Investing – Sevens Report Research

What Direction is the Pain Trade?, May 16, 2017

May 16, 2017/in Investing/by Tom Essaye

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Longer term readers know that one of the better indicators we use to determine the near-term trend of markets is the “pain trade,” and figuring out whether the pain trade is higher or lower can help us determine whether the near-term risk for stocks is for a breakout, or a pullback.

For reference, the pain trade is an industry term that describes the most painful market outcome for investors. It’s based on the simple (and accurate) principle that the market always moves to extract the most amount of pain from the most amount of people.

So, if the most amount of people are long and positioned for higher stock prices, the pain trade is lower. Conversely (as has been the case for most of the 2010s), when investors are underweight equities and are cautious and expecting a correction, the pain trade is actually higher, because investors lament underperformance and are “missing” the rally.

We think that after years of the pain trade being higher, we are approaching a turning point where the pain trade will once again move lower, like it was for most of the 90s and 00s, and we wanted to cover the reasons behind that observation. This matters, because if, in the coming months, the pain trade does turn lower, that will effect how we are positioned.

When determining which direction the pain trade lies, I look at

1) Sentiment and

2) Investor exposure to stocks.

Again, as a general rule, if sentiment is bullish/positive and investor exposure to stocks high, the pain trade is lower, meaning a drop in stocks elicits the most pain from the most people.

Conversely, if sentiment is skeptical/cautious and investors are underinvested in equities, the pain trade is higher, meaning a rally in stocks elicits the most pain from investors as they are “missing” the rally.

Investor Sentiment: No Irrational Exuberance, but the Multi-Year Caution is Eroding. Various measures of investment sentiment are simply not signaling an undue amount of euphoria out there at this time.

Put/Call Ratios are in the middle of the historical range (and well above the 0.45% that represents excessive bullishness). Meanwhile, the AAII Sentiment Survey (American Association of Individual Investors) shows just 32.7% bulls, well below the historical average of 38.5%. Again, that’s not the type of extreme bullishness that would make the pain trade lower.

However, not all sentiment indicators are cautious. The Investors Intelligence Advisor Sentiment Index is above 3.0 (the level that denotes excessive expectations of higher stock prices) and the percentage of bullish advisors is creeping towards the peak of 60% (currently 58.7). So, it would appear that advisors are a bit more bullish than options traders or individual investors. But, it’s still a mixed picture, and doesn’t imply the pain trade is materially higher or lower.

Takeaway: For the past several years, market skepticism has helped power stocks higher; but while the expectations of investors and advisors has turned more positive (and hence reduced the upside pain trade) it is still not bullish enough to make us think the pain trade has turned definitively lower near term, yet.

Investor Exposure to Equities: Getting More Long. Underinvestment in the stock market also has been a powerful tailwind on stocks over the past seven years, as cautious investors have been waiting for another financial crisis (one that’s yet to arrive). So, with each new high, investors and advisors have “chased” stocks higher after throwing in their bearish towels and finally getting back in the market.

That’s one of the reasons super-cap internet and tech stocks have outperformed. Those stocks are called “long rentals,” because they are ultra-liquid and are positively correlated to the market in general and tech specifically. It’s an easy, general way to get a client more long the market in a hurry without taking too much risk.

However, now, that broad market underinvestment situation also has somewhat resolved itself. Since October we’ve seen consistent inflows into US mutual funds and ETFs, including in April (if we ignore the large outflows during the first week of April, as people liquidated accounts to pay taxes, contribute to IRAs, etc.)

Additionally, the amount of money market fund holdings over the previous year.

Takeaway: The extreme levels of underinvestment that prompted investors and advisors chasing markets higher has not been eliminated, but it has been seriously reduced… and that also reduces the upward direction of the pain trade.

Bottom Line

For years, the pain trade has been higher due to cautious/pessimistic investors who were burned by the financial crisis, combined with lots of dry power in the form of equity market underinvestment. However, while the pain trade likely is still marginally higher, it is not the bullish force that it once was. As such, we do not expect to see stocks magically grind higher in the face of unimpressive fundamentals the way we did over the past several years.

