakens. We also see substantial opportunity going long dollar / yen (a bet that the Japanese yen will decline), coupled with long Japanese equities.

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Trading Model - SPX

� Our trading model is clearly short (almost half its maximal capacity, and 90% of its effective capacity) and calls for a pullback targeting 1757 – 1739 and 1671.

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Risk Aversion

� Nothing new since last report. At 0.26, the RAI stands in neutral territories.

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BoA-ML Global Financial Stress Index

� World stocks are still coherent with the GFSI…

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Pattern Recognition

� Our Pattern Recognizer applied to the period Oct. 2007 – Present on the Dow exhibits tow similar periods in the past:� The first ending on Jun. 6, 2007, with a

correlation of 87%� The second ending Mar. 30, 1937 with a

correlation of 90% � Both periods end with a significant correction.

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Equity Volatility

� Volatility continued to trend down. VIX is back on its lowest regime according to our HMM model.

� Higher real rates and lower inflation will drug the volatility higher

� There is not a lot of room for the market to keep moving higher with the VIX at this level.

VIX Vs.10-Year Inflation Premium

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FIXED INCOME & CREDIT

� Over the short-term, we are neutral Govies, overweighting EMU and Germany vs US and UK.. We stay, however, biased towards higher yields, and thus UW Govies over the medium-term.

� Last month, we have changed our view on overall credit from OW to neutral after a pronounced tightening in the third quarter.

� Spreads continue to tighten across all credit but mostly in higher-yielding credits: US HY and EM sovereign credit spreads.

� The current friendly macro mix (better growth, low inflation, low volatility and accommodative monetary policy) makes the high yield market attractive (as a source of carry), as it weights on risk premia and default risk.

� The current search-for-yield environment remains strong and may push spreads a bit tighter from here. But on the medium term, the downside risk looks predominant

� The upside for total returns is also limited with rates likely to move gradually higher� �We stay OW High-Yield (BB and B) vs Investment Grade. We also OW European HY vs US High Yield

as the latter has higher gearing et more exposed to hike risk in benchmark rates

� Bottom line : neutral Govies, Neutral credit, keep our OW High Yield and EM sovereigns vs High Grade

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Fixed Income

� Forward calculation implies that the 10 year U.S. Treasury yield should rise from its current level 2.75% to 3.17% in one year.

� Post-crisis history has repeatedly shown that bond yields have actually risen sharply with QE and fallen just as dramatically without QE


Fixed Income

� We see an exhaustion pattern on 30y US Treasury yields, currently just under multi-decade channel resistance off the Sep. ‘90 high at 4.20%.

� A few levels need to be broken from 3.90 to 4.20% in order to open the upside


Investment Grade

� HG bonds are trading 25bp wide to their CDS, on average. This negative basis is the widest since January 2012 (and since the beginning of 2011 if taken in % of the average CDS spread).

� The bond-CDS basis trends ytd could be explained, in part, by the tightening in swap spread, as most bond investors value bonds over Treasuries

� However, most of the gap is a reflection of the poor performance of IG cash bonds, specially on non-financials.


High Yield

� High Yield P/E (even if it is off from its highs of 19x seen in May 2013) continues to trade at a consistent premium to stocks. This is the first time since 1982 that the equity market has traded at a persistent discount to HY.

� HY bonds are trading at 16.6x (the inverse of its YTW ~ 6%), when the S&P 500 forward P/E is 14.8x.� Should the convergence of multiples be bullish for the stocks or corrective for High Yield?.


High Yield

� The credit trend (as shown, among other indicators, by the upgrade to downgrade ratio) is still benign

� However, lower rated non-refinancing new issue volume are clearly on the rise. The recent wave of more aggressive issuance should be closely monitored.


High Yield

� The current slow growth conditions (with low default rates and low macro risk) are enough to make the high yield market attractive, specially in such a search-for-yield environment.

� This favorable environment may push spreads a bit tighter from here, but credit quality could be threatened by corporate re-leveraging.

