How to trade Today's Divergences

If you Google the word “divergence” the first search result you get talks about vector operators, outward flux and infinitesimal volume.

Basically, you need a PhD to understand the 4 line definition.

But in plain terms, a divergence is simply a deviation from a course or standard. In trading, real opportunity for out sized returns comes when the public’s perception of an event diverges from the actual probabilities.

Divergence means opportunity. And I see a number of divergences around the financial markets.

 

The Mother of All Divergences

I’ve been writing for well over a year about the divergence between US monetary policy and the rest of the world, and the knock-on effects that divergence would have for financial markets.

When I first mentioned this underlying fundamental, I said that it was the most important catalyst moving markets for quite some time and it remains the primary driver of asset prices today. This divergence trade received new life last week with the newest US labor market data and the market coming around to the fact that there is a high probability of a rate hike by the Fed in December.

This realization coupled with a dovish ECB Mario Draghi and unexpected declines in German factory orders and industrial output, opens the door even wider that the ECB and the Fed will be moving in opposite directions next month.  Even the Bank of England was more dovish last week than expected.

Next month is setting up to be one of the most important months for global monetary policy in the last few years. Obviously, the Fed meeting on December 16 and the ECB meeting on December 3 are the headlining acts. Draghi reiterated last week that the ECB will maintain monetary accommodation and that this accommodation will be examined at the December meeting.

As for the Fed, the market is pricing in a rate hike and as long as the data remains average over the next month, the Fed will hike if for no other reason that to try and retain some level of credibility. The Fed has been saying all year that it plans to raise interest rates in 2015.

The Fed has delayed for a number of reasons over the past few years. In the absence of a significant economic reason not to hike, the Fed would lose credibility if it remained on hold. The market would doubt that the Fed will ever be able to lift off. The Fed stressing a 2016 rate hike, in the absence of a December rate hike, will not be enough. In addition to the headlining acts, a number of other developed market central banks, including: Bank of England, Bank of Canada, Reserve Bank of Australia are meeting and are expected to maintain or increase easing policies.

There are also no shortage of emerging market central banks also meeting between now and the end of the year, 18 to be exact. Obviously the Fed is the 800 pound gorilla and is the deciding factor in whether this divergence trade continues beyond the middle of December.

In addition to the US divergence, which is the undercurrent to everything that is occurring in financial markets, there are other divergences that are worthy of our attention.

 

Companies and Economists Divergence

Regular readers know that I’m not much for forecasts and could care less how a particular economic data point measures up against the consensus expectations. That said, in order to look for a divergence between peoples expectations and the true probabilities of an event, you have to know what peoples expectations are.

From that perspective, I like to hear what company executives have to say about the global economy when they are talking about their company’s results during earnings season. There is currently a divergence between some of the world’s largest corporations and the economists.

You can find out a lot more about what’s really occurring in the global economy listening to what the executives at companies like Walmart, Caterpillar and Boeing think about the world rather than a bunch of economists working at Wall Street banks.

One of the pivotal companies at the center of the global economy is Maersk, which is the world’s largest shipping company.  The CEO said last week that "The world’s economy is growing at a slower pace than the IMF and other large forecasters are predicting. We conduct a string of our own macro-economic forecasts and we see less growth - particularly in developing nations, but perhaps also in Europe -- than other people expect in 2016.”

This sentiment has been echoed by a number of companies over the course of this latest earnings season. You don’t use this type of information directly for trade ideas but it is very helpful as you continually strive to better understand what is happening.

 

US Dollar and US EPS Divergence

The USD’s strength negatively impacts a number of markets and that certainly includes the earnings of a plethora of US companies. A stronger USD, coupled with lower oil prices and slower global growth will provide a significant headwind to US commodity and industrial capital goods producers for the foreseeable future.

There is also significant risks to companies levered to high foreign profits. The impacted sectors include technology, industrial's, consumer staples, and many consumer discretionary stocks. I’ve been SHORT or NEUTRAL on the energy, material and industrial sectors in the Fund since late last year and I remain so today.

 

US Manufacturing and Service Sector Divergence

Another divergence of note is the separation between the manufacturing and service sectors in the US. Keep in mind that the manufacturing sector is more exposed to international drivers and the strong USD than the service sector, which rises and falls largely in response to domestic demand.

The two sectors have been moving in opposite directions since late last year and the current gap between the two sectors is the second largest gap going back to 1997 and will probably widen from here.

Because of the USD’s strength, weak global demand and lower prices for commodities and manufacturing goods, the manufacturing sector has significant headwinds to overcome.

Historically, a gap between these two sectors is not a directional signal for the broader US economy but the gap is important for US equity investors. Lean LONG towards the service sector because it has better growth and pricing power prospects than the manufacturing sector.