From a practical standpoint, this analysis reinforces our cautiously positive opinion on stocks, but also restrains us from chasing stocks without evidence of a reignited reflation trade. Bottom line, the pain trade now is much more two sided than it has been in years, and that puts even more emphasis on getting the political and economic analysis right—because at this point just as much pain will be elicited from investors if we roll over, or if we breakout.

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Weekly Market Cheat Sheet, May 15, 2017

May 15, 2017/in Investing/by Tom Essaye

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Last Week in Review:

Economic data last week was mixed in total, but from a market standpoint the takeaway was that it was neither strong enough to support a push through 2400 in the S&P 500, nor weak enough to generate any real selling. So, the net effect is that the market is left wondering whether the economic acceleration can continue, or whether we are losing momentum.

Retail Sales was the most important report last week, and while on the headline it appeared disappointing, a closer look revealed it was basically in line with expectations.

I say that, because while the headline missed estimates (0.4% vs. 0.6%) the revisions to the March data were positive, from -0.2% to 0.1%. Taken in aggregate, the two-month retail sales performance was slightly better than expected.

Looking at the more important “control” group, which is the best measure of discretionary consumer spending, it also appeared to be a disappointment, up just 0.2% vs. (E) 0.4%. But once again, the revisions were positive (from 0.5% to 0.7%), so if you take the two months together it was in line with estimates.

Bigger picture, consumer spending remains decently healthy, but activity isn’t on pace with Q3/Q4 of last year, when consumer spending powered economic growth. Without an acceleration in consumer spending, it’s hard to see the US economy accelerating materially from here.

The other notable domestic numbers last week were the April CPI and PPI. The former was much-hotter-than-expected, as the core rose 0.7% vs. 0.2% on surging service inflation (financial services costs, especially). However, core CPI was slightly underwhelming, rising just 0.1% in April, and up 1.9% year over year, below the 2.0% estimate.

Bottom line, it’s a given that inflation pressures continue to build, but all the statistical data implies they are building very slowly. And given the Fed watches the statistical data, nothing in the inflation numbers will make the Fed think about hiking more aggressively or delaying the June rate hike.

The other notable data last week came from China, and it was on balance negative. April exports, imports, M2 money supply and PPI all missed estimates, although not by wide margins. Not all the data was bad, as new yuan loans were slightly better than expected. Then, this weekend, Fixed Asset Investment, Retail Sales and Industrial Production all slightly missed expectations.

Bottom line, legitimate doubts are creeping in about the state of the Chinese economy, but it’s simply too early for anyone other than Kyle Bass to declare a problem (he’s been warning about the implosion of China for years, and I’m sure one day he will be right. In the meantime, he has plenty of capital to wait it out). Yet for us, slowing Chinese growth remains a risk, but one that just needs to be monitored for now, which we are doing.

This Week’s Preview:

The calendar is once again relatively quiet this week, although we will get the first look at May data, which will help us decide whether the March/April lull in economic growth is ending.

To that point, the two most important numbers this week are the Empire Manufacturing Survey (today) and the Philly Fed survey (Thursday). Both give us our first look at May economic activity, and while both are just regional surveys, they still matter given the seemingly precarious trend in economic data (is it the pause that refreshes, or are we losing momentum?).

Outside of those two manufacturing surveys, April Industrial Production comes Tuesday, and that will give us another hard-data look at manufacturing activity. Remember, while manufacturing PMIs soared in early 2017, actual hard data hasn’t really moved (hence the gap between soft sentiment indicators and hard data). So, it’ll be an economic positive if Industrial Production can show an acceleration in manufacturing activity.

Outside of those reports, the only other notable numbers are housing related, as we get the first look at April home sales numbers. The Housing Market Index comes today, Housing Starts come tomorrow. Sentiment towards housing is pretty buoyant right now, so it’d be unlikely (and a big surprise) if we saw a housing roll over.

Bottom line, this week will shed some incremental light on the current state of economic growth, and given the markets are starving for a catalyst (positive or negative) usually inconsequential numbers may indeed move stocks.