� Based on the debt to EBIDTA ratio, balance sheets have already entered their cyclical deterioration trend.


Emerging Markets

� Comparison between EM bonds and US High Yield shows that the emerging bond market anxieties haven't recovered yet from the Fed tapering scare

� Headwinds remain: slowing growth in China and India, inflation in Turkey and India, and the looming uncertainty about the tapering effect on EM

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EXCHANGE RATES

� The US dollar shows clear signs of bottoming out

� Since our last report, we’ve been long USD against EUR and JPY. Both of our targets (1.3460 and 101.4) was reached during the month.

� Historic comparison to 1995/96 on the DXY suggests a top is forming in EURUSD. That, combined with the exhaustion pattern we see on it, encourage us to keep ;� our bearish view on the EUR-USD, targeting 1.31, then 1.25! � Our bullish view on the USD-JPY targeting 108.30 (given by the break of the triangle). A medium-

term target stands at 120!



DXY

� Since 2012, the US dollar has been putting in a massive sideways base.

� The macro drivers that disfavored the dollar are now fading:

� The QE and the dovish US policy (vs. hawkish European policy) is now shifting, as we see the Fed more hawkish, and the ECB more dovish

� The attractiveness of emerging markets assets relative to US assets is a dollar-weakening phenomenon that is now souring. The capital flows are now going back home, strengthening the USD.

� The US deficit is contracting due to budget restriction measures and falling government spending. This is a currency strengthener, especially when others countries (Europe and Japan) are supposed to stimulate spending in order to avoid the deflation trap.

� A low return, slow-growth world favors mature assets and favors the USD, as investors increasingly favor safety over sexy returns and the hot money issues they convey.

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EUR-USD

� Net non-commercial futures positions are decreasing but are still more compatible with a level of 1.40-1.45 on the EUR-USD

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EUR-USD

� Compared to the sovereign spread between Germany and US, EUR-USD stays too expensive.

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USD-JPY

� The very important pivot area 101.25-101.67 has been broken to the upside, opening another material upside with 108 as a first target.

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COMMODITY

� We stay neutral on commodities in the short and medium term., with a clear preference for energy and livestock, over precious metals and agri. Our neutral stance is due to the strength of the supply and the risk of a weaker growth in emerging markets.

� On MT, we stay UW precious metals (targeting 1180-1150 on gold and 18-17 on silver) because of rising real interest rates. Reaching 1150 – 1180 on gold would give, if that level holds, a buying signal not only on physical gold but also on gold miners.

� On MT, we are now UW copper. The downside risk due to increasing supply is too significant to be ignored. We target 6600, and ultimately 6000.


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Crude Oil

� The downtrend in oil prices continues. The main driver for the last move comes from weekly oil inventory from the DoE, which increased by 2.95 million barrels, when only 0.75 million increase was expected.

� This is the 10th week in a row inventories are up� Increasing inventories could be seen as a warning

sign that usage is down. The spread between Brent oil and WTI suggests this is not.

� Instead, this appears to be driven by robust oil production in the U.S, which explains the upside move in the Brent-WTI spread, currently at $18.40 well above the $3.20 level in mid-July.


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Crude Oil

� According to Goldman Sachs Research, the amount of crude oil that can be brought on at $80-$100/bl has increased substantially

� On MT, the risk seems biased to the downside because of the slowdown in global demand growth and the higher supply.


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Precious Metals

� Overall, the bias seems skewed to another significant move lower.

� Last week, the strong support of 1250$/ounce (which is roughly the cost of production per ounce) was broken, suggesting a very bearish development for gold.

� From a technical point of view, retesting its June low of 1180$/ounce in the very short term seems very likely.

� Real yields increase still explains a big part of the downside move on gold �

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Precious Metals

� Our theoretical price (implied by US$, sovereign CDS and Real Rates) stands now at 1182, versus a market price at 1240.

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Precious Metals

� Commitment of Traders (COT) weekly data as of Nov 26th, show that Large speculators .

