INDUSTRY INSIGHT | Updated: 31-Oct-17
In-depth analysis of trends that are driving the hottest sectors and most attractive ETFs.

The Macro ChartBook: Mechanical Bull (QQQ,SPY,IWM,VXX,SVXY,USO,FXE,EWG,TLT,EWW,ASHR)

Key Points:

  • We have continued upward action without a sentiment extreme and without a deficit of cash at funds. The action has been fueled by real reflatonary growth leading to strong earnings and top-line results. Not much to complain about here.
  • A major risk exists in the VIX-related domain of the financial system, but it is now widely understood and covered daily in the press, so we should assume it is increasingly being accounted for by major players in the form of some kind of hedging (though I cannot seem to find the hedges). That said, the drought of low-volatility is almost always followed by a deluge and flood of excessive volatility. So, if those hedges aren't there, some sort of dislocation is plausible.
  • Sentiment is middling, still.
  • We have an increasing number of distortions being caused by the fact that both the BoJ and ECB are resolutely signaling continued asset purchases well into next year despite near-boom conditions in the global economy at present. The Fed is continuing to normalize at the same time, which is creating many oddities, as we discuss below.
  • Oil, Mexico, and China are also discussed in detail this month.

.
The Big Idea

In the last edition of the Macro ChartBook, we suggested that sentiment and cash readings, as well as an unconventional theory on the impact of Fed balance sheet tightening, were sufficient reasons to remain broadly bullish on stocks and risk assets of basically every kind, with a bias particularly in favor of highly cyclical assets as part of a rotation moving out of mega-cap technology.

We also noted at the end that China should be favored into the NPC but might be trouble afterward, and that bonds at the long end of the curve should slide in a steepener trade.

How those predictions played out is quite revealing.

Most of this was really just a single idea on accelerating nominal global growth and a lack of positioning for that growth. Typically, one sees outperformance in materials, energies, emerging markets, industrials, transports, and the like, a steepening of the yield curve, and a bid in the underlying commodities complex in that type of environment.

However, while we did see many of those outcomes, despite a major bid in the underlying commodities complex (and a continued run in the Baltic Dry Index), we did not see a steepening of the yield curve for reasons we will discuss below, and we certainly did not see a rotation out of mega-cap tech even on a relative basis.

The other thing we have not seen in any form is any clear evidence in sentiment data of a true burst of retail investor exuberance where the stock market is concerned. We continue to watch this market levitate on low volume and a complete absence of typical hedging. In that sense, this is truly one of the strangest bull markets I have seen, having been heavily personally involved in both the 1990's boom and the 2003-2008 bull, and having spent many years studying market data going back to the markets of the late 19th century.

If anything, this bull cycle is most remarkable for being so strong on such tepid volume and with such an understated significance in our current cultural context. One almost gets the feeling that the market could double tomorrow and it wouldn't even make the front page of the newspaper.

Sentiment data reflects that sense, as does cash on hand at major funds.


    Retail-Only, Buy-to-Open Put/Call Ratio. Source: www.sentimentrader.com


    National Association of Active Investment Managers Survey. Source: www.sentimentrader.com



    Nasdaq 100 (QQQ)



    S&P 500 (SPY)



    Russell 2000 Small Caps (IWM)

.
The VIX Conundrum

I wanted to describe a dynamic here that I have been discussing on our trader product at times over the last few months as we have watched the situation evolve.

This argument has started to pop up in a bunch of places. I'm not in any way suggesting others are reading my material and recasting it as their own. I think it's far more likely that other people are simply starting to see the same issue. In fact, I have come across folks pointing this issue out before me. And I think we can safely say, at this point, that a majority of the professional money management industry probably has at least an inkling of the dynamic I am about to describe (in fact, just yesterday it was covered by both the IMF and the Financial Times).

The issue is this: we know from fund flows data that a highly irregular amount of money has piled in to play a contango trade in the VIX futures market over the past 6-12 months. Derivatives portfolio managers have been involved, but so has retail. In fact, two of the most powerful vehicles for doing this are the XIV and SVXY exchange traded funds. Each holds short contracts in the VIX futures market and holds a spread of front and second out-month exposure on the curve, rotating a bit every day to move out of the front-month contract ahead of expirations.

