finlight research - market perspectives jan 2014

Market PerspectivesJan 2014

January 3rd, 2014

www.finlightresearch.com

MACRO VIEW

� The Good� Earnings outlook looks good. Expected Q4-2013 earnings growth rate for the S&P500 is now

projected to be in the 7-10% range� Durable goods orders for Nov. surprised on the upside� Q3 GDP was revised up to 4.1% (annual growth rate) thanks to consumer spending (a good thing)

and increasing inventories (a puzzling thing that should be monitored closely)� Initial jobless claims are still encouraging� Consumer confidence from the Conference Board produced a slight beat of expectations� ISM manufacturing beat expectations and the New Orders sub-index which historically correlates to

the economy improved.� Merger activity picked up especially in the latter quarter of the year.

� The Bad� Personal income growth has been disappointing� Real household incomes are in worse shape than they were four years ago when the recession

ended.� China's PMI hit a three month low, pointing to some slowdown in economic growth� Investment sentiment remains very bullish� Pending Home Sale Index for November missed expectations by a wide margin. The underlying

downtrend for housing sales appears to be accelerating.

� The Ugly � Smell of war in Middle-East (Iraq and Syria)

2FinLight Research | www.finlightresearch.com


Big Four Economic Indicators

� The global picture is that of a slow recovery. 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.

4FinLight Research

Industrial Production

� November industrial production rose much more than expected (+1.1% vs. +0.6%), led by a 0.6% increase in manufacturing production which accounts for about three quarters of industrial production

� Manufacturing production is up 5.1% annualized rate in the past three months.

� Industrial production in the US has now reached a new all-time high.

� The contrast between the U.S. economy and the struggling eurozone economy


Manufacturing

� ISM manufacturing index reading looks consistent with a GDP growth of at least 4%.

� ISM New orders index continues its steady improvement implying better manufacturing conditions in the near future.

� It is interesting to note that ISM Manufacturing represents less than 10% of USA employment, and approximately 20% of the business economy.


Manufacturing

� Business spending is picking up on the back of risi ng confidence

� Markit’s final U.S. Manufacturing Purchasing Managers Index rose to 55.0 in December 2013, beating November's 54.7 reading and an initial December estimate of 54.4.

� This upward movement was led by a solid increase in output, boosted growth in the sector and increased demand for plants and machinery.

� Manufacturing conditions in the Eurozone have improved significantly over the past year, and are now tracking improvement in U.S. manufacturing.


Employment

� Initial Jobless Claims fell to 339K vs. an expected 344K, while Continuing Claims were also much lower at 2,833K vs. 2,890K.

� Unemployment should continue to trend lower, despite another debt ceiling debate next month


Retail Sales

� Retail Sales have accelerated over the past two months. � The question now, of course, is how this key indicator behaves during the holiday season


Real Personal Income

� This indicator remains the laggard of the Big Four.


Household Income

� At this point, real household incomes are in worse shape than they were four years ago when the recession ended.

� The real median household income series spent most of the last 14 years struggling slightly below its level at the beginning of 2000.

� The real recovery from the trough is still very weak.


Real Estate

� Comparing Median New Home Sale Price to Median Household Income shows that prices restart inflating after July 2012, drawing a trend similar to that of Nov 2011.

� Is that a second U.S. housing bubble?


Real Estate

� The Pending Home Sales Index measures housing market activity based on signed sales contracts for existing homes in a given month. This index is subject to revisions because of cancellations (especially when mortgage rates are increasing)

� For November, the index gained 0.2% mom, was reported at 101.7 vs. 101.5 for October (revised down from 102.1, shows a 1.2% drop from September 2013 and 2.2% drop from the October 2012). However, it dropped 1.6% vs. November 2012 � A negative trend in contract signings on existing ho me sales is emerging


Investment Sentiment

� Investment sentiment remains very bullish, generally viewed as a contrarian market indicator. Bespoke analyzes the AAII series, where bulls are over 50% for the first time since January..

� Equity allocations among individual investors reached their highest level since June 2007. Stock and stock fund allocations rose by 4.1 percentage points to 68.3% (Historical average = 60%). In June 2007, equity allocations reached 68.6%.

� Bond and bond fund allocations fell 2.1 percentage points to 15.2%, below the historical average of 16%. This is the smallest fixed-income allocation since May 2009, when bond and bond fund allocations were 14.2%.

