China: Deja vu all over again

The Shanghai Composite today found support at 3500 today after plunging more than 8% on Monday. The large divergence on 13-week Twiggs Money Flow continues to warn of selling pressure.

Shanghai Composite Index

* Target calculation: 4000 – ( 5000 – 4000 ) = 3000

Japan’s Lost Decade

From Wikipedia:

The Japanese asset price bubble….. was an economic bubble in Japan from 1986 to 1991 in which real estate and stock market prices were greatly inflated. The bubble was characterized by rapid acceleration of asset prices and overheated economic activity, as well as an uncontrolled money supply and credit expansion. More specifically, over-confidence and speculation regarding asset and stock prices had been closely associated with excessive monetary easing policy at the time.

By August 1990, the Nikkei stock index had plummeted to half its peak by the time of the fifth monetary tightening by the Bank of Japan (BOJ)…..the economy’s decline continued for more than a decade. This decline resulted in a huge accumulation of non-performing assets loans (NPL), causing difficulties for many financial institutions. The bursting of the Japanese asset price bubble contributed to what many call the Lost Decade.

“…uncontrolled money supply and credit expansion….overheated stock market and real estate bubble.” Sound familiar? It should. We are witnessing a re-run but this time in China. Wait, there’s more…..

…..At the end of August 1987, the BOJ signaled the possibility of tightening the monetary policy, but decided to delay the decision in view of economic uncertainty related to Black Monday (October 19, 1987) in the US.

…..BOJ reluctance to tighten the monetary policy was in spite of the fact that the economy went into expansion in the second half of 1987. The Japanese economy had just recovered from the “endaka recession” ….. closely linked to the Plaza Accord of September 1985, which led to the strong appreciation of the Japanese yen.

… order to overcome the “endaka” recession and stimulate the local economy, an aggressive fiscal policy was adopted, mainly through expansion of public investment. Simultaneously, the BOJ declared that curbing the yen’s appreciation was a “national priority”……

Global stock market crash leads to prolonged monetary easing…… aggressive expansion of public investment to stimulate the domestic economy…..central bank efforts to curb appreciation of the currency. We all know how this ends. We’ve seen the movie before.

It’s like deja-vu, all over again. ~ Yogi Berra

Australian stocks: Buy in July?

Australian stocks typically encounter tax loss selling in June (before end of the financial year), followed by a rally in July/August that often carries through into the next calendar year. Sale of poor performing stocks before EOFY withdraws money from the market and effectively lowers all stock prices. After the year end, investors start to accumulate stocks again, lifting the market.

ASX 200 Accumulation Index

A monthly chart of the ASX 200 Accumulation Index since 2006 shows 2 years where the rally started in August (dark green), 5 years where the rally started in July (light green), and 2 years (red) where the EOFY rally disappointed, continuing a down-trend.

This year is complicated by turmoil in Greece and China. July 2011 also had its Greek drama. Prime Minister George Papandreou survived a confidence vote but was eventually replaced by Lucas Papademos, former governor of the Bank of Greece and vice-president of the European Central Bank. S&P also downgraded US government debt at the start of August 2011.

What does July 2015 have in store for us?

I don’t have a crystal ball, but breakout above the trend channel on the ASX 200 daily chart would indicate the correction is over, suggesting another advance. Rising 21-day twiggs Money Flow indicates mild buying pressure.

ASX 200 Index

But it would be prudent to wait for confirmation, in case it turns into a bull trap like 2011.

ASX 200 Index

Sources of stock-market fluctuations: New evidence | VOX

Interesting work by Dan Greenwald, Martin Lettau and Sydney Ludvigson on what moves the market.

There is little mystery that the real value of the stock market drifts upward over long periods in a largely predictable way as productivity (driven by technological progress) improves. This same deterministic trend has also propelled output per capita and the average standard of living upward over the last several centuries. It is instead the random shocks, the boom and busts around this trend, about which we have little knowledge, yet on which a continuous stream of media speculation centres. Such random shocks can persistently displace the market from its long-term trend for periods as long as several decades. What drives these movements in the market?

They identify 3 types of shocks that account for market fluctuations around the long-term trend:

  1. Productivity shocks which increase total output relative to inputs
  2. Factor shocks which increase/decrease the share of output paid to workers
  3. Changes in investor risk tolerance which affect their willingness to hold stocks.

