Is The Bond Market Sniffing Out Equity Market Trouble?

A short-term testing phase is underway in the global equity market, and a number of factors argue that it needs more time to play out. Five major concerns could weigh on stocks from a tactical perspective.

First, policy divergences between the Fed and the ECB are unlikely to widen further, as the ECB signaled at its March meeting that the Eurozone is past peak monetary policy easing with the latest 4-year TLTRO II bank take up coming in at €233bn fixed at 0%. Historically, the relative sovereign spread has been a reliable equity market topping out signal. The chart shows that the U.S./Eurozone 10-year sovereign bond spread has been an excellent leading indicator of the broad equity market, and the current message is to expect at least a tactical pullback. In fact, every time the spread has hit 100 basis points, relative bond market mean reversion has subsequently occurred, leading also to a broad equity market wobble.

We doubt that monetary policies can diverge significantly for much longer without any negative global ramifications. Given that the inflation expectation gap between the U.S. and the Eurozone has remained intact since last summer, real interest rate differentials are the driving factor of the recent steep divergence. Historically, this pushes capital flows onto U.S. shores to the point where the dollar typically overshoots thus draining global liquidity and eventually a tipping point occurs.

The weak link this time could be emerging markets, as a sustained and unchecked dollar bull market (underpinned by policy divergence) risks uncovering the hard currency debt excesses in the region. This is a risk we are closely monitoring.

Second, our global equity market EPS model has…

For additional details, please see the April 7th Report titled “Quarterly Review And Outlook”, available at gss.bcaresearch.com.

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Is The S&P500 Suffering From Short-term Fatigue?

Equities are exhibiting signs of mild fatigue. Breadth has begun to narrow, and new highs have sagged compared with new lows (see chart). Both of these technical developments have warned of previous tactical pullbacks. The recent reset in oil prices may also test investor nerves.

Oil prices have been a critical macro variable, because they influence inflation expectations and the corporate bond market (high yield bond spreads shown inverted, see chart). Crude oil price
corrections have accurately timed equity retreats (see chart), and general risk aversion phases. To be sure, the global economy is no longer on a deflationary precipice, suggesting that weaker oil prices may not foreshadow a soft patch, but they may be a good enough excuse for profit taking in the equity market after a good run.

Contrary to popular perception…

For additional details, please see the U.S. Equity Strategy latest report titled: ”Reading The Market’s Messages”, available at uses.bcaresearch.com.

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Are Eurozone Banks A Buy?

Buying Europe at the expense of America has been a widow maker trade since the depths of the Great Recession, but factors finally appear to be falling into place for a preference shift away from the U.S. and toward the Eurozone.

Given the relative regional outlook, buying euro area banks/financials at the expense of U.S. banks/financials should be a winning pair trade.

Nevertheless, we would rather err on the side of caution and boost euro area financials to overweight in global equity portfolios.

The euro area is lifting out of the economic doldrums. The ECB’s easy money policies have finally coaxed the economy close to a self-sustaining recovery. The latest manufacturing PMI data were very strong, signaling that real GDP growth should accelerate. In addition to easy monetary policy, fiscal policy has also contributed to GDP growth. Keep in mind that in calendar 2016, the euro area’s real GDP grew faster than the U.S. A healthy economic backdrop typically spurs loan demand, which is positive for bank profitability (see chart).

Moreover, inflation is at the ECB’s target. Headline CPI has accelerated…

For additional details, please see the February 24th Report titled “Nearing Stall Speed”, available at gss.bcaresearch.com.

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What Does The S&P 500’s Forward P/E Controlled For Volatility Signal?

In a blog post in early February, we showed that our Complacency-Anxiety Indicator hit a new high. Another way to measure greed overwhelming fear is the relentless rise of the S&P 500 forward P/E over the VIX. The spread between these two measures can also gauge complacency. As seen in the chart, this indicator has also soared to an all-time high. Momentum continues to drive the broad market trend and valuations have taken a backseat, emblematic of blow-off phases.

How long can this overshoot phase last? There are obviously no easy answers. However, in the absence of any major monetary, economic and/or geopolitical shocks, an examination of our Composite Technical Indicator suggests…

For additional details, please refer to the U.S. > Equity Strategy Report titled “Overbought, But…”, available at uses.bcaresearch.com.

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What Is The Equity Market Implication Of The Spike In The “Soft” Vs. “Hard” Data?

A number of indicators we track are signaling that the global equity market is extremely stretched.

First, our Complacency-Anxiety Indicator is flashing red (please refer to this post). This sentiment indicator has recently vaulted to an all-time high, and warns of a challenging near-term equity backdrop.

Second, the “Soft” vs. “Hard” economic data Indicator (compiled using Bloomberg data) is also approaching an historic zenith. Such a divergence in survey vs. actual economic data has typically been a precursor of an equity market wobble (see chart). An economic validation period looms and the specter of a soft-patch could serve as a corrective catalyst.

Finally, U.S. dollar based liquidity has plunged to a level associated with recession. The draining in U.S. dollar liquidity is worrisome as it represents a de-facto tightening in global monetary policy. We substituted commodity price inflation for the MSCI All-Country World Index cyclical momentum. The U.S. dollar liquidity message remains similar, warning that at least a digestion period in equities is imminent.

Our sense is that in order for the equity market overshoot phase to prove lasting, a pullback is a prerequisite at this juncture. Were such a phase to materialize in Q1 as we expect, we would view it as a “buy-the-dip” opportunity.

For additional details, please refer to the report titled “Eerie Calm”, available at gss.bcaresearch.com.

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