� Cash: 16.5%, down 2.0 percentage points


Consumer Confidence

� The current reading of the Conference Board Consumer Confidence Index at 78.1 is 6.1 above the November 72.0 (previously reported at 70.4).

� Mechigan Consumer sentiment is now only 3 percent below the average reading


Consumer Confidence

� National Federation of Independent Business (NFIB) Small Business Optimism Index continues to track fairly closely the Conference Board Consumer Confidence.


Market Flows

� Mutual fund asset allocation, as represented seems heavily weighted towards equities. The ratio of assets in money market and fixed income funds to total mutual fund assets is at near record lows.

� However, according to ICI data, the rotation out of fixed income into equities has only just begun : 2013 was the first year of inflows in equities after five straight years of outflows !


Market Flows

� Commodities and EM are the big losers in terms of ETF flows.


China PMI

� HSBC China PMI fell to 50.5 in December, from 50.8 the previous month, but showed a steady increase of new orders

� The official PMI, published by the National Bureau of Statistics, dipped to 51.0 in December, as export orders and output weakened

19FinLight Research

GS – Global Leading Indicator (GLI)

� Nothing new compared toNovember.

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

� 5 of the 10 underlying componentsimproved in December

� 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

� we have been left with no other choice than to take a bullish stance on equities, even if we still wait for a limited correction (5% to 10%).

� US equities are boosted by an improving economy and upward. Japanese equities are boosted by expectations of additional BoJ stimulus.

� EM equities should underperform given the subpar EM growth and Fed tapering

� The improvement in the PMI in the last quarter should favor Cyclicals over Defensives

� Bottom line:

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

� We UW Europe and EM vs. the US and Japan.

� We prefer more defensive high-yielding stocks.

21FinLight Research

Equity - Long-Term Valuation

� Market overvaluation suggests a cautious long-term outlook… But periods of over- and under-valuation can last for a long period

22FinLight Research

Equity – S&P 500

� The market looks stretched but the SPX has room to extend further from current levels

23FinLight Research

Equity – S&P 500

� Macro hedge funds exposure to equity is still high

24FinLight Research

Equity – NIKKEI

� The monthly close in December is noteworthy as it breaks the primary downtrend from June 96� This is a bullish signal to watch. The next potential target is around 16 800

25FinLight Research

Equity – NIKKEI

� But CFTC non-commercial positions on NIKKEI have been decreasing since mid-2013

26FinLight Research

Equity – Emerging Markets

� EM equity funds witnessed outflows for the 10th consecutive week to January 1.

� Most analysts continue to expect subpar EM growth implying further EM equity underperformance this year. The Fed tapering is another negative factor.

� According to Consensus Inc. data, Risk-Love sentiment is euphoric. In the past, episodes of such high Risk-Love saw EM equities going sideways to down

27FinLight Research

Equity – Emerging Markets

� When the US dollar is strengthening (and this is our macro view), Emerging Market equities tend to underperform developed markets.

28FinLight Research

Trading Model - SPX

� Our trading model stopped its shorts

29FinLight Research

Risk Aversion

� Nothing new since last report. At 0.07, the RAI remains in neutral territories. Equity 6m-momentum should go down

30

FIXED INCOME & CREDIT

� We retain our core strategic view for higher long-e nd yields going forward .

� But given the sharp upward move in treasury yields over the past month, we tactically stay neutral govies(but keep an eye on the 3.00% threshold on 10y UST) on the short-term and wait for a better spot to go short / UW

� We also stay OW EMU and Germany vs US and UK. � A way to express our short duration bias is to take 2y/10s curve steepeners which benefit from better

carry than outright short duration. We are long 5Y Bobl vs. 5Y UST.� We remain long duration in German bunds at the short end.� We are OW TIPS� We stay overweight peripheral vs. core govies.

