FinLight Research - Market perspectives Jun 2014

Market Perspectives
June 2014
June 6th, 2014
www.finlightresearch.com
Where is the vol?

“There is no doubt that corporate profitability has surged from the recessionary
lows. However, if I am correct in my assessment, then the recent downturn in
corporate profitability may be more than just due to an economic 'soft patch.'
The problem with cost cutting, wage suppression, labor hoarding and stock buybacks,
along with a myriad of accounting gimmicks, is that there is a finite limit to their
effectiveness.
While Goldman Sachs expects profits to surge in the coming years ahead - history
suggests something different.”
Lance Roberts
“The financial system responds to volatility. When volatility declines the natural
tendency is to use more leverage and concentrate risk.”
Lewis Alexander (Nomura)
2
FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation
There are some economic grounds for optimism. But, the
conflicting signals between survey and activity data leave
economic visibility low right now
No doubt, the world is moving out of an extraordinary period
of central bank largesse. Headwinds have to be expected to
asset prices , implying a higher volatility
After a period of Sideway trading on equities, Bulls are
winning (thanks to BCE activism) the battle of
indecisiveness. Is that capitulation of the Bears? But the
history of market valuations still suggests a cautious
perspective.
We expect the quiet time to end, with a break in one
direction or another.
We continue to see the main systemic risk coming from
China.
We summarize our views as follows
3

MACRO VIEW
The Good
Forward earnings estimates rose for the sixth consecutive week
Conference Board LEI rose 0.4%, beating expectations.
Tensions in Ukraine and Russia are de-escalating gradually
ISM reports were positive. The composite report seems consistent with economic growth of 4 % or
so.
Employment showed a clear strength, although some worries are still alive (job quality, part time
jobs, participation rate…)
The Bad
Most housing reports are sluggish
Existing home sales missed growth expectations.
The pace of permit issuance for single family home construction remains depressed.
Trade deficit was $6 billion above expectations
Tensions between Russia and Ukraine remain high
The Ugly
Chinese bank loans continue to rise at a rapid pace. But lending activity is delivering less and less
growth per yuan.
No effective monitoring of default risk from industries with overcapacity, the property sector and other
vulnerable debtors.
4

5
Conference Board LEI
“The Conference Board LEI for the U.S. increased in April for the third consecutive month. This month's
gain was driven by large positive contributions from the yield spread and building permits”.
“This latest report suggests the economy will continue to expand, and may even pick up steam through
the second half of the year.”
“Despite a brutal winter which brought the economy to a halt, the overall trend in the leading economic
index has remained positive”

6
S&P500 Volatility
Over the last 3 months, the S&P500 has traded in very narrow range (less than 5%). When the average
S&P500 intraday high/low range over a 3 month period is 13.2%
To find a similar period in the past, we have to go back to October 2006.
Source: Bespoke Invest.

7
Big Four Economic Indicators
The Big Four average declines after two positive months
Most of the downside comes from Industrial Production
Real Retail Sales is declining too

8
Personal Income
Here is Personal Income less Transfer Receipts in real terms
Transfer Payments consist mainly of retirement and disability insurance benefits, medical benefits,
income maintenance benefits...
On a YoY basis, Real Personal Income less Transfer runs at the hardly exciting level of 1,7%
Transfer Payments have been an increasing portion of Personal Income since the 60’s

9
Employment
Nonfarm Employment for April was up by 288K, the largest increase since January 2012.
On a YoY basis, Nonfarm Employment increased at 1.74%, a level that appears low for a typical mid-
cycle recovery
The 0.4% decline in the unemployment rate from 6.7% to 6.3% is a good point, even if it’s mainly
explained by the decline in the Labor Force Participation rate

10
Retail Sales
????The Advance retail sales (headline and core) came in better than expected in March
Is that a sign that the winter slump was weather related?
When adjusted for both population growth and inflation, retail sales are now back to March 2004 level

11
Economic Data Surprise
Economic visibility is low as recent data is
giving conflicting signals between (improving)
survey-based data (jobless claims, Markit
PMI) and (decelerating) hard activity data
(retail sales, industrial production)
Over May, economic data has disappointed
relative to consensus, pushing JPMorgan
Economic Data Surprise Index south

12
GS – Global Leading Indicator (GLI)???
According to the GLI, global growth
is no longer decelerating, but there
is no significant positive
acceleration.
The May Final GLI reading and
momentum were down marginally
in May.
The GLI continues to locate the
global industrial cycle close to the
‘Expansion’ phase (defined by
positive and increasing momentum)
7 of the 10 underlying components
improved in May
We note the extreme difficulty
the GLI has to move more
decisively into expansion.

