Avoid the Rocks

The best investment processes typically have some components that focus on the fundamentals of a given market as well components that focus on the quantitative aspects of a given market, specifically price action.

Trading is a lot like sailing.

In sailing, the wind matters but the tide matters too. If you base every decision on what the wind is doing and you don’t pay attention to the tide, you crash into the rocks. In trading, price action matters but the fundamentals matter too. If you make decisions based on price action alone, sooner or later, you will crash into those proverbial rocks.

As a macro guy, I firmly believe that you must understand the fundamental context in which price action occurs. Price action on its own is meaningless.

Also, given the fact that markets will, at times, front-run fundamental developments, understanding both the tide and the wind, can give you a marked advantage over other market participants. 

Currently, there are two scenarios playing out, which make this point for me: US retail sales, and China.


The US Consumer

Last week we received the latest US retail sales report for the month of March. Let’s dig in and better understand the tide.

The monthly growth rate was the strongest in over year, accelerating from a decline in February to an almost 1% gain in March. Given that there tends to be a lot of noise in data that is reported on a weekly or monthly basis, I focus on the year over year comparisons. Specifically, I focus on the slope of the year over year comparisons.

When you evaluate March’s retail sales from this perspective, it's been the worst 4-month stretch for retail sales since 2008. Yearly growth rates have decelerated for the 3rd straight month and are well below the 4.5% average growth rate we saw throughout 2014.

Retail sales peaked at 5% annual growth last August and as of March sit at just +1.3%. Last week, some people chose to focus on the strong monthly growth rate, while others discussed the impending doom because of the lack of consumer confidence.

The rationale for the weakness in sales is believed by many to be transitory due to bad weather and the fact that people went crazy in Q4 2014. The consumption component of Q4 GDP was the largest in almost a decade.

Now that we have a clear picture of the tide, let’s take a look at what the wind is telling us. If we evaluate the performance of the 9 primary sectors in the S&P 500, I see a couple of interesting things.

First, the consumer discretionary sector, which is the most sensitive to US retail sales, is the second best performing sector year-to-date behind healthcare. In addition, it has held that position for almost the entire year.

Second, despite the market’s negative reaction to the retail sales number, the consumer discretionary sector’s performance last week was middle of the road. Half of the 9 sectors performed better and half performed worse. Third, the consumer discretionary sector has outperformed the broader US equity market by a healthy 300 basis points so far this year.

How do we put all of this together?

As for the tide, the long-term fundamentals are saying that the US consumer continues to slow down the pace of consumption. The short-term fundamentals show a very healthy uptick in activity. The wind behind the US consumer has been strong all year long. My instinct says that the yearly growth rate has bottomed and we should start to see an acceleration higher, which will begin to mirror the strength that the equity market has been pricing in.



Nowhere in the world today is the wind and the tide pulling more strongly in opposing directions, than in China. Part of understanding the tide, specifically as it pertains to a specific country, is to understand that country’s monetary policy.

As I’ve said many times, the only driver of asset prices, ultimately, are the economic conditions and how central bankers respond to those conditions. The PBOC has been easing, in one capacity or another, since last Summer.

At the time, China’s economic numbers looked steady and strong. Clearly the PBOC saw something the rest of us did not. Ever since the PBOC announced they were easing, China’s economy has been decelerating.

Last week, we received the latest round of data on what I call China’s Big 3: industrial production, retail sales and fixed asset investment. If you pay attention to no other economic data coming out of China, the Big 3 will give you a very good picture of the underlying fundamentals. Industrial production (IP) reported at the lowest annual growth rate since 2008. IP peaked last July and has been decelerating ever since. The annual growth rate of IP has been cut in half since last Summer.

The picture is similar for retail sales. Retail sales have decelerated every month since peaking last June and the annual growth rate is down over 20%, sitting at the lowest rate in 9 years. Fixed asset investment also painted a bleak picture dropping to the lowest growth rate in 15 years.

And as if the Big 3 weren’t bad enough, China also released its latest trade data, showing that both imports and exports declined on an annual basis. This latest report proves that China’s economy is slowing very quickly, not to mention that the trade numbers do not bode well for global growth expectations.

The PBOC’s response to what the tide is saying has been to ease policy. It hasn’t worked so far, the numbers have only gotten worse since last Summer. But that hasn’t stopped investors from speculating about further stimulation with each bad economic number that gets released. Which brings us to the wind.

Since the PBOC began its latest round of easing, the Shanghai Composite, their version of the S&P 500, has doubled in price. Domestically, we have a number of exchange-traded funds that allow investors to trade everything from broad-based Chinese equities to specific sectors. FXI, which is the largest Chinese ETF based on assets, is up almost 40% since last Summer.

Chinese equities are by far the best performing asset class over the last 12 months. So, what do you do when the tide is bearish and the wind is bullish?

This is why understanding the tide can be such a game changer. Keep in mind that investors are pricing in further central banking intervention, not improving fundamentals. At some point, all future intervention is priced in and incremental easing won’t be able to push markets higher. For me personally, I only trade markets where the tide and the wind are aligned and moving in the same direction.

For me to be involved in Chinese equities at this point I would need to see two things. First, I would need to see a very healthy reduction in the “PBOC easing” premium that has been built into that market over the last 8 months. Second, I would need to see a bottoming and acceleration higher in the data of the Big 3.

The wind typically begins to turn bullish or bearish in advance of the tide. Once you see the tide turning and aligning itself with the wind, that’s where the real money can be made. I hope you can start to see how understanding and evaluating the fundamentals, which underlie a particular instrument can help you to make better trading decisions, rather than just focusing solely on price action.

I’m not saying you can’t get where you want to go focusing just on the wind, but the risk of ruin is much greater than if you combine your knowledge of the wind with a firm understanding of what’s happening beneath the surface.