For example a company may experience a surge in output through improved technology. The share of increased earnings paid to workers will determine the level of profits remaining for distribution to shareholders. I illustrated this recently in a graph of the inverse relationship between employee compensation and corporate profits as a percentage of value added.

Profits and Labor Costs as a percentage of Net Value Added

The current “Grexit” turmoil is an example of the third factor, investor risk tolerance, where output and factor shares are unaffected but investor willingness to hold stocks decreases. The increased risk premium demanded causes market valuations to fall while earnings are unaffected.

….We find that these shocks explain the vast majority (87%) of fluctuations in quarterly stock wealth growth, implying that we can decompose almost all of the variation in the US stock market into components corresponding to these three sources of economic variation. We find that:

When we measure variation in the stock market over short to intermediate horizons (i.e. over months, quarters and business cycle frequencies), fluctuations in stock market growth are dominated by shocks to risk tolerance that have no discernible effect on the real economy.

Over longer horizons (i.e., over years and decades), 40-50% of the variation in stock wealth growth can be attributed to factors share shocks–those that move the stock market in one direction and labour income in the other.

Shocks to productive technology have a very small effect on fluctuations in stock prices at all horizons.

Factor Shocks

This does not mean that we should ignore market valuation. High earnings multiples are more prone to shocks than low ones. But we can ignore secondary influences on risk premiums — I call them “media corrections” — caused by market noise. The study also confirms that fluctuations in factor shares (or profits as a percentage of value added) can last for more than a decade; so reversion of US profit margins to the mean may take some time.

Read more at Sources of stock-market fluctuations: New evidence | VOX, CEPR’s Policy Portal.

Are US stocks really over-valued?

Stock Market Capitalization

Let us start with Warren Buffet’s favorite market valuation ratio: stock market capitalization to GDP. I have modified this slightly, replacing GDP with GNP, because the former excludes offshore earnings — a significant factor for multinationals.

US stock market capitalization to GNP

The ratio of stock market capitalization to GNP now exceeds the highs of 2005/2006, suggesting that stocks are over-valued — approaching the heady days of the Dotcom era.

Corporate Profits

If we dig a bit deeper, however, while the ratio of market cap to sales is also high, market cap to corporate profits remains low.

US stock market capitalization to Business Sales and Corporate Profits

Clearly profit margins have widened, with corporate profits increasing at a faster rate than sales. The critical question: is this sustainable?

Sustainability of Profits

At some point profit margins must narrow in response to rising costs. Increases in aggregate demand may lift employment and sales, but also drive up labor costs.

Profits and Labor Costs as a percentage of Net Value Added

The brown line above depicts labor costs as a percentage of net value added, compared to corporate profits (blue) as a percentage of net value added. There is a clear inverse relationship: when labor costs rise, profit margins fall (and vice versa). At first the effect of narrower margins is masked by rising sales, but eventually aggregate profits contract when sales growth slows (gray stripes indicate past recessions).

Interest Rates and Taxes

Other contributing factors to high corporate profits are interest rates and taxes. Corporate profits (% of GNP) have soared over the last 30 years as bond yields have fallen. The benefit is two-fold, with lower interest rates reducing the cost of corporate debt and lower finance costs boosting sales of consumer durables.

Corporate Profits as % of GNP and AAA Bond Yields

Lower effective corporate tax rates (gray) have also contributed to the surge in profits as a percentage of GNP.

US stock market capitalization to GNP

The most enduring of these three factors (labor costs, interest rates, and tax rates) is likely to be taxes. Corporate tax rates have fallen in most jurisdictions and US rates are high by comparison. Even if a long-overdue overhaul of corporate taxation is achieved in the next decade (don’t hold your breath), the overall tax rate is likely to remain low.

If Not Now, When?

The other two factors (labor costs and interest rates) may not be sustainable in the long-term but it will take time for them to normalize.

Treasury yields are rising, with the 10-year at 2.37 percent. Breakout above 3.0 percent still appears some way off, but would confirm the end of the 35-year secular down-trend.

10-Year Treasury Yields Secular Trend

Interest rates are likely to remain low until rising labor costs force the Fed to adopt a restrictive stance.

Labor Costs as a percentage of Net Value Added

Labor markets have tightened to some extent, as indicated by the higher trough on the right of the above graph. But this is likely to be slowed by the low participation rate, with potential employees returning to the workforce, and a strong dollar enhancing the attraction of cheap labor in emerging markets.