13
Real Estate
Prices continue to rise across most of the country and significantly fewer borrowers are still underwater.
Number of underwater homes halved since 2009
However, among the 43 Mln mortgaged homes that have positive equity, almost 25% are “under-
equitied” (with less than 20% equity)

14
Real Estate – an Alternative View
Relationship between the trailing 12-month average of median new home sale prices and median
household income tends to show the formation of a second U.S. housing bubble!

15
Chinese Economy
According to Chinese President Xi Jinping, the nation needs to adapt to a “new normal” in the pace of
economic growth
A new stimulus program seems to be ruled out, because of the excess capacity already in the economy
PPI has been deflating for the past 2 years, confirming that there is relatively weak demand and
plenty of excess industrial capacity in China.

16
Fund Flows
In May, we’ve seen positive inflows in all fixed income funds except loan funds.
Ytd, all US fixed income sectors have had positive inflows. Money market funds, EM debt and
commodities suffered outflows.

17
EQUITY
After a period of sideway trading on equities, Bulls are winning the battle of indecisiveness. Is that
capitulation of the Bears?
On the S&P500, short-term indicators are reaching levels often associated with interim peaks or
periods of consolidation. It has now been almost 3 years since the last 10% pullback!
The first real sign of momentum loss will be a clean break below the uptrend since Nov. 2012.
We continue to think that any further upside on the S&P 500 should be driven by earnings
growth rather than P/E expansion
Bottom line :
We remain Neutral equities. Breaking through the 1833 pivot on the S&P500 would likely be the
signal we wait for to go short stocks
We keep our UW on (deflationary) Europe and EM vs. US. We remain neutral to UW on Japan

18
Earnings
Based on 97.5% of the S&P 500 available data (as of May 29), reported earnings dropped to $24.79
(down 6.82% QoQ). Trailing 12-month reported earnings increased 0,57% QoQ, from $100.20 to
$100.77
Analysts continue to extrapolate earnings growth indefinitely into the future without taking into account
long term cyclicality of earnings
2015 earnings are projected above the 6% peak to peak growth line!

19
Earnings
Equity market is running well ahead of
earnings growth expected in 2015.
Current levels in equity markets cannot be
sustainable without a substantial growth in
global earnings
Any further upside in equities should be
driven by earnings growth rather than P/E
expansion
Since 2009, reported EPS (up 230%) has
been completely disconnected from revenue
from sales of goods and services (up 26%
only!)… thanks to wage / labor reduction,
labor productivity increases and stock
buybacks.
None of this could be done indefinitely

20
Equity Long-Term Valuation
The historic P/E10 average is 16.5.
The current ratio is at the highest level since Dec ‘07. It stands at the 91st percentile of the time series
(since 1880).

21
Equity Long-Term Valuation
Bull markets could be decomposed into 3 phases: Skepticism, Acceptance and “Sumer will last
forever”…
Are we in the third phase of this bull market?

22
Market Risk Perception
Fixed income, currency and stock volatilities are all at
extreme lows that we’ve rarely seen over the last two
decades
The steep term structure suggests investors are still
pricing in a substantial premium for longer-term risks.
We expect an eminent sharp rise in volatility over the
next weeks
We also expect realized correlation to pick up in the
next month.
Extremely low volatility encourages leverage and
risk concentration

23
Market Risk Perception: Risk Concentration
US household assets are now more concentrated in equities than ever… except during the tech bubble

24
Market Risk Perception: Risk Concentration
Retail investors maintain
full investment even
through corrections. The
last time they did that was
at the end of 2007.
Assets in Rydex bull-
oriented funds relative to
bear or money market
funds is at the highs last
seen during the tech
bubble.