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What Comey’s Firing Means for Markets, May 11, 2017

May 11, 2017/in Investing/by Tom Essaye

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Regardless of how the rest of the year turns out, I personally will always remember 2017 for the fact that I had to try and figure out the market implications of political events that I never thought I would have to worry about.

Case in point, Tuesday’s firing of FBI Director James Comey moved markets yesterday, and I wanted to cover what that means going forward (it’s a mild and potentially negative, but not a bearish game changer). Now, to be clear, the market is agnostic to the politics of this drama and as such so am I. Whether you or I think the firing was a coverup or justified, it matters not from a market standpoint, so as I always do with political coverage, I will strictly stick to market implications.

The reason Comey’s firing is a mild negative on markets is because it further undermines President Trump and the Republicans’ ability to pass their pro-growth agenda.

Case in point, just yesterday, we saw part of the fallout from the Comey firing as the Republicans were unable to pass a reversal of an Obama rule against methane gas capture on oil and natural gas wells (Republicans say the environmental regulation increases the cost to drill natural gas and oil wells).

Three Republicans; Graham, Collins and McCain, voted with the Democrats, and the repeal measure failed 49-51. Graham and Collins were always “no” votes on the rule, but McCain was expected to vote “yes”—so much so that Vice President Pence was in the Senate to cast the tie breaker. McCain didn’t say so explicitly, but his “no” vote is widely seen as a protest vote against Trump.

Bottom line, the controversy now surrounding Trump’s move to fire Comey is a political hot stove, and some Republicans are already distancing themselves from the President as they are already thinking about re-election. Point being, the path to passing meaningful tax reform or other pro-growth policies just got more difficult.

Now, the good news is that this isn’t a bearish game changer for markets in part because expectations for tax cuts in 2017 are already pretty low.

Still, there is risk here, because the market does still assume some corporate tax cuts/foreign profit repatriation in 2018. If Trump/Republicans lose enough political capital to put a corporate tax cut in 2018 in doubt, then that will be at least a modest negative on stocks.

More specifically, after June 2018 (at the latest), everything in Washington will stop as focus shifts to the mid-term elections. So, if the market begins to think there will be no corporate tax cuts and no foreign profit repatriation, then that will begin to weigh on stocks later in 2017/early in 2018.

Bottom line, unfortunately politics remains an important influence on markets in 2017. On balance, expectations have been tempered from a policy standpoint, but the “gap” between likely policy reality and policy expectations remains wide… and it got wider this week with the Comey controversy.

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Volatility—What Goes Down Must Come Up, But It Can Take a Long Time!, May 10, 2017

May 10, 2017/in Investing/by Tom Essaye

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Historically low volatility is becoming a bigger topic in the markets these days, and while earlier in the year low volatility was referenced with more of an observational tone, recently I’ve been hearing the bears touting low volatility as something that simply must revert soon, and as such we should be cautious on markets.

I don’t have a crystal ball, so I don’t know when normal volatility will return. However, I do want to spend a few moments pushing back on the idea that low volatility by itself means a correction is coming (obviously volatility will return, but as usual the key question is “when,” and ultra-low volatility doesn’t always mean it’ll return to normal levels soon).

First, you’re not seeing things. Volatility is at multi-decade lows, and that can be seen in multiple ways. First, the VIX hit a 23-year low yesterday, falling to the lowest level since 1993.

Second, so far in 2017 the S&P 500 has moved more than 1% on just three separate days, all of which were in March. By this time of year we’ve normally had 19 days where the S&P 500 has moved more than 1%.

Third, with a close at 9.98 yesterday, the VIX now is lower than nearly 99.5% of all the closes since Jan. 1, 1990. Put another way, it’s only closed this low about 0.05% of the time during the last 27-plus years. So, the VIX is extraordinarily low.

But, that doesn’t mean it’s going to bounce back soon.

First, According to a note from ConvergeEx, the all-time low for the VIX 50-day moving average is 10.8, which it hit in Feb. 2007. Right now, the 50-day moving average for the VIX is 12.17.

