Market Perspectives: Earnings Growth to Drive Stocks Despite Risks

Market Perspectives
November 2014
Nov. 4th, 2014
www.finlightresearch.com
Who will be the first to fall out of bed when rates start rising?

“Stocks have reached a permanently high plateau.”
Irving Fisher (just before the 1929 Crash)
“The best way out is always through.”
Robert Frost
2
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Executive Summary: Global Asset Allocation
The Fed ended QE on Oct 29 as widely anticipated and, less than 2
days later, the BOJ stepped in to make sure the QE bucket remains
full.
GDP grew 3.5% in Q3 while unemployment claims remained at a low
level, justifying the tone more hawkish than expected of the Fed
Despite the market rally and the good US data, there are reasons
to be cautious. October was one of the most tumultuous months for
equities in several years. Europe and China are slowing, and their
troubles could drag down the market. Risk factors re-emerge, driving
market volatility higher.
But expansionary monetary policies, low interest rates and abundant
liquidity are still keeping us from moving to an underweight on
equities. We remain neutral on global equities and think earnings
growth should be the only driver of markets from here.
Commodity markets were mixed, Nevertheless, we still like them (for
diversification purposes and as a risk hedge) but with a dispersion in
views across the sectors as individual fundamentals matter.
We remain underweight government bonds and corporate credit
overall (but with an intra-asset class preference for IG), and
Overweight US dollar.
We summarize our views as follows
3

MACRO VIEW
The Good
The average consumer's mood, appears as strong as it's been in years. Consumer Confidence,
as measured by the Conference Board, just reached a seven-year high, driven notably by
increased optimism about labor market conditions
US GDP grew 3.5% in Q3, beating expectations, but it is worth noting that some of the surprise
came from defense spending.
The Bad
Europe's economy and low inflation could eventually impact the US
Growth rate of forward 4 quarter estimate seems on a downtrend, declining from 9.1% to 7.9%
Real Retail Sales for Sep. ‘14 (-0.3% in nominal terms, and -0.4% in real terms) has
disappointed
China's PMI (down to 50.8) highlights the ongoing weakness of the economy.
The Ugly
Main systemic risk resides in China : China’s economy is supported by approximately six
trillion dollars of 'shadow debt', which may eventually create major systemic issues.
Ebola epidemic is still propagating. Economic effects have been limited so far, but the picture
may get worse rapidly…
4

The overall picture had been one of slow recovery, but there is no indication of a recession using the
5
Big Four Economic Indicators
indicators monitored by the NBER.
At 0.41%, real Retail Sales for Sep. ‘14 has disappointed

6
US GDP
US GDP grew 3.5% in Q3, beating expectations, but it is worth noting that:
The surprise mainly came from defense spending.
Government spending is rising again after a long shrinkage, is rising,

The Final University of Michigan Consumer Sentiment for October came in at 86.9, a small rise from
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Consumer Confidence
The average consumer's mood appears stronger than it's been in years.
the September Final of 86.4. This is the highest level since July 2007.
The Conference Board Index exhibits a remarkably similar pattern.

According to the NFIB Business Optimism Index, the mood of small business owners is also in its best
8
Business Confidence
shape since 2007.

9
GS – Global Leading Indicator (GLI)
GLI is back into ‘Expansion’ phase,
7 of the 10 underlying components
of the GLI improved in October
We’ve been thinking for a while
that the current acceleration
remains quite modest for a
typical expansion phase.
Available data is more indicative of
a stable macro environment rather
than one with a growth pulse.
More data are still needed to
confirm our fears about the current
economic situation.

10
US Inflation?
M2 velocity is still decreasing but
the rate of decline is slowing.
Is that an inflationary signal in
the US?
Source: St Louis Federal Reserve. % change in M2 velocity measured as
q/q change in 3-quarter moving average.

The median price for new homes plummeted from $286,000 to $259,000. In dollar terms, it's the
Prices are falling when quantity is increasing. This is probably due to a high level of inventories,
11
Housing
worst MoM plunge ever.
combined with the need to make big discounts

China's PMI (down to 50.8) highlights the ongoing weakness of the economy. New orders declined for
the third consecutive month and new export orders declined below 50 for the first time in five months
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European Chinese Economies
European growth also remained sluggish
Source: Markit