� Given the spread tightening that happened in the last two months on IG bonds, the potential for any further tightening seems very limited

� We stay neutral on credit as a whole� 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, OW TIPS, keep our OW High Yield and EM sovereigns vs High Grade

FinLight Research | www.finlightresearch.com


Fixed Income – 10y UST

� The upside trend on 10 year US Treasury yields is likely to continue in 2014

� The main drivers affecting the U.S. Treasury market are the overall U.S. economic outlook (GDP expected around 2.5% + inflation expected around 1.2% and thus below Fed’s target) and the way (speed + communication) the Fed is going to unwind its current monetary policy accommodation

� In the central scenario where Fed implements its exit strategy properly, we target � 3.70% on 10y US benchmark yield (Feb 11 level)� A 50bps steepening on the yield curve, because the Fed will probably keep short-term rates rock

bottom until 2015

� Alternative scenario : A disastrous exit from the $4 trillion balance sheet would drive 10y yield in the 4.5-5% range



� The price action since Oct 30 appears similar to that from July into Sep 6� At this stage, a little pullback is very likely



� Looking at the channel formed off the Mar. 89 peak, the break of 3.00% could open the door to another leg higher targeting 3.76 (Feb. 11 high) and 3.90 (downtrend).

� Breaking the downward sloping channel would give a strong signal on the ability of the Fed to unwind its monetary policy accommodation

� A pullback on the 3.90 level will probably be concomitant with a downside move in stocks


Fixed Income – Global

� Yields increased sharply, specially on the 5y and 10y maturities, in reaction to early Fed tapering in December

� The 2s/10s continued to steepen globally – Source: JP Morgan


Inflation

� While the PCE deflator (Fed's favorite inflation measure) remains near 1%, the GDP price index rose at an annual rate of 2% during the Q3-2013, suggesting inflation might be running higher than Fed expects

� Increasing inflation is driving TIPS higher versus govies


High Yield

� High-yield default rate falls to a six-year low. � The par-weighted US high-yield default rate decreased to 0.66%, its lowest level since December 2007

(0.38%). The default rate is down from 1.26% at the end of last year and is considerably below the long-term averages of 3.9%


High Yield

� With underlying macro fundamentals improving, the HY market continues to weather the rise in Treasury yields well

� HY fully absorbed the increase in Treasury yields in 2013 with spreads and yields contracting significantly.

� Present situation is clearly similar to the one experienced in 2006-2007

� HY new-issue activity totals a record high in 2013, in US as in non-US…

� The spread between HY and IG is now on a record low

38

EXCHANGE RATES

� Since our last report, we’ve been long USD against EUR and JPY. None of our targets (1.31 and 108.3) was reached during the month.

� US dollar should start trading again on monetary-po licy outlooks more than the risk-on / risk-off moves of recent years

� The US dollar shows clear signs of bottoming out� Rising U.S. Treasury yields as the Federal Reserve scales back quantitative easing are expected to help

boost the U.S. dollar against most of the world’s major currencies in 2014� However, as Fed funds rate is expected to remain low, the US dollar should stay sideways through 2014-

H1

� Compared to the EUR, a widening of yield differentials in favor of the dollar will probably be driven by a more aggressive action from the ECB.

� On the EUR, we target a pull back to 1.31-1.25.� On USDJPY, we target 107-108 region, but set a stoploss at 103.70


39

US Dollar - DXY

� FX hedge funds and non-commercials are increasing their exposure to DXY



EUR-USD

� With softer euro zone data, low inflation and continued contraction in private sector lending, the ECB may move again by launching a quantitative-easing program (probably in the latter half of 2014)

� There is speculation that ECB would adopt a negative deposit rate. The German 2-year yield peaked around 26 bp in mid-December and is now trending lower

� On the other side, the bias is to a stronger US growth and a more hawkish Federal Reserve

� The US 2-year yields is moving up, helped by the positive data surprises.

� A material top seems to be forming in EUR-USD chart, after the spot failed to go through the 1.38 resistance area

� We target a pull back to 1.31, then to 1.25.


EUR-USD

� Yield differential between US and Germany implies in the 1.20 – 1.25 range


USD-JPY

� The initial target for wave 5 has been met at 104.71

� The market could extend its move to 107-108 but we should keep an eye on any signs of a meaningful turn like crossing down the May 2013 high at 103.73

� After identifying the top of wave 5, a subsequent correction / consolidation should be expected.

� At this stage, we keep our target of 108 and set a stoploss at 103.70


USD-BRL

� Looking at the chart, it seems reasonable to wait for a correction within the tunnel, without negating the USD upward trend.

� We target 2.60

44

COMMODITY

� We expect a better performance for commodities in 2014. The GSCI index should deliver 5% to 10% thanks to energy, backwardation, higher prices on base metals and a stabilization in precious metals.