Takeaway: It’s very unlikely that the VIX will stay at these ultra-low levels for very long, but that doesn’t mean a big rally is looming. It would take several more weeks of VIX at these levels to drag the 50-day MA down towards the all-time lows.

Second, looking at the VIX to measure volatility can cre-ate a bit of an odd picture, because again the VIX is based on options prices and not the actual price move-ments of the S&P 500. Looking at actual stock price movement, it confirms what our eyes tell us.

Going back to the 1950s, the current volatility of stock prices is 48% of its longer-term average. That’s really low. And, this period of historically low volatility has been going on for 78 days (including yesterday). But, that doesn’t mean it necessarily will bounce back.

First, there have been two specific periods of similarly low volatility in the last 20 years. First in mid-2014 (75 days) and second from Nov. ’06 to March ’07 (79 days).

Second, we’re not even close to the record for low volatility. In 1992/1993 and 1995/1996 we saw respective periods of ultra-low volatility last for 179 and 254 days, respectively. That’s double and triple what we’ve seen so far in 2017.

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Earnings Season Post Mortem & Valuation Update, May 9, 2017

May 9, 2017/in Investing/by Tom Essaye

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The S&P 500 has been largely “stuck” in the 2300-2400 trading range for nearly 10 weeks, despite a big non-confirmation from 10-year yields, modestly slowing economic data and political disappointment. Given that less-than-ideal context, the market has been downright resilient as the S&P 500 only fell to around 2320ish. The main reason for that resilience is earnings and valuation.

While it’s true that stocks are at a valuation “ceiling” right now, and need a new macro catalyst to materially breakout, it’s also true that given the current macro environment the downside risk on a valuation basis for the market is somewhat limited. That’s why we’re seeing such aggressive buying on dips.

Here’s the reason I say that. The Q1 earnings season was better than expected, and it’s resulted in 2018 S&P 500 EPS bumping up $1 from $135-$137 to $136-$138. At the higher end of that range, the S&P 500 is trading at 17.4X next year’s earnings. That’s high historically to be sure, but it’s not crazy given Treasury yield levels and expected macro-economic fundamentals.

However, if the S&P 500 were to drop to 2300 on a macro surprise, then the market would be trading at 16.67X 2018 earnings. In this environment (low yields, stable macro environment), that could easily be considered fairly valued.

Additionally, most analysts pencil in any help from Washington (including even a small corporate tax cut and/or a foreign profit repatriation holiday) adding a minimum of $5 to 2018 S&P 500 EPS. So, if they pass the bare minimum of expectations, it’s likely worth about $5 in earnings, and that puts 2018 earnings at $143.

At 2400, and with $143 expected earnings, the S&P 500 is trading at 16.8X 2018 earnings. Again, that is high historically, but for this market anything sub 17X will elicit buying in equities (whether it should is an open question, but that is the reality).

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Weekly Market Cheat Sheet: May 8, 2017

May 8, 2017/in Investing/by Tom Essaye

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Last Week in Review:

Economic data last week, highlighted by the strong jobs report, helped to somewhat narrow the gap between soft sentiment surveys and hard economic data… although it’s fair to say that gap remains open and is still a headwind on stocks, just a slightly less strong one. It was not all positive last week, though, as we got several signs of potential loss of momentum in China, which was an underreported but potentially important development last week. Finally, the Fed meeting proved to be a non-event, except in that it reaffirmed a June rate hike is likely (but that’s already mostly expected from the markets).

Starting with the jobs report, it met our “just right” scenario. The overall job adds were strong at 211k vs. (E) 185k, but revisions to the March report were negative 19k, so the net number was more in line. The unemployment rate dropped to 4.4%, but that was in part due to a decline in the participation rate. Meanwhile, year-over-year wage increases declined to 2.5% from 2.7%. Bottom line, this number was “fine,” but it wasn’t massively reflationary (in part due to the wage number) and that’s why we didn’t see the strong headline jobs report ignite an immediate reflation rally in stocks (again, the wage number undermined the strong job adds).

