Author: Mark Dow

If you’ve been following my tweets—especially on @behavioralmacro—you will have noticed a shift in my long-standing bullishness over the past week. Here’s an edited DM to a friend who is more bearish bonds than I am that kinds of lays out the bare bones of why. I welcome questions.

Remember, predictions of a bear market or recession are mostly bullshit. These are complex behavioral phenomena that defy timing. But, like a good doctor, even if you may not be able to forecast when or if a patient will have a heart attack, you can identify vulnerabilities to one, look out for early warning signs, and prepare measures in the hope that if it happens you will recognize it early and come out strong on the other end.

I’ll be honest: I’m less bullish on virtually all time horizons than I was even a couple of weeks ago. Base case still a longer cycle in the US, China muddles and the EU doesn’t implode. But odds of this have dropped and risks are more skewed to the downside.

My bullishness in the risk cycle has been underpinned by three things: 1) the old Rudiger Dornbusch saying that “you can’t commit suicide jumping out of the basement window” and 2) deep, pervasive PTSD from the GFC, and 3) various asset shortages. I think the PTSD and asset shortage parts are still broadly operative, but the US economy is no longer near the ground floor. We’re not on the top floor either, but the labor market and corporate positioning have been pumped up enough by natural cycle progression goosed by recent deficit spending that a meaningful shock from home or abroad could lead to a fall, even if not a deadly one.

Spot growth does look decent right here, right now, but we are definitely more vulnerable to negative shocks than we were before the fiscal impulse, even if the financial sector is clean and a proper recession isn’t that plausible to me. But our top end growth is clearly limited, and politics are about to get a lot more noisy. I’d be wrong if 2019 growth turned out anywhere close to 3%, and unless we pick back up closer to that, I don’t think rates are going to get away from us, and a market dislocation on every growth scare seems likely. I’ve locked in a good return already in my investment account this year. I like the idea of moving to cash and taking an option on being able to reinvest into a dislocation. I’ll take the risk that the market gets away from me to the upside. I don’t think–even with the artificial beginning-year marker–that the SPX is going to put up a 30% year. In my Trading book, I’ll be ready to be active either way, depending on more tactical opportunities.

I admit I haven’t been tracking bitcoin very closely for a while. The energy behind it seems dead and the long-promised institutional investors keep not materializing. On top of that, the futures that I had used to short bitcoin has been discontinued.

However, a pattern is a pattern. And bitcoin has historically been the most pattern-perfect asset I can remember seeing–both on the way up and the way down.

One of my subs asked me about the current set up, so I took a look.

Guess what? It’s bullish. It says nothing about the fundamentals. It could still be a dying asset. It could still be a bubble unraveling. But the pattern has gone from bearish to bullish. Higher-to-flat highs and higher lows is a bullish wedge (at least that’s what I call it). It is the opposite of the bearish wedge we saw in bitcoin from June to October last year. Bitcoin fell 50% on that drop.

The difference between a bullish and bearish wedge couldn’t be any cleaner than in this chart. Totally textbook.

Here’s the chart:

Feel free to follow up with questions on @behavioralmacro.

Good luck.

Paul Krugman tells a story about the Brazilian economic crisis of 2015-2016. I am usually a fan of his large economic brain. You can disagree with his politics, and even quibble with his economics, but any objective reading of the outturn since the GFC makes it clear that he got the big things right when very few others did.

His story about Brazil, however, while not outright wrong, could be substantially improved. He argues that the trifecta of a commodity shock, large domestic debt burden, and application of expansionary austerity (contractionary fiscal and monetary policies) did them in.

First, Brazil is not a big commodity exporter as a share of GDP. The pervasiveness and persistence of this misconception goaded me into posting this a few years back.

The TL;DR is that Brazil’s exports are not only about 11 percent of GDP (very low by EM standards), but the ratio actually declined over the course of the boom years (from 15% of GDP to 11%). Hardly what you’d expect to see in an export-led boom—even if you account for currency appreciation on the export share of GDP.