Hourly earnings growth in the manufacturing sector remains comfortably below the Fed’s 2.0 percent inflation target. Any breakout above this level, however, would be cause for concern. Not only would the Fed be likely to raise interest rates, but profit margins are likely to shrink.

Manufacturing: Hourly Earnings Growth

For the present

None of the macroeconomic and volatility filters that we monitor indicate elevated market risk. I expect them to rise over the next two to three years as the labor market tightens and interest rates increase, but for the present we maintain full exposure to equities.

India threatens reversal

India’s Sensex is testing primary support at 26500. Breach would signal a primary down-trend, confirming the signals from 13-week Twiggs Momentum & Money Flow, both of which have crossed below zero. Twiggs Momentum has been warning of a reversal with a bearish divergence since late 2014, while Twiggs Money Flow chimed in from March 2015. Breach of support would offer a target of 23000. Recovery above the descending trendline is unlikely, but would suggest another rally.



* Target calculation: 26500 – ( 30000 – 26500 ) = 23000

The S&P/NSE Nifty index tells a similar story, testing primary support at 8000. Breach would offer a target of 7000*.


* Target calculation: 8000 – ( 9000 – 8000 ) = 7000

ASX 200: Support or resistance?

ASX 200 support at 5750, 5650 or 5550: which is most relevant? Judging by some of the questions received, I succeeded in confusing a number of readers. Here is a brief summary:

  • 5750 acted as medium-term support until the beginning of May, when breach of 5750 and the rising trendline warned of a correction.
  • 5750 transformed into medium-term resistance and penetration would suggest the correction is over.
  • There is a strong band of support between the two recent (2014) highs of 5650 and 5550.
  • Breach of this band (i.e. below 5550) would indicate a test of primary support at 5120.
  • Respect (i.e. 5550 intact) would provide a solid base for a rally and a further (primary) advance if resistance at 6000 is broken.

Mild decline of 13-week Twiggs Money Flow suggests medium-term selling pressure — not a reversal. Recovery above 5750 remains more likely than breach of 5550.

ASX 200

* Target calculation: 6000 + ( 6000 – 5750 ) = 6250

Asian stocks

The Shanghai Composite is consolidating between 4000 and 4500. Breach of either of these levels would signal future direction. Declining 13-week Twiggs Money Flow warns of medium-term selling pressure, favoring the downside.

Shanghai Composite Index

* Target calculation: 3500 + ( 3500 – 2500 ) = 4500

Short retracement on Japan’s Nikkei 225 Index is a bullish sign. Breakout above 20000 would offer a target of 22000*. Declining 13-week Twiggs Money Flow reflects medium-term selling pressure; recovery above the descending trendline would be a bullish sign.

Nikkei 225 Index

* Target calculation: 20000 + ( 20000 – 18000 ) = 22000

India’s Sensex found support between 26500 and 27000. Long tails suggest medium-term buying pressure. Recovery above 28000 and the descending trendline would suggest another attempt at 30000. But 13-week Twiggs Money Flow remains below zero, warning of (long-term) selling pressure. Another peak below zero would warn of breach of primary support and a reversal.


European stocks

Germany’s DAX encountered support above 11000. Penetration of the descending trendline would indicate the correction is over and follow-through above 12000 would suggest a primary advance. Declining 13-week Twiggs Money Flow warns of continued selling pressure and a further test of 11000, but respect of support remains likely and would provide a solid base for further advances.


The Footsie also displays long tails, suggesting medium-term buying support, but declining 13-week Twiggs Money Flow indicates continued selling pressure. Breach of 6900 would warn of a correction to 6700, but further losses are unlikely at present. Recovery above 7100 would confirm the long-term breakout, offering a target of 8000*.

FTSE 100

* Target calculation: 7000 + ( 7000 – 6000 ) = 8000

Long-tailed candles: North America

Stocks are recovering from their recent soft patch and breakout above resistance is likely, signaling further gains.

The S&P 500 is testing medium-term resistance at 2120. Breakout would signal an advance to 2200*. Three weekly candles with long tails reflect medium-term buying pressure, while a 13-week Twiggs Money Flow trough high above zero indicates long-term pressure. Retracement that respects the new support level at 2100 would further strengthen the bull signal.