The most recent rally has been nearly as violent in terms of speed and magnitude as the one we saw in
The BoJ stimulus announcement added more fuel to that pattern. But, defensive sectors and Treasury
Over the course of the past five years, the SP has advanced five times faster than GDP. We
As said in our Sep. report, breaking through the 1900-1920 pivot area on the SP500 would
likely be the signal we wait for to go short stocks, as that could lead to a temporary sell-off in
equities We’ve got it!
In our Oct. report, we also said : “But a clean break of 1805 (Oct. ‘11 uptrend) will give the
Thus, we remain Neutral equities. At this stage, expansionary monetary policies, low interest
rates and abundant liquidity are keeping us from moving to an underweight on equities. Even
bad news for the economy (in Europe, Japan and China) appear as good news for stocks, as they
allow for further stimulus.
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EQUITY
October was quite a roller coaster ride for equities, but the main trend remains bullish.
Mar. 2000 (14.4% in 7 days to get to the 1,553 top on 3/24/2000)
yields have not confirmed the excitement in stocks
think this is hardly sustainable.
Bottom line :
signal of a BIG reversal on stocks.” This break down hasn’t occurred as the SP500
bounced violently on our threshold.

We keep our UW on Europe vs. US. We move to OW on Japan on the back of an aggressive
In our equity bucket, we favor the most defensive, high-dividend stocks (Utilities, Healthcare, and
The coming rate hikes (probably in Q2-2015) will depress all asset prices for at least part of next
14
EQUITY
Bottom line :
BoJ intervention, a weaker yen and good earnings growth.
We remain UW in US small caps vs large caps
Consumer Staples)
year, in our view

15
Earnings
Forward earnings estimates decline
further. The blended earnings
growth rate for Q3 2014 is 7.3%.
Q4 Earnings Guidance are
negative for 72% of the 64
companies in the index have
issued EPS guidance for the fourth
quarter. This percentage is above
the 5-year average of 67%.
Analysts are cutting earnings estimates for future quarters
As of Oct. 31st, the 12-month forward P/E ratio is 15.5.

16
SP500 Sector Breadth
As of Oct. 31st, 71% of stocks in
the SP 500 are above their 50d
MA
Defensive sectors (Utilities,
Consumer Staples, and Health
Care) have the highest breadth.
This behavior is usually present
in the latter innings of a bull
market.
Source: Bespoke

We watch 4 long-term indicators : 2 P/E ratios and Q Ratio through their deviation to their arithmetic
Based on the average of these indicators, the market looks 70% overvalued, suggesting a cautious
17
SP500 – A Long-Term Perspective
means and the inflation-adjusted SP Composite deviation to its exponential trend.
long-term outlook

Thus, based on the real SP500, the March 2009 low cannot (not yet) characterized as the end of a
18
SP500 – A Long-Term Perspective
The real SP Composite monthly averages of daily closes is still 5% below the tech high.
secular bear market and the beginning of a secular bull.

19
SP500 QE Ending
Equities have tended to underperform
Treasuries post QE programs ending.
Will this time be different as ECB and
BoJ are stepping in to make sure the QE
bucket remains full?
As learned from the recent history of
quantitative easing, the ending of QEs has
had a boost effect on volatility

Using a monthly MACD on the SP500 could be a way to avoid downturns. A cross between the
MACD lines seems possible in the months ahead. This cross would give the first sell signal since
2011.
20
SP500 – The Sell Signal to Come…

SP 500 Picture
From our previous report:
“A clean break of 1805
(Oct. ‘11 uptrend) will give
the signal of a BIG
reversal on stocks.”
The break down hasn’t
occurred and the SP500
bounced up right above the
trend across the lows since
Oct. ‘11
The index is now moving
back towards the prior high
at 2,019 and the probability
of making a new high is
clearly increasing.
We stay Neutral for the
moment. We will revise our
view to OW above 2040-
2060, and to UW below the
trend from Nov. ‘12 low
21

Our prop. Short-Term trading model went modestly short on Oct. 24h at 1964.58 on the index
The model targets 1962, 1903 and 1847 on the downside and would stop its losses at 2041-2062
22
Trading Model – SP500

23
FIXED INCOME CREDIT
We’ve been UW on 10y-UST for a while now, expecting 10-year yields to reach 2.90%-3.20% over
next months, because of sustained US growth, increasing US inflation. As said in previous reports,
only a material weekly/monthly close below the 2.40-2.30 range could make us change our mind.
Since last month, we’ve been questioning our underweight positioning, as U.S. 10-year yields
was ticking below the 2.40-2.30 range. We’ve decided to move to Neutral each time the 10y yield
goes below 2.25. We actually did that for a few days around Oct. 15th. But we moved UW since then
The FOMC’s hawkish tone supports our view that the Fed will indeed start tightening from Q2-2015
and will hike rates more than is currently priced in.
Falling inflation expectations, disappointing growth and the outlook for low official rates largely explain
the level of Eurozone yields. While we are neutral on German yields, we think US yields are too low
for the current growth and inflation outlook.
We continue to OW Eurozone vs. US and UK given continued policy divergence, BCE action and
the more hawkish than expected Fed. The ECB is probably planning to buy corporate bonds directly,
but even if not, its purchases of asset-backed securities and covered bonds may lead to investors
adjusting portfolios towards this asset class.