Looking at other economic data last week, there were more positives than negatives, highlighted by the ISM Non-Manufacturing PMI, which hit 57.5 vs. (E) 55.8. That strong Non-Manufacturing PMI helped to offset the soft April Manufacturing PMI, which dipped to 54.8 vs. (E) 56.5 while the New Order component dropped below 60 for the first time in five months. While disappointing vs. expectations, it’s important to remember that the absolute level activity remains strong.

Turning to the Fed, the key takeaway from last week’s Fed meeting was that the Fed viewed the loss of economic momentum in Q1 as “transitory,” and still said risks to growth were “roughly balanced.” Both terms are Fed speak for, “We’re going to hike in June despite the soft Q1 GDP.” The market largely expects that (Fed Fund futures have a hike priced at 83% (which is close to a universal conclusion).

Finally, I want to take a moment and focus on Chinese economic data from last week, as the numbers were universally disappointing. Official April Manufacturing PMI dropped to 51.2 vs. (E) 51.7 while composite PMI declined to 51.2 vs. previous 52.1. Additionally, iron ore went into quasi freefall this week, as iron ore futures ended limit down on the Dalian Commodities Exchange on Wednesday night. The drop came after the Chinese steel industry PMI dropped below 50, signaling contraction. Oversupply has something to do with the price drop as well (exports are surging out of Australia) but the bottom line is that base metal prices are a coincident indicator of economic activity. The declines in iron ore, steel and copper last week, combined with the under-whelming Chinese data, definitely caught our attention. We now are officially watching this closely for everyone, and will keep you updated.

This Week’s Cheat Sheet:

This week, April CPI and April Retail Sales (both Friday) are the important reports to watch. The latter is more important for markets at this point than the former, as we need to see a rebound from Q1’s paltry consumer spending. If retail sales fail to show progress and beat expectations, it’ll widen the gap between soft data and hard economic numbers. With CPI, we should see some mild cooling of the recent uptick in inflation, but overall inflation pressures continue to slowly build.

Outside of those two numbers, focus will be on the Chinese CPI and PPI, as again data there suddenly turned lower last week. Bottom line, it should be a quiet week, but retail sales and CPI are important as the “gap” between soft sentiment surveys and hard economic data remains… and it needs to close further if we are going to see a breakout in stocks.

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Jobs Report Preview, May 5, 2017

May 5, 2017/in Investing/by Tom Essaye

For the first time in 2017, the risks to tomorrow’s jobs report are balanced, as a “Too Hot” number will increase the possibility of more than three rate hikes in 2017 while a “Too Cold” number will fan worries about the pace of economic growth, and the ability for better economic growth to push stocks materially higher.

Here’s The Sevens Report traditional “Goldilocks” breakdown:

“Too Hot” Scenario (Potential for More than Three Rate Hikes in 2017)

>250k Job Adds, < 4.6% Unemployment, > 2.9% YOY wage increase. A number this hot would likely reignite the debate over whether the Fed will hike more than three times this year.
Likely Market Reaction: Withheld for subscribers. Unlock with a free trial at 7sReport.com.

“Just Right” Scenario (A June Rate Hike Becomes More Expected, But the Total Number of Expected Hikes Stays at Three)

125k–250k Job Adds, > 4.7% Unemployment Rate, 2.5%-2.8% YOY wage increase. This is the best-case scenario for stocks, as it would imply still-stable job growth, but not materially increase the chances for more than three rate hikes in 2017.
Likely Market Reaction: Withheld for subscribers. Unlock with a free trial at 7sReport.com.

“Too Cold” Scenario (A June Rate Hike Becomes in Doubt)

< 125k Job Adds. Given the recent unimpressive economic reports, a soft jobs number could cause a decent sell-off in equities. As the Washington policy outlook continues to dim, economic data needs to do more heavy lifting to support stocks. So, given the market’s focus on future growth, the bottom line is bad economic data still isn’t good for stocks.
Likely Market Reaction: Withheld for subscribers. Unlock with a free trial at 7sReport.com.

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This Week’s Fed Decision Takeaway and Rate Hikes To Come, May 4, 2017

May 5, 2017/in Investing/by Tom Essaye

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The Fed made no changes to interest rates this week, as expected.