Money flowing into these ETFs, and the money flow driven by these ETFs, has been reinforcing and exaggerating the extremes of contango in the forward VIX curve (successively expiring contracts currently pricing above antecedent expiries -- ie, the current price on Dec expiry VIX is above that of Nov, but below Jan, and so forth), and will continue to do so as long as we don't see a steady rise in the value of the spot VIX, which is itself pressured lower by the same mechanism.

More simply put: people are betting that forward contracts will descend in price through time and expire at a level that is roughly in line with the current extremely low VIX level. And the effect of those bets has been creating a self-fulfilling prophecy creating this outcome.

At the same time, over the past 5-6 years, we have seen the rise of a portfolio management strategy called "Volatility Control" or "Equity Volatility Targeting". The IMF just put out an estimate that assets invested in volatility targeting strategies have risen to about $500bn at this point.

There are many slight variations on this theme, but at the base of all of them is a feedback loop between low and stable VIX levels and the application of leverage in long-only equity portfolios. The most important thing to realize about this strategy is that it implies carrying more cash and less leverage in relatively higher-volatility markets, and less cash and more leverage in lower-vol markets.

Hence, as volatility climbs, managers are implored to sell assets, reduce leverage, and raise cash. And as volatility falls, managers are implored to buy assets, increase leverage, and shun cash.

In other words, for each individual involved, it makes sense, but there is a tragedy-of-the-commons kind of dynamic implied here, as well as an obvious feedback loop. The popularity of this portfolio management strategy arose after the last crisis, so it has not been battle-tested, so to speak, in an environment other than that of a steadily falling or low and stable VIX.

The conclusion is this: Two odd things are working together in a potentially insidious manner -- the first is creating an illusion of an unnatural level of safety, and the second is keying off that illusion to create an unnatural level of risk. All else equal, that could become a recipe for bad things.

However, at present, this argument overlaps into other analytic areas that contradict the danger here. Most notably, the idea that we have money managers all piled into historically overleveraged exposure to the stock market is not particularly consistent with other data points on sentiment and positioning.

In other words, the danger is not that people are too complacently and aggressively levered up long the stock market. The danger is in too many people trying to make money on strategies that are specifically predicated on the idea that VIX is in a normal place at 10. It isn't. The long-term average is around 19, and it has been very predictable in mean-reversion around that level.

In other words, the danger is that we could conceivably see feedback from specific bets about the VIX into general bets about the stock market that could carry the potential for a price dislocation in many instruments.

If there is any takeaway here, it's this: Markets do not transition from drought to delightful afternoon sprinkle. They transition from drought to hurricane/flood/deluge. It must be this way. A prolonged absence of volatility gradually invites a whole ecosystem of bets predicated on leveraging up to make money in a low-volatility environment. Those bets are like kindling wood piled up around a can of lighter fluid. At some point, something will come along and play the part of a lit match and set the whole thing off.

This is effectively me telling you that, in some markets, it's okay to try to catch a falling knife based on traditional intrinsic value measurements. This is not one of them because the market may be "booby-trapped" for a fat tail on the downside at some unpredictable point.

While that may seem out of place in such a seemingly strong and stable market, I am convinced that this is precisely when it may be most important to make such considerations apparent.



    VIX Index (VXX)



    Inverse VIX (SVXY)


.
Crude Oil (USO)

I have continued to express a bullish view on crude oil for a few reasons. First, my sense is refiners will likely be running at higher than average capacity perhaps through year-end. Hurricane Harvey hit outside of any normal refinery turnaround/maintenance period and depleted inventories of gasoline and distillate products. Now, we are in the Fall maintenance season, which will have the same impact. The time in between is likely going to be spent rebuilding and possibly over-building inventories of refined products, which should now feel like an extra push on demand through year-end.

Second, as we covered above, nominal and synchronous global growth has been accelerating. That is always the most important driver of oil prices.

Third, from what I can see, price has acted well despite a massive amount of hedging by shale producers. I can't be entirely certain that this has been going on, but some recent research by the BIS suggests that US shale companies have been working new hedges through swap dealer reporting standards in the CFTC data, and the move in the swap dealer open interest matches that assumption, diving to a historic high in net short interest in the last few reports.

The flip in the forward curve into long-term backwardation is likely another strong sign of this aggressive selling 2-5 years out at levels that are profitable for shale production costs.


    WTI Crude Oil Futures Forward Curve

If this is the correct idea, it is both understandable and potentially important for the action.