25
Market Risk Perception: Leverage
Investors are deploying higher leverage than ever before. Margin debt exceeds that reached in 2000 and
2007 on an absolute and relative basis
Decline in leverage should precede a decline in equity prices. Is that really the top?

26
Market Sentiment
Large speculators and hedge funds are the most net short futures on the Russell 2000 since July 2008.
According to BoA Hedge Fund Monitor, speculators have moved to a net short position in the S&P 500.
According to the commitment of traders report, commercials (“smart money” ) are the most bullish they
have been in years. Commercials have had a tendency to increase their net long exposure to the Dow
and the NASDAQ at market bottoms bullish sign?

27
FIXED INCOME & CREDIT
In our central scenario we continue to see higher intermediate-duration yields, lead by a rise in
the US and UK, and marginally tighter peripheral spreads vs. Germany.
Nevertheless, we keep our short positioning on UST and expect 10-year yields to reach 2.90%-
3.20% by mid-year
We continue to OW Eurozone vs. US and UK given disinflationary risks in Europe and BCE activism.
An improving Eurozone growth outlook and ECB credit easing measures should induce further
Peripheral-Core spread convergence. We remain, however, neutral Peripheral vs Core as we see
lasting spread compression to be very limited.
We are now more bullish on TIPS breakevens and hold 5y-TIPS breakeven wideners
We remain short 5yx5y Eurozone inflation as a hedge against the risk of Eurozone deflation.
As a tail hedge, we keep our 10y bund swap spread receiver swap

28
FIXED INCOME & CREDIT
In corporate credit, investors appear to be seeking out risk on the margin, moving down in quality in
search for yield, encouraged by low default rates and benign event risk
The search-for-yield is likely to remain strong and may push spreads a bit tighter over the rest of the
year. But, the risk of a liquidity shock is significant.
We think that rising Treasury rates would be disruptive to high yield technicals. Such a move would
slow the high yield market advance in the second half of 2014, even if default rates remain contained.
We expect erosion in returns on 2H-14 to be more effective in high yield than investment grade, due to
the progressive deterioration in new issue quality.
We choose to stay Neutral (but may move to UW very soon) on credit overall. We are clearly less
constructive over the medium-term.
Regionally, we keep our Neutral stance between the US and Europe. European credit has a much
stronger potential for returns but :
this is mainly due to its much higher exposure to banks and peripheral credit.
the growing yield differential between EUR and USD high yield should induce some reallocation
back into dollars, given the low cost of hedging the forex.
On a risk-adjusted basis, we continue to prefer IG over HY.
Bottom line : Still UW Govies, Neutral credit, OW TIPS, UW High Yield vs High Grade

29
US Treasuries
In contrast to our strong expectations for
higher yields, we’ve rather seen sideways
move in Govies and even an acceleration to
the downside
The rally in May was different from that in
January. It was led by lower real rates, with
TIPS breakevens actually rising and the
curve steepening Is market pricing in a
more dovish Fed action?
In our last report, we expected the range low
(~ 2.60) to hold but we instead witnessed a
brief excursion to the 2,40 level. We are now
back to the old range support after a clear
rejection of the 2.40 support.
Thus, we stay near term bearish
Breaks through 2.825% would put our
original outlook back on the table

30
Inflation Linked
At this point, the economy is still showing only nascent signs of growth. 5y and 10y US TIPS
breakeven rates remain stable.
We are now more bullish on TIPS breakevens, for several reasons: strong demand for TIPS (TIPS
ETFs are in their 5th week of inflows), a improving labor market and still a positive carry.
Hold 5Y TIPS breakeven wideners.

31
Investment Grade
Should interest rates stabilize around this level, credit spreads
could tighten further by 20bps. This is now our view.
We expect interest rates to go up, inflows in IG to go down
and spread volatility to go up.
Given the limited upside and the higher risk in IG spreads, we
move back to Neutral on IG.
Itraxx Main shoud outperform CDX IG because of BCE action
and its higher exposure to banks.

