Trading in financial markets is one of the most highly competitive occupations in the world.
To earn above average returns demands 3 things:
First, you must see things that others have missed.
Second, you must bring insight that only you possess.
Finally and most importantly, you must be willing to behave differently than other market participants.
It’s no secret that risk assets around the world have ripped higher since mid-February. Crude oil, emerging markets, high growth US sectors have all rallied significantly since finding a short-term bottom. But the real question is: Is it time to load up the risk in your portfolio?
My market biases are anchored in the underlying fundamentals for that market. I then use quantitative analysis and an evaluation of the behavioral aspects of a market to find divergences that offer trade ideas that offer huge upside compared to the downside.
Remember that the day to day markets are not fundamental barometers but merely a barometer of investor sentiment. Eventually all markets are pulled back towards their fundamental gravity, whether that be up or down. There is no more clear example of a market disconnected from its fundamentals than Brazilian equities.
The Bovespa, which is the Brazilian equivalent of the S&P 500, has rallied 32% since bottoming on January 26. That rally is just a drop in the bucket considering that the Bovespa lost over half its value since peaking in 2010 and lost 36% of its value since just last year. The Bovespa would need to rally another 20% from here just to get back to trading where it was last May.
To say that Brazil’s economy looks like a Saw movie would be an understatement. Brazil is setting all of the wrong kind of economic records.
Brazil’s GDP growth has been in a downtrend since peaking post-Crisis in 2010. We just got Q4 GDP data, which showed that the economy contracted another 5.9% from the previous year. That is the worst growth rate ever. Ever, as they say, is a very long time!
But that was 2 months ago, what about now? The Brazilian economy took another hit in February. The latest PMI data shows that economic activity continues to contract at a record pace and unemployment is accelerating. The lack of external demand is killing manufacturing and the lack of domestic demand is killing the service sector. Brazil is getting hit from all sides and with the continued signs of slowing in the global economy there won’t be a pick up in external demand for quite some time.
This most recent rally is a counter-trend short squeeze and nothing more. Don’t attempt to trade this market from the LONG side because you think it’s a regime shift, it’s not.
I’d also be cautious attempting to SHORT this market. Short squeezes can always last much longer than you anticipate. Better to wait for signs that the rally is reaching exhaustion before bravely entering a short sell. That said, it’s only a matter of time before Brazil’s fundamental gravity pulls the Bovespa back down to where it belongs.
We’ve seen a similar, albeit much more mild divergence, between the US stock market and the US economic landscape. Last week everyone was focused on the headline job growth from the monthly labor markets.
The fact that both the ADP and NFP crushed economists’ expectations has everyone believing that despite the fact that global growth is slowing quickly, somehow the US labor market has found a way to decouple and remains in high gear. However, the devil is in the details.
The problem with all of the jobs being created is that they are being created in the wrong sectors. Wage growth is languishing because jobs are being created in the lowest paying service sector jobs rather than high-wage sectors like energy and manufacturing.
This isn’t surprising given the state of manufacturing worldwide and specifically here in the US. Manufacturing job growth is at 5-month lows, production is the slowest its been in over 2 years and overall activity has fallen consistently since peaking in 2014. That downtrend is still very much intact.
Make no mistake, just because the US is a “service based” economy doesn’t mean that manufacturing isn’t important to the overall health of the US economy. Quite the opposite. But if it's services you’re interested in, that part of the economy looks even worse.
At least manufacturing is still expanding, ever so slightly. As of last week’s report, the service sector is officially in contraction. The current levels in both manufacturing and service is implying that GDP growth is actually going to be negative in Q1, rather than the 2.2% growth rate that the Atlanta Fed is currently forecasting.
And if that picture isn’t fragile enough for you, the annual growth of US factory orders contracted for the 15th consecutive month. In 60 years, the US economy has never encountered a 15-month continuous fall in growth rate of factory orders without being in a recession.
But for those that are still convinced that a 10% rally in the S&P in less than a month is an indication that things are fine in the US, lets dig a bit deeper.
I monitor 2 proprietary indices to help me gauge what the markets are thinking about future US growth. One is built from markets that perform well when US growth is accelerating higher and one is built to alert me when US growth is slowing.
Those indices are flashing a very interesting divergence. If you evaluate the overall performance so far this year, my indicators are saying that Q1 US growth is going to slow from Q4. My Slow Growth Index is up 9.1% year to date versus the High Growth Index, which is down 3.1% and the S&P at -2.1%. This performance is accurate through Friday’s close, which means it incorporates a 13.6% rally in the high growth index since February 11 and a 10% rally in the S&P.
So even with a monster 3-week rally, slow growth assets are outperforming by 14.2%.
Now for the interesting divergence. Since the risk asset rally began on February 11, the slow growth index is also up 4%. Historically, these indices move in opposite directions. However, when they move in concert, like they have over the last 3 weeks, 80% of the time slow growth breaks to newer highs and the high growth index rolls over.
I like those odds. Markets are speaking loudly and they are saying that slower growth is ahead. Don’t be bamboozled by headline numbers and counter trend rallies designed to suck you into to wrong side of a trade.
Position yourself accordingly by being LONG cash, volatility, US Treasuries and gold. If you must have US equity exposure make sure its defensive: utilities and consumer staples. You may not make money but these sectors will certainly hold up better than other sectors when the market rolls over.