This doesn’t mean that the terms-of-trade shock didn’t matter. It certainly had a negative effect on output, especially when you consider the negative signaling effect to foreign investors who deeply bought into that narrative, and had, by that point, already become a material part of Brazil’s domestic debt financing. But at 11% of GDP, this part of the story was not nearly as nasty as it was made out to be.

Second, he lays a lot of blame at the feet of the Brazilian policy response. And in a very strict sense, he’s right. Raising rates in an economy that just built up a lot of domestic debt (more on that in a sec) while contracting the fiscal position will hit an economy like Brazil’s hard. Government outlays there are a large share of GDP (IIRC just under 40%).

The important omission here though is “how risky would simulative policies have been”? In most developed economies—and certainly in the US–policy credibility allows for expansionary fiscal and accommodative monetary when there’s a downturn. This is not the case in emerging market countries. In fact, many would argue that this is the defining distinction between EM and DM countries.

To the point, the legacy of liquidity and solvency crises in emerging markets results in running the risk that expansionary countercyclical policies scare investors—rightly or wrongly—and induce more aggressive retrenchment by foreign portfolio investors and further capital flight by locals. The muscle memory in Latina America on this runs particularly deep.

As a rule of thumb, the greater the perception that a country is or could easily be faced with a liquidity-cum-solvency crisis, the greater the risk that expansionary countercyclical policies prove counterproductively tragic. At some point along the credibility spectrum countries decide, understandably, that it’s not a policy risk worth running.

The real culprit in the Brazilian crisis was the sudden stop. Not the classic sudden stop à la Calvo, but the sudden stop of domestic credit. And this is the part where Krugman gets the emphasis right, citing Atif Mian et al.

From 2003 to 2014, domestic credit to the private sector in Brazil went from 23% of GDP to 70%. This, not exports, is what fueled the economic boom (and in many other EM countries in the same period). It left Brazil with a credit overhang it had to digest and a lot of debt that needed to be rolled over at higher rates, as Brazil jacked up the SELIC (Brazil’s policy rate) from 7% to 14%.

Maybe this all seems like one big quibble, but to me there are two important take-aways: (1) It’s a myth that Brazil’s s a country driven by commodity exports, and (2) the role of policy credibly needs to be a larger part of the discussion of optimal policy responses to adverse shocks. This may be obvious to someone who has spent a career toggling between EM and DM sovereign analysis, but is regularly absent when DM economists–even great ones like Krugman–go tourist.  (Side note: This is particularly important in all the current chatter surrounding MMT, but that’s a post for another day.)

There’s a lot going on right now. Tons of cross-currents. Lots of risk, but lots of good risk/reward set ups as well. Here are the charts and thoughts that to me matter most.

First, and most importantly, we are very, very oversold by historical standards.

The above is the McCellan advance-decline summation index. If you line up all the other times since the GFC that the indicator has been at this level with the SPX, you will see that either contemporaneous to or within a few days of the local low, stocks started a meaningful bounce. The three times this did not hold true were in the July 2008-March 2009 window. There is also a pronounced divergence in the NYSE cumulative AD line and its RSI.

(NB: For an aggressive trading style, there is a big difference in sizing a position in anticipation of an immediate bounce, and sizing it for a bounce that you think is likely to happen after the next couple/few days.)

Second, shorter-term, many of the major and sector indices are running into natural resistance spots–either popular moving averages or overhead supply points. Most investors right now are some combination of skittish, wounded, and underperforming; Can’t afford to lose more, can afford even less to be left out of a year-end rally. This creates the exaggerated buy the rip, sell the dip dynamic that is often referred to as a ‘short gamma mindset’.

Here are the SPX, IWM, and QQQ:

You can also see overhead/natural resistance in the SMH and the XLF, among others. However, on a more constructive note, if you look closely at the above charts you will see that when they made lower lows in price, their RSIs (relative strength indices) made higher lows; in other words, positive divergences.