� Agriculture prices should trend lower on higher supply

� Over the short run, � After being neutral, we become OW on commodities, with a clear preference for energy and base

metals, over precious metals and agri. � We stay UW precious metals (targeting 1180-1150 on gold and 18-17 on silver) because of rising

real interest rates. Technically, the bias seems skewed to another significant move lower.� Reaching a base will give a buying signal not only on physical gold but also on gold miners.

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

� On MT, we are bullish on commodities. The institutional money is starting to flow back into the commodities space.


45FinLight Research

Precious Metals - Gold

� Gold prices under the all-in sustaining costs of $1,200 - $1,400 per ounce will curb the development of new mines, which will effect the supply of gold within 5 to 10 years

� We are positive on gold for 2014 as we expect outflows from gold ETFs to stabilize in the coming year

� On the ST, the bias seems skewed to another significant move lower. Much of gold’s weakness comes from the likelihood of the Fed tapering its QE program as the U.S. economic outlook is starting to improve

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

46FinLight Research

Precious Metals - Gold

� Our theoretical price (implied by US$, sovereign CDS and Real Rates) stands now at 1142, versus a market price at 1205 (as of Dec 31). Our fair price should continue its downward movement as US$ and real rates go up.


Precious Metal - Gold

� Like for silver, a near-term base seems to be developing around 1180 (In our previous report, our target was 1180 – 1150). A clean rebound would imply a short-term recovery

� We are in a corrective action. From here, the bias seems skewed to another move to the downside.

� Target ~1150

� But breaking 1270 to the upside would imply another move higher into the 1330 area

48FinLight Research

Precious Metals – Gold Miners

� The downturn in PM prices has created golden opportunities within miners.

� The stocks we prefer are Gold Corp (that appears as the least volatile of the miners and the most conservative bet for those interested in making an investment in a gold miners) and Silver Wheaton (for its effective correlation to silver price)

� Prefer to invest in broader baskets (like GDX) over individual names for diversification and risk control reasons.

� Prefer larger miners to junior miners, as the latter tend to be more volatile and are at far greater operational risk if PM downtrends persist.

� We have to wait until the gold reaches a floor some where in the area 1150, before going long GDX


Precious Metal - Silver

� On the open of Dec 31, more than 7,500 contracts were sold pressuring prices to a new low of 18.72 intraday, inducing a immediate rebound of 1$.

� This is 3rd time in 2013 this kind of rebound occurs identifying the 18.70 level as a near term base. Going through 18.8 – 19 would imply a test of 17 which stands below the cost of production


Precious Metal - Silver

� The pivot area to watch is 20.51-20.93 where multiple levels are converging.

� It is important to know if the primary downtrend from Nov 12 will hold again, as it did on two occasions: Aug 13 and Oct 13

� Breaking above this downtrend would give a strong positive signal on gold.

� Without a clean break above this downtrend, continuation to the downside should be privileged

� Target ~ 17$


Precious Metal – Market flows

� Spec positions on gold have almost vanished� Money continues to flow out of gold ETFs

52

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


53

Hedge Funds Exposures

� According to BoA Model :� Market Neutral funds increased market exposure to 9% net long from 7% net long.� Equity Long/Short market exposure reduced to 29% net long � For Macros funds, the following significant moves were reported:� They reduced their long exposure to S&P and NASDAQ. � They kept their long exposure to US Dollar. � They switched from short exposure to now long exposure to 10-year treasuries and

commodities� They maintained short EM exposure

� Based on CFTC data , the following HF moves were reported:� Equities: Large specs marginally decreased their net longs in the S&P 500 but increased long

position in NASDAQ and Russell 2000.� Interest Rates: Large specs strongly added to their 10-yr short position .� FX: Large specs decreased their longs in EUR and shorts in JPY . � Metals: Large specs increased Gold, Silver, Platinum and Copper long ex posure� Energy: Large specs maintained Crude longs and reduced Natural Gas and Heating Oil short

position. � Agriculture: Large specs decreased their long positions in Soybean and increased short Wheat /

Corn exposure.


54

December 2013 Performance Review



Bottom Line : Global Asset Allocation

� Most of the important recent news was good� The economic outlook for 2014 seems rather benign . Growth in

the US is likely to pick up, but there is always the possibility of another shock somewhere. And the simple fact is that the eurozone is one shock away from plunging into a deflationary trap.

� The global economy looks poised to display better growth performance in 2014. Leading indicators are pointing upward - or at least to stability

� We summarize our views as follows �

finlight research - market perspectives jan 2014

Economy & Finance