32
High Yield
The success of credit investing in attracting
capital over the last 2 years was triggered by
low return volatility and attractive volatility
adjusted returns.
12m-Volatility Adjusted Returns
Annualized Volatility

33
High Yield
The success of credit in attracting capital over the
last 2 years was also strengthened by:
low default rates
An attractive upgrade to downgrade experience
Current levels are similar to those of end of 2006

34
High Yield Extension Risk
Higher Govies rates would negatively affect
both callable and bullet bonds, but callables
are more exposed due to the extension risk.
Higher government yields make embedded
calls less worthy and bonds longer and more
sensitive to credit risk negative convexity
Convexity for High Yield Market is close to
its post-crisis lows.
Further yield increases induce additional
market losses, duration extension and thus
an acceleration in losses

35
High Yield vs Investment Grade
We expect erosion in returns on 2H-14 to be more
effective in high yield than investment grade, given the
sharp tightening seen in HY and the progressive
deterioration in new issue quality.
On a risk-adjusted basis, we continue to prefer IG
over HY.

36
EXCHANGE RATES
We keep our view for a stronger USD index in 2014 based on higher US rates and non-US
fundamental weakness
The ECB’s dovish rhetoric and action should finally diminish support for the Euro.
The ongoing deterioration in Japan's current account deficit , combined with the rise in US yields, should
drive USDJPY higher
As the Fed continues to taper, we expect many EM currencies to remain under pressure versus USD
On EUR-USD, our previous monthly report states “We remain Neutral and wait for a clean break below
1.3675 to become UW and target 1.31 - 1.28”. So, we are now UW and target 1.34 - 1.31 - 1.28.
On the USD-JPY, the corrective phase has been well supported so far. The rally of the USD should
resume shortly. Our previous target on the downside was not reached, but we decide to wait for a last
pullback before switching our view to OW again. We remain UW but move our stop loss down to
103.50.

37
EUR-USD
Medium to long-term picture of
EUR-USD looks heavy.
In our last report, we were expecting
an exhaustion pattern, coupled with
a lack of momentum. We also said:
“In order for our EUR bearish view
to realize, the spot should hold
below the trend across the highs
since Feb. 2012”. This was the case
as we saw a near double top just
below the psychological resistance
of 1.40
On EUR-USD, we remain UW and
target 1.34 - 1.31 - 1.28.

38
EUR-USD
Yield differential (definition on next slide) between US and Germany implies a forex in the 1.20 – 1.25
range
After reaching a top last month, the gap is diminishing again

39
EUR-USD
Till mid-2013, EUR-USD were highly correlated to an equally weighted basket of German/U.S 2, 5 and
10y-spread
This spread has clearly broken the primary uptrend from Jun. ’99.
The next big pivot should be around -115bps EUR-USD has some room to go down…

40
USD-JPY
In our last report, and given the “on
hold” status of BoJ QE, we decided
to become UW, to target 99.50 and
to use the area 103.93-104.34 as a
stop loss.
The corrective phase has been well
supported so far. The rally of the
USD should resume shortly.
Technically, the picture is not
easy to interpret.
JPMorgan interpretation (which we
like) is that this is a triangle
consolidation that began at Jan. 2nd
peak. We can wait for a last
pullback into the middle of the range
before switching our view to OW
again.

41
COMMODITY
The return picture in commodities is currently a more mixed one than was the case for most of Q1
We remain UW on the short run, and expect fundamentals (idiosyncratic supply and inventory cycles ) to
re-emerge as the main driver for prices.
Over the short run,
We remain Neutral (to a light OW on contracts in backwardation such the Brent / WTI) on
Energy. Crude oil prices could be driven to the upside by an already tight supply and demand
balance, low inventories and a higher summer oil consumption.
The GSCI agricultural index is up around 20% year to date. We remain moderately OW on
Agriculture, especially crops (Negative weather effects and concerns about the geopolitical
situation in the Black Sea) but we expect lower prices in the next quarter or so, because of the
supply response from US and Europe. We remain OW premium coffee and cocoa
We remain Neutral on base metals as prices seem to stabilize in the short term, but we think prices
could slip further in the months to come, especially for Copper and Iron Ore
We stay UW precious metals. We expect gold to resume its downward trend (targeting 1180-1150
on gold and 17 and eventually 12.50 on silver) as central banks move from ultra-accommodative
towards tighter monetary policy
Reaching a base will give a buying signal not only on physical gold but also on gold miners.
Over the MT, we stay UW copper. The downside risk due to increasing supply and a lower Chinese
demand is too significant to be ignored. We target 6400 (Q3-2014), and ultimately 6000.