S&P 500 Index

* Target calculation: 2120 + ( 2120 – 2040 ) = 2200

CBOE Volatility Index (VIX) at 12 indicates low risk typical of a bull market.

S&P 500 VIX

Dow Jones Industrial Average is testing resistance at 18300. Buying pressure appears similar to the S&P 500 and breakout would offer a target of 19000*.

Dow Jones Industrial Average

* Target calculation: 18300 + ( 18300 – 17600 ) = 19000

Canada’s TSX 60 found support at 870. 13-Week Twiggs Momentum holding above zero continues to indicate a primary up-trend. Breakout above 900 would offer a long-term target of 1000*.

TSX 60 Index

* Target calculation: 900 + ( 900 – 800 ) = 1000

S&P 500 Ichimoku Cloud

The S&P 500 has struggled to break resistance at 2120 since February, but weekly Ichimoku Cloud continues to show a strong primary up-trend, with Tenkan-sen (blue) and Kijun-sen (red) above a long green cloud and Tenkan-sen respecting Kijun-sen since December 2012.

S&P 500 Index Ichimoku Cloud

Long tails on the last two completed candles suggest short-term support, while 13-Week Twiggs Money Flow floating above the zero line indicates strong long-term buying pressure.

S&P 500 Index

Dearth of capital investment

Interesting graph from RBA governor Glenn Stevens.

A striking feature of the global economy, according to World Bank and OECD data, is the low rate of capital investment spending by businesses. In fact, the rate of investment to GDP seems to have had a downward trend for a long time.

One potential explanation is that there is a dearth of profitable investment opportunities. But another feature that catches one’s eye is that, post-crisis, the earnings yield on listed companies seems to have remained where it has historically been for a long time, even as the return on safe assets has collapsed to be close to zero …..

US Australia Yields

Perhaps this is partly explained by more sense of risk attached to future earnings, and/or a lower expected growth rate of future earnings.

Or it might be explained simply by stickiness in the sorts of “hurdle rates” that decision makers expect investments to clear. I cannot speak about US corporates, but this would seem to be consistent with the observation that we tend to hear from Australian liaison contacts that the hurdle rates of return that boards of directors apply to investment propositions have not shifted, despite the exceptionally low returns available on low-risk assets.

What this illustrates is the limits of monetary policy to restore economic growth.

Such [monetary] policies are, then, working through the channels available to them to support demand. But these channels are financial in nature. They don’t directly create demand in the way that, for example, government fiscal actions do……

Footsie breaks 15-year high

The FTSE 100 overcame resistance at its December 1999 high of 6950, closing the week above 7000 for the first time. Expect retracement to test the new support level, but breakout signals a primary advance with a long-term target of 8000*. A 21-day Twiggs Money Flow trough above zero confirms long-term buying pressure.

FTSE 100

* Target calculation: 7000 + ( 7000 – 6000 ) = 8000

Germany’s DAX recovered above 12000, suggesting continuation of the advance. Expect resistance at the Deutsche Bank target of 12500 (from late 2014). Rising 21-day Twiggs Money Flow indicates strong buying pressure. Reversal below 11800 is unlikely at this stage, but would warn of a correction.


* Target calculation: 12200 + ( 12200 – 11900 ) = 12500

Strong advances on these two indices suggest a broader European recovery.

India: Sensex advance

India will also benefit from lower oil prices. The BSE Sensex broke resistance at 29000, signaling a primary advance to 31000*. Rising 13-week Twiggs Money Flow troughs above zero signal strong, long-term buying pressure. Retracement to test the new support level at 29000 is a possibility, but breach of support is unlikely.


* Target calculation: 29000 + ( 29000 – 27000 ) = 31000

China: Will history repeat itself?

China’s Shanghai Composite retreated from resistance at 3400, but this is a long way from signaling a down-trend.
Shanghai Composite Index

Hong Kong’s Hang Seng Index has shown much stronger gains over the last 3 years, but diverged in the second half of 2014, falling while the Shanghai Composite soared. Breach of support at 22500, and the rising trendline, would warn of a primary down-trend.
Hang Seng Index

This opinion by Andrew Sheng highlights some of the challenges facing the Middle Kingdom:

It is hard to find earlier examples of economies which experienced similar growth spurts to that enjoyed by China over the last decade. The closest are probably the US in the 1920s and Japan in the 1980s. Both of these should serve as a warning that times of rapid growth can generate vast imbalances within an economy that inevitably lead to periods of painful adjustment.