� reduced gold longs $3.3b from $6.1bn.

� reduced their silver exposure to $0.6bn from $1.0bn.

� The graphs represent the large speculator net position in gold / silver futures as a percentage of total open interest

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Producers vs Commos

� For Oil as for gold, producers are lagging the underlying commodity…

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Gold Miners

� The Market Vectors Gold Miners (GDX) continues its slide. It is hitting new lows when the RSI and the MACD are making higher lows (on weekly data)

� Although the slide is hard, we maintain our view: This diverging configuration is a classic bullish pattern

� We have to wait until the gold reaches a floor somewhere in the area 1150-1180, before going long GDX

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Gold vs Stocks

� The chart of the Dow in gold terms shows that the correction we’ve been seeing, since Sep. 2011, in relative value of Gold vs US Stocks is hardly significant… at least at this stage.

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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 overweight position focuses on Commercial Real Estate (even if the current message is still mixed)

� We are OW Equity long-short market-neutral, Convertible arbitrage, CTA’s and Global Macro


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Hedge Funds – Market Positions

� According to an analysis done by BoA, based on CFTC data, Large specs seem to have made the following significant moves across the main asset classes:

� They increased their net longs in the S&P 500 and NASDAQ exposure and decreased Russell 2000 shorts.

� They reduced their 10-yr shorts. They increased their longs in 30-yr from close to flat and increased long 2-yr

� They reduced their longs in EUR and increased their shorts in JPY. They reduced short GBP

� They increased their long positions Soybean. They also increased corn and wheat short exposure.� They reduced Gold and Silver longs and increased short position in Copper. � They slightly decreased Crude longs. They increased Natural Gas shorts. (pg 11-12).


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Hedge Funds – Macro Funds Positioning

� Macro funds reduced their long exposure to S&P500, but maintained NASDAQ long exposure.

� They kept short exposure to USD� They increased short exposure to 10-yr.� They increased commodity exposure� They maintained their long EM exposure.


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Hedge Funds – Equity Funds Positioning

� As inferred from the 1 month rolling market exposures for Equity Long/Short strategy, its exposure stands at ~18% net long (increased from 10% previously), well below the 35-40% benchmark

� LS Funds increased their large cap� preference. They are neutral on style and

inflationary expectations

� For Equity Market-Neutral strategy, market exposure decreased to 7% net short (from 3% net short)

� Equity MN funds neutralized small cap and low quality bias


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Hedge Funds

� Hedge fund leverage remained just below record levels set earlier in 2013� Net long exposure, measure of risk appetite, remained at 51% at the start of 4Q


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Real Estate

� The last update on newly issued housing permits appears as a convincing signal for the continued growth of the residential real estate market in the near term.

� As the previous month, October data for permits beat expectations by a healthy margin.

� Privately-owned housing units authorized by building permits in October were at a seasonally adjusted annual rate of 1,034,000. This is 6.2% above the September rate of 974,000 and is 13.9% above the October 2012 estimate of 908,000.

� Single-family authorizations in October were at a rate of 620,000; this is 0.8% above the September figure of 615,000.

� Both the Case-Shiller Index as well as the FHFA housing price index said house prices are still on the rise

� We still have to check the release of the hard data on housing starts, expected for Dec 16.

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November 2013 Performance Review


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Bottom Line: Global Asset Allocation

� UW equity overall. OW EM stocks and European stocks vs US. OW defensive high-yielding stocks

� Neutral Govies and wait for better levels to enter shorts. We OW EMU and Germany vs US and UK

� Neutral on credit. OW High Yield and EM sovereigns vs High Grade. OW European HY vs US High Yield

� OW US dollar against EUR and JPY

� Neutral commodities overall. OW energy and livestock. Underweight precious metals and base metals.

� In Alternative Investments, OW risk diversifiers (Equity long-short market-neutral, Convertible arbitrage, CTA’s and Global Macro). OW Commercial real estate.


finlight research - market perspectives - dec 2013

Economy & Finance