In the first case, if you're a shale oil producer and you managed to barely scrape by and avoid bankruptcy early last year (when oil sank to $26), then you will be thinking first and foremost about survival for the years to come, and about making a sustainable return, rather than getting rich in the next boom.

Hence, as soon as oil is trading at levels where you can turn a decent profit, you will likely be concerned with selling your future production in the market now (when you know you will get a return), and pumping it later to deliver on those contracts, rather than holding off and selling future production only after you have it pulled from the ground (when the price might be anywhere -- much higher or much lower).

In other words, when you have just witnessed serious and vivid existential risk, your focus is likely to be on derisking future survival as a first priority.

However, that implies certain other likely market dynamics, the most important of which should be an impact on the shape of the outcome distribution for oil traders.

This idea springs from a couple of assumptions, but ones I feel very safe in presenting. First, when a market is strong and major players are left out, they tend to foment the potential for the rough equivalent of a price squeeze. In other words, if oil sees north of $65, these guys are going to start to feel the pain of those hedges, and we might see that fuel the move to $70-75.

On the other hand, if we start to see weakening demand and some kind of tension arise that creates a lack of cooperation in the OPEC-plus-Russia cabal, and that translates into either or both of excess supply and a lack of confidence in regulating supply, then we might still see $40 oil. At that point, because of this hedging, the US shale players will have already locked in $50-55 on future production and need to keep servicing debt. So, even at lower prices, production from the US will stay strong. That could turn $40 oil into $30-35 oil as supply doesn't constrict in reaction to lower prices as normal.

So, this giant hedging position seems like it holds the potential to translate into an exaggeration of trend at either extreme, but likely doesn't matter much in the absence of strong directional movement in either direction. 


    WTI Crude Oil Continuous Contract Futures (CL#); ETF: USO


Euro and ECB (FXE, VGK)

Europe continues to act like a perfectly normal and stable economic system not at all in the grips of an economic crisis. And the ECB continues to act like a perfectly normal major developed-world central bank overseeing a collapsing economic system in need of desperate help to avoid a total implosion that could send the region back into the dark ages.

However, because they don't have a pressing inflationary conundrum, no one seems to have a problem with this mismatching of concepts.

As a result, we now have some major funhouse mirror distortions, particularly in global credit spreads. The idea that market pricing of interest rates somehow reflects information about the economy has been glaringly refuted by recent market action. At some point this is going to matter.

In the 1970's, the Nixon administration tried out price fixing with disastrous consequences. Communist Russia went through a similar experience. Whenever someone acts to distort markets such that information is no longer represented about supply and demand, it impacts lots of other things and eventually results in serious problems of some sort.

Right now, companies in the EU that have debt rated as "Junk" can issue bonds, have them readily bought up, and use the proceeds to buy US 10-yr treasuries for a profitable carry trade. We haven't ever seen this level of distortion in credit risk pricing. At some point, this is going to matter.

At this point, I would think the dip in the euro is probably a buying opportunity because the first result of this absurd state of affairs is likely going to be increasing pressure on the ECB to step up its plans to normalize policy. If the Catalan situation in Spain works itself out of the headlines in some manner, the door for markets to start discounting such a shift will be open.



    Euro Continuous Contract Futures (FXE)



    German Equities (EWG)



   EU Junk Debt versus US 10-yr T-Note Yield

.

Bonds (TLT)

One would certainly think, as noted above, that we would be seeing a steepening yield curve right now. Crude oil is breaking out higher, copper remains in a marching upward trend, the Baltic Dry Index is now up a stunning 94% since July, emerging market stocks and debt continue to run. It's hard to reconcile those ideas with the fact that, in the US, the 2-10 spread has visited new decade-long record lows within the last 10 days.

There are a number of theories as to why. In my book, the principal driver is the fact that the short end is driven by the Fed -- who is hiking -- while the long end is controlled by the ECB and BoJ, who are continuing to buy 10-yr sovereign debt, which is fungible on a cross-border basis. Currency volatility is low, so currency hedging is cheap, which is fueling the carry trades as people borrow in euros and yen, and use it to buy treasuries for an easy buck: large financial institutions letting JP and/or EU debt go into the hands of their respective central banks, and taking that cash and using it to buy US debt of a similar duration where yields are now much higher, and also buying into exposure in currency forwards or swaps to hedge the currency risk out of the equation (which closes the differential a bit but not all the way at this point according to my calculations). Hence, the net impact of the ECB and BoJ continuing to conduct asset purchases is actually demand for US long end treasuries.