Corporate profits and employee compensation

Employee compensation as a percentage of net value added by nonfinancial corporations has been falling since its Dotcom peak in 2000 and is now approaching lows last witnessed in the 1960s. Both rising productivity, through technological advances, and offshoring of blue-collar jobs have contributed to the fall.

Net Value Added: Employee Compensation & Corporate Profits

Corporate profits (as a percentage of net value added by nonfinancial corporations) have shown a corresponding rise for the same period, demonstrating an inverse relationship over the last half-century. Rises and falls in both employment costs and corporate profits (as a percentage of net value added) are most likely attributable to fluctuations in output per employee (productivity) rather than fluctuating wage rates.

The question is: are rises in corporate profits and corresponding falls in employee compensation, as a percentage of net value added, sustainable? Is this time different, or are we likely to witness a peak followed by a sharp fall as in the 1960s? Productivity improvements through offshoring jobs are likely to continue for as long as the Dollar remains strong relative to Asian exporters. In other words, a very long time. Technological advances such as automation may also reduce employment costs per unit of output. But there is no clear answer as to how far profit margins will be eroded by increased competition from Europe and Asia. All we can do is monitor the relationship between employee compensation and net value added for nonfinancial corporations for clues. So far, there is no indication that the decline is reversing.

Health Care (Australia)

A chart of Australia’s ASX 200 Health Care [XHJ], compared to Financials-x-Property [XXJ] and the overall index [XJO] over the last 15 years, shows that outperformance of the Health Care sector is not just a recent occurrence.

ASX 200 Health Care

The sector also proved resilient during the GFC.

Markets back on track

Threat of a Russian collapse roiled markets in early December, but the immediate crisis now seems to have passed.

Recovery of the S&P 500 above resistance at 2080 would indicate another advance , with a target of 2150*. Rising 13-week Twiggs Money Flow troughs indicate long-term buying pressure. Reversal below 2000 is most unlikely.

S&P 500 Index

* Target calculation: 2000 + ( 2000 – 1850 ) = 2150

A 10-year view of CBOE Volatility Index (VIX) suggests low to moderate risk typical of a bull market.

S&P 500 VIX

My favorite bellwether, transport stock Fedex, also underwent a correction. The long tail suggests buying pressure and breakout above the recent high would confirm a strong bull trend, indicating rising economic activity.


Dow Jones Euro Stoxx 50 found support at 3000 and is likely to test 3300. Rising 13-week Twiggs Money Flow indicates buying pressure, but the index is likely to continue ranging between these two levels until tensions between Russia and Eastern Europe are resolved.

DJ Euro Stoxx 50

China’s Shanghai Composite Index is in a strong bull trend, having broken resistance at 2500, and is likely to test the 2009 high at 3500. Rising 13-week Twiggs Money Flow indicates strong (medium-term) buying pressure.

Shanghai Composite Index

I continue to question China’s ability to sustain this performance, given their poor economic foundation.

Japan’s Nikkei 225 Index breakout above its 2007 high of 18000 would signal an advance to 19000*. Rising 13-Week Twiggs Money Flow indicates strong buying pressure. Index gains are largely attributable to rising inflation and a weaker yen.

Nikkei 225 Index

* Target calculation: 18000 + ( 18000 – 17000 ) = 19000

India’s Sensex found support at 27000. Recovery above 28000 would suggest another advance. Breakout above 29000 would confirm a target of 31000*.


* Target calculation: 29000 + ( 29000 – 27000 ) = 31000

ASX 200 performance remains weak. Breach of the recent descending trendline suggests that the correction is over, but only breakout above 5550 would complete a double-bottom formation, suggesting a fresh advance. Rising troughs on 13-week Twiggs Money Flow indicate medium-term buying pressure. Reversal of TMF below zero, or breach of support at 5000/5150, is now less likely, but would warn of a down-trend.

ASX 200

* Target calculation: 5500 + ( 5500 – 5000 ) = 6000

Apologies for my absence

Apologies for my absence over the last week. My computer was damaged during a thunderstorm. Even though I unplugged and powered off, it was dead as a dodo when I tried to turn it back on. Backups are only as good as the recovery software unfortunately (in future I will take mirror images of my hard disk), so I am going through the tiresome process of setting everything up manually.

Regards, Colin