Fed Decision Takeaway

The Fed statement almost perfectly met our “Meets Expectations If” scenario, as the Fed acknowledged the slight loss of economic momentum since March, but stated it viewed the slowing as only temporary, and left the door firmly open for a rate hike in June.

Looking specifically at the statement, the Fed said yesterday that economic activity had “slowed” compared to “expanded at a moderate pace” in March. But, in the second paragraph, the Fed said the loss of economic momentum appears to be “transitory,” and signaled the recent underwhelming data won’t make the Fed deviate from future rate hikes.

Underscoring that point was the fact that the Fed said risks to the near-term economic outlook continue to be “roughly balanced,” which is Fed speak for “we can hike rates at any meeting going forward.” Bottom line, the Fed was not spooked by the recent soft data and it is not deterring them from any future rate hikes… yet.

From a market standpoint, there was a mild “hawkish” reaction, not so much because the statement was hawkish, but instead because there was nothing dovish in the statement. That’s what markets have become conditioned to expect. The Dollar Index drifted to the highs of the day 30 minutes after the statement while the 30-year Treasury erased small gains and closed fractionally lower. Stocks drifted slightly lower, but selling was mild. Overall, the Fed statement was not a market mover.

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Tom Essaye on “The Bell” Podcast with Paul Sweeney and Adam Johnson

May 4, 2017/in Investing/by Tom Essaye

I was a guest on Adam Johnson’s podcast “The Bell” last week. We talk with Paul Sweeney of Bloomberg Intelligence, “the man who’s turning Wall Street research upside down”. There are big changes in the research industry and Sweeney is on the leading edge of those changes. We also talk about “Animal Spirits” vs Hard Economic Data, Earnings and Employment, Mortgages being back under 4% here in Fed Week.

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Another Oil Plunge, Futures Down, May 3, 2017

May 3, 2017/in Investing/by Tom Essaye

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Oil futures sank 2.74% yesterday, with a large portion of the losses coming in the final hour. The catalyst for the decline was a collection of analysts’ estimates for this morning’s EIA report that started to come in showing more substantial builds in product inventories even though oil stocks are supposed to fall.

RBOB gasoline futures have been leading the way lower since they topped out on April 12. In fact, since that day, futures have only notched one single gain (that is three weeks with just one positive trading day). Gasoline futures now are within 3% of their 2017 lows, and if the downtrend continues that will be a headwind on the rest of the energy space.

Oil futures came within 1% of their 2017 lows yesterday and the momentum is clearly with the bears. Yesterday’s move was amplified by a “stop run” as futures broke through the March lows in the June contract. But in an encouraging sign of weakness, futures were unable to rebound.

On the charts, futures broke through a longstanding technical uptrend line that dated back to early August. That is another sign of technical weakness in the market.

In doing some cross-asset analysis yesterday, there was evidence that the inverse correlation between oil prices and long bond prices is resurfacing. As a reminder, for a period of time back in early 2016, long bond futures were trading almost exclusively off of the price of oil (specifically when WTI had a $20 handle). The reasons were twofold.

First, low oil prices are a drag on inflation readings, which would have dovish implications for Fed policy (long bond positive). Second, long bonds benefited from a safe-haven/fear bid as lower oil prices increased the risk of small producers defaulting on loans, many of which were issued by southern and central regional banks. Ultimately, contagion fears weighed on regional banks and the broader financial sector collectively. Now, it is not clear whether this is happening again as it was only one day of trading so far, but it is something to keep in mind going forward. If oil declines cause a sharp break lower in longer-term interest rates, that will weigh on stocks.

Bottom line, the fundamentals (rising US production and still-overflowing global stockpiles), technicals (new five-week lows), and market internals (bearish term structure) all continue to favor the oil bears right now, and the idea that we are in a “lower for longer” price environment still stands.

Oil and the rest of the energy complex is, however, near-term oversold, and we could see a volatile short covering rally given the right catalyst. Such a move would likely be short-lived, and if we were to see a continued move into the low $40s or even high $30s that would have serious implications for all asset classes (as in early 2016).

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