At a certain point in the course of the Fed hiking, we could get an inverted yield curve. But it would not, in this case, be a valid signal about coming recession. It would be a pinching driven by the US normalizing while other major central banks are effectively conducting QE on US debt assets through the channel of institutional carry trade exposure.

As we covered above, this situation may be coming to a head before long as we now see such publicly obvious distortions in pricing credit risk and such a clear economic boom going on in the EU and even in Japan.

Hence, if you see a flattening yield curve, understand that it is reflecting the tension between a stubbornly normalizing Fed and a stubbornly lagging ECB and BoJ. In the end, it's yet another distortion that shows quite clearly that central banks should consider more than just inflation when making decisions about asset purchase programs.


   30-yr US T-Bond Continuous Contract Futures



   US 2-yr - 10-yr Yield Spread

.
Mexico (Peso and EWW)

I was long EWW and the Peso from December until August on the basis that Mexican assets had been clearly mispriced according to fears that Trump, once President, would immediately act to reshape trade policies to disastrous effect for Mexico, and would somehow get Congress to fund the building of a wall along the Mexico-US border that would be paid for over time by costs, tariffs, or fees passed through to Mexican citizens.

My sense then, as now, is that rhetoric from Trump painted this picture as part of a political campaign. But none of these policies are either productive or politically feasible. In the end, the most likely outcome is that Mexican-US dealings over the next 3 years will look very much like they have over the past 10. And in a cyclical economic boom that is becoming increasingly global and increasingly reflationary, highly cyclical economies such as Mexico will likely benefit even more than mature economies like the US on a relative basis. That, all else equal, should mean bearish sentiment action in Mexican assets, especially when fueled by speculation related to Trump or trade with the US, should represent particularly good opportunities.

This might be wrong, but it makes sense to me from just about every angle.

The trade during the first half of the year was very productive. I have recently begun to put the same position back on, with unleveraged exposure to both the peso and the EWW ETF. I do not have any stops in place. I am not married to the idea and will kick it out of my investment portfolio if I see red flags in the idea or the action. A good example of a red flag would be grinding downside movement that persists even in the face of positive news for Mexico related to NAFTA or Trump or its relationship with the US.

Finally, this is a cyclical position. If and when we see a cyclical downturn take root at some point, I would not expect the peso or Mexican stocks to be a good port in the storm.


    Mexico (EWW)

.
China (ASHR)

Last time, we discussed the risk for China in terms of its massive growth in debt. But we also suggested it should have plenty of cover through the National People's Congress and the reaffirmation of Xi Jinping as Core Leader. However, now that we are past that event, we should expect some volatility in China to emerge as the government starts to work on its agenda items -- one of which is trying to reduce leverage in the Chinese banking system.

However, I wanted to add a point to our quantitative discussion last time: one critical difference between the Chinese debt crisis and other clear historical examples of debt-driven implosions we have seen throughout recent financial history (Greece, Argentina, Spain, etc) is that the others all consist of a mountain of debt financed on some level by foreign money.

For China, the debt is all held by Chinese savers. In addition, the Chinese banking system may be overleveraged, but it is not stretched by banks borrowing short to lend long. Instead, it turns out that Chinese banks are still funded on domestic deposits as a simple fractional reserve multiplication effect.

That could lead to a bank run crisis. But it doesn't represent a traditional debt collapse scenario.

That said, now that we are past the NPC, we will likely see Beijing take steps to reduce risk in the system. The Shanghai Index is up more than 30% in the past 18 months. This is probably a vulnerable trend right now for strictly policy-based reasons.

I also believe the situation represents some level of risk for other markets, including the US.



    Shanghai A-Shares Market (ASHR) Versus the S&P 500 (SPY)

 

 - Brett Manning (bmanning@briefing.com)

The ETF ChartBook can be found on the Trading Ideas/Exchange Traded Funds and Trading Ideas / Fundamental home pages under the column heading "Industry Insight". To read past updates, click here to access the archive. On In Play, all of the Industry Insight content related to ETFs can be searched for, and have alerts generated by, the "ETFXX" ticker. Please send feedback to bmanning@briefing.com or ETF@briefing.com.

 
     Crude Oil (USO)
 
     Crude Oil (USO)
 
     Crude Oil (USO)