24
FIXED INCOME CREDIT
We see investors moving up the quality spectrum, selling high yield bonds and growth sectors and
getting into investment grade bonds, govies and defensive sectors. This is probably a sign we are
moving into the final stage of the bull market and economic expansion
We remain UW on corporate credit, due to valuation, to position within the credit cycle, to the
expected rise in government bond yields and given the weak total return forecast
We continue to prefer IG over HY on a risk-adjusted basis and keep our Neutral stance between
the US and Europe.
We closed our OW in EM corporates, given the tightening move we’ve seen overs the past 3 months,
and our view on the approaching Fed tightening (which will probably raise concerns about EM
vulnerability again)
Bottom line : Still UW Govies, UW credit, Neutral TIPS and OW HICP Inflation, UW High Yield vs
High Grade, Neutral on EM corporates

25
10y US Treasury Yields
For the last 2 months, we’ve been
questioning our underweight
positioning, as we saw U.S. 10-year
yields ticking below the 2.40-2.30
range. As explained in our previous
report, we decided to move to
Neutral each time the spot goes
below 2.25.
We actually did that for a few days
around Oct. 15th. We’ve been UW
since Oct. 23rd.
The technical rejection of the new lows
tested during Oct. 15th (~1.87) is very
positive for 10y UST yields. The next
levels to watch closely are 2.35 and
2.47. Above that point, we will feel
more comfortable with our bearish
view on US treasuries.
We still think that the structural
channel that has been in place since
the late-’80s will be broken to the
upside over the next few months.

26
US Credit
High-yield bond spreads have tightened back,
but are still wider than where they bottomed in
late June.
We also expect higher credits to continue
outperforming lower credits, especially in Europe
where ECB may start buying (Q1-2015?) senior
non-financial IG corporate bonds
We continue to believe that equities should
outperform credit given the point where we stand
within the cycle

27
US Credit
The credit risk premium (spread needed to compensate for expected losses due to default), as calculated
by Citi, is near all-time lows
We remain UW credit overall, and continue to prefer IG over HY on a risk-adjusted basis

28
EXCHANGE RATES
Signals we watch argue for further USD strength to develop in time
In our previous monthly report, we said that the US dollar was due for a pullback. This correction took
place but was short lived.
The EUR-USD underlying structure still looks very negative. Our ST target of 1.25 was finally
reached. The break of this pivot will open the door to 1.24, and ultimately to 1.21-1.20. Thus, we remain
UW EUR-USD as long as the pivot stays below 1.25
As expected, additional BoJ intervention has weighed on JPY.
We are again OW on USD-JPY as the pivot broke above 108. We target 119.30 and ultimately 124-
125

29
EUR-USD
The corrective phase
we’ve mentioned on
EUR-USD, in our last
report, was short lived.
Our ST target of 1.25
was finally reached. The
break of this pivot will
open the door to 1.24,
and ultimately to 1.21-
1.20.
We remain UW EUR-USD
as long as the pivot
stays below 1.25

30
USD-JPY
BoJ final move pushed the
JPY down the road. USD-JPY
broke above 108 and
even 110, making us OW
again.
The next big levels to wait for
/ watch are 112.40 and
119.30 (Q2-2015)
Our ultimate LT (medium-term?)
target remains at 124-
125!