42
Commodity Performance
The performance picture in Q2 was more mixed than the one we saw in Q1, when commodities were
clearly outperforming the other asset classes.
In May, Precious Metals prices were under pressure due to signs of improving US economic data
and easing tensions in Ukraine.
Industrial Metals performed well due to the increase in China’s PMI in May
Agricultural commodity prices declined on forecasts of better weather conditions.
Energy was mixed with Crude prices going up and Natural Gas going down.

43
Commodity Performance
The China MSCI Index tends to be a leading indicator for the CRB raw industrials.
It’s down 8% Ytd, has been trading sideways since 2011, and seems to predict a near end to the
rebound in commodities. We remain UW on the short run

44
Precious Metals
Many have called the bottom for gold as being the 2013 June
low of $1180 which is something that we remain skeptical
about.
A re-test of the June lows now looks highly plausible
We still have a LT bullish view on precious metals, but prefer
to wait for this bear phase to exhaust itself.
On Silver, absent a break above the 50dma around 19.5, the
downside should dominate: technical targets17.44, 16.33 and
12.50.

45
Precious Metals – Spec Positions
Large speculators decreased gold and silver longs

46
ALTERNATIVE STRATEGIES
We are always OW on AI as we expect a 10% return in the coming year versus 5% on a traditional
balanced portfolio (stocks + bonds+ cash).
We still prefer risk diversifiers to return enhancers
We keep our OW on:
Equity Market Neutrals despite its disappointing performance over the last 3 months
Event-Driven, as M&A activity is heating up and Event-driven strategies continues to maintain
momentum.
CTA’s and Global Macro as a diversifier and tail hedge. Both strategies recovered a little during
May.
We are now OW on Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all
regions). This strategy has shown a great ability in terms of protecting capital during adverse periods, and
a volatility that compares favorably with the hedge fund industry.

47
Hedge Fund Performance
Based on Credit Suisse HF Index estimates for May
‘14, top performing strategies were Managed Futures at
+3,10% (we were OW), LS Equity at 1,60%, Emerging
Markets +1,53%, Event-Driven 1,19% (we were OW),
Global Macro 1,11% (we were OW),
The worst performing strategies were ConvertArb at -
0,30% (we moved Neutral last month) and Equity MN -
0,29% (we remained OW!)

48
Hedge Fund Performance
Based on universe of 3850 funds aggregated by Citi, the dispersion within alternative strategies remains
the rule

49
Volatility Trading / Arbitrage
Despite the extremely low-vol environment, May was a good month for the Volatility Arbitrage
program., as it took advantage from the mismatch in implied vs realized volatility.
Implied volatilities across most markets continued to post historically low levels.
But, at the same time, realized vols have begun to drop sharply in most markets, going ahead of the
implieds that are a bit sticky to the downside
Two reasons to be OW on Volatility Arbitrage:
Given the wide gap between implied and realized volatilities, the Vol. Arb. strategy is making
money in this low-vol environment.
In addition, this strategy is normally designed to act as a tail-risk hedge.

Bottom Line: Global Asset Allocation
There are some economic grounds for optimism. But, the
conflicting signals between survey and activity data leave
economic visibility low right now
No doubt, the world is moving out of an extraordinary period
of central bank largesse. Headwinds have to be expected to
asset prices , implying a higher volatility
After a period of Sideway trading on equities, Bulls are
winning (thanks to BCE activism) the battle of
indecisiveness. Is that capitulation of the Bears? But the
history of market valuations still suggests a cautious
perspective.
We expect the quiet time to end, with a break in one
direction or another.
We continue to see the main systemic risk coming from
China.
We summarize our views as follows
50

FinLight Research - Market perspectives Jun 2014

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