Third,  EMFX, metals, and some EM names bottomed in early September, and platinum, gold, and some gold miners have really promising patterns. It is true whatever safe-haven bid that may have crept into gold and gold minors would unwind in a meaningful equity bounce, but the fact that EMFX bottomed at the same time, and platinum is leading gold, is encouraging.

Here are: FXJPEMCS (JPM’s EMFX spot index), AU, ABX, GLD and BFR (one of the Argentine banks)

Fourth, and at odds with the last point, real and nominal yield patterns have shown no sign of stopping their rise.

Below are the 5-year real yield and the 10-year futures contract:

The bottom line on rates is that despite whispers of global slowdown, the data–in the US at least–are still running on the hot side and yield patterns still look higher. This could turn quickly, on even the smallest of comments from the Fed, but it is important to underscore that until it shows signs of doing so, it’s little more than wishful thinking.

Fifth, there are a lot of names that have asymmetric entry points. Stop outs are fairly close by, and if global markets do rebound, there would be a lot of room to run. Some, like Deutsche Bank, Argentine banks (BFR, BMA, GGAL), homebuilders (PHM, MTH, NVR, , are knife-catches–and in the cases of European banks and US homebuilders, they are bets that the US and global cycles haven’t ended. Others are strong secular growers–thinking about names like AMZN, Tencent, BIDU, SQ–that only give us entry points when we are least inclined to want to buy them.

It should also be pointed out that many of the charts that have bumped up into resistance of one type or another could easily pull back for a day or three and turn into a ‘W’ or an inverted Head-and-Shoulders–two common bottoming patterns–so the timing over the next couple few days could be tricky even if a meaningful bounce is upon us. But the signs, on balance, are quite constructive.

How you risk-manage (how to size, where to set stops, how much correlation across positions/risk concentration) is a function of your ‘mandate’, your personal style, your current level of ‘mental capital’, etc. But it is worth underscoring the importance of managing your risk in a way where you aren’t likely to get ‘chopped out’ because positions are too large, or the portfolio is too concentrated.

Good luck.

This is the time when we look for divergences. There are many ways to look at divergences and the approach should always be a weight-of-the-evidence kind of thing. It’s not binary. You simply want to see if there are enough indications that the odds have been tweaked in favor of a reversal.

The classic divergence is when, in the re-test of a hard decline, price undercuts the previous low but other indicators don’t exceed the levels reached on the day of the first decline. If there are enough such divergences, the odds of a rebound improve significantly.

More often than not, though, the picture is somewhat muddied. And that’s the case here. A few indicators do show divergence, but one important one doesn’t.

Here they are:

First, I’m posting a chart of the SPY. I’m using SPY instead of futures so we can also get a clean read on volume.

You can see that today the October 11th low in price was undercut. But you can also see that it did so on lower volume. That’s one divergence.

Another common divergence go-to is the 52-week new low list. You want to see the new lows contract relative to the first low.

Here, you can clearly see that new lows expanded a fair amount today relative to October 11th, so no divergence.

Another common indicator is, of course, the VIX. You want to see it make a lower high.

You can see that here, the VIX did make a lower high, so we have another indicator suggesting the selling pressure today was less intense.

I also like to look at the number of declining names in the NYSE (common stocks only), which you also want to see contract.

And here we have another divergence. Today’s 2,574 is lower than last week’s 3,209.

Lastly, even though I don’t place too much emphasis on relative strength indices, the RSI on the SPY did make a higher low today, which constitutes another divergence.

Bottom line: We do have a number of divergences. The odds of a rebound are decent. It would be a lot better if new 52-week lows also contracted, but still, decent.

Catching falling knives is a dangerous game. It might be a little bit easier in an emerging market economy that has just gone through a crisis, but figuring out when there’s the right amount of blood on the streets, when others are sufficiently fearful, is always a dicey task.

But it is also, potentially, a very lucrative one. There are no guarantees, but there are a couple things in situations like this you can do to tweak the odds in your favor.