31
COMMODITY
2014 has been a year of extremes for commodity markets: after outperforming other assets over H1, the
commodity complex has experienced the steepest price drop since 2008
Over October, commodities reported negative returns as Energy, Precious Metals and Livestock sectors
declined, while Industrial Metals and Agriculture advanced
We continue to like owning the GSCI energy index, and to think that commodities hold value as
cross-asset portfolio diversifiers.
While we are neutral on prices we continue to see substantially positive roll returns in many
commodities. We remain OW commodities but with a dispersion in views across the different sectors. At
this stage, individual fundamentals matter a lot!
We continue to favor commodity futures with steep backwardation (for positive carry).
Our bearishness on agriculture commos (except Cocoa and premium coffee) was a very bad deal:
Grains have rallied 15% in October despite markets entering peak Northern Hemisphere harvest
We have been proven right in going UW precious metals and base metals. But our bet against
Copper was bad: We saw a sharp short covering rally in copper prices, after the better than expected
Chinese September industrial production data, and rumors of copper purchasing by China’s State
Reserves Bureau. Aluminium (one of our favorite metals) prices increased for demand-supply
imbalances.
But we were completely wrong about energy, as crude continued its slide breaking down $80

32
COMMODITY
We remain UW on agriculture (except on premium coffee and cocoa), and move to Neutral on base
metals (we prefer Aluminium and copper to Iron Ore).
Precious metals are suffering from a stronger dollar and higher US rate rise expectations
We are close to our target on gold (1170-1150). We will move Neutral on gold below 1150 and switch
progressively to OW (accumulate) as the spot slides down towards 1000-980, which is probably the final
leg down.
Our first target on silver (~17) has been reached. Silver is probably ready for its final leg down towards
12.50. At current levels, we move Neutral but, like for gold, we will switch progressively to OW
(accumulate) as the spot breaks the first material resistance around 14.70 and slides down towards 12.50
Our dilemma is about energy, and especially crude oil!
The current correction is impressive but still falls within the norm of recent corrections.
Breaking the $80 support zone would be a very bad signal for crude oil, unless the OPEC decides to
stop the bleeding
We’ve decided to keep our OW bias on energy as long as the $80 support zone is not clearly broken.
But it was. We stop our losses and move to Neutral, waiting for a clean break above $80.

33
Crude Oil - WTI
WTI seems to be finally breaking
down our important support of 80.
The rebound we’ve been waiting
for hasn’t occurred
The next big level to watch down
comes at 74.95-73.75.
A very similar pattern is also
developing on the Brent

34
Gold
The Fed hawkish statement
coupled with a strong Q3 U.S.
GDP, pushed up the dollar and
rate rise expectations Interest
in gold was shaken a little
more...
On the other hand, gold
continues to be strongly
correlated to JPY (through
USD).
Our bullish view on USD-JPY
is thus coherent with our
bearish ST view on gold. Our
target of 1150 seems now at
hand.
But what is next?

35
Gold
In our last report, we thought
that a bounce was forming on
gold around 1190
We ‘ve proven wrong. That was
a false bounce similar the one
we’ve seen near 1520-1530
Is the gold ready for a last leg
down?
Current levels should be
watched closely as we can
witness a powerful break below
1180-1150 towards 1000-980
We move Neutral on gold
below 1150 and switch
progressively to OW
(accumulate) as the spot
slides down towards 1000-980

36
Copper
Since end of July ’14 (level ~
7100), we’ve been UW Copper,
targeting 6400 in Q3 and
ultimately 6000. The spot
reached the 6600 – 6550 range
but now seems ready for a
bullish reversal.
We move Neutral on Copper
and wait for a break of 6960
(trendline since the highs of Feb.
‘13) to become OW.

37
ALTERNATIVE STRATEGIES
Within the hedge fund complex, we’ve been OW Equity Market Neutral, CTA, Global Macro and Vol
Arb.
Three months ago, we decided to move from OW to Neutral on Event-Driven, as MA activity was
calming down, volatility was expected to bounce, and geopolitics were threatening… The share of MA
deals withdrawn or terminated has sharply increased this year.
Our bets have paid off handsomely except for Global Macro
We maintain our previous positioning: While preferring risk diversifiers to return enhancers, on a risk-adjusted
basis, we keep our OW on:
Equity Market Neutrals both for their “intelligent” beta and their alpha contribution
CTA’s and Global Macro as a diversifier and tail hedge.
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.

38
Event Driven
The share of MA deals withdrawn or
terminated has sharply increased this
year.
We stay Neutral and wait for a softer
flow of negative announcements .

39
CTA and Global Macro
Unlike Global Macro managers, CTAs
are still long rates which have proven
profitable over the month.
CTAs held short positions in
commodities, making significant gains
over the recent months.
The erratic trends on rates and FX
have induced losses for CTAS and
Global Macro.

Bottom Line: Global Asset Allocation
The Fed ended QE on Oct 29 as widely anticipated and, less than 2
days later, the BOJ stepped in to make sure the QE bucket remains
full.
GDP grew 3.5% in Q3 while unemployment claims remained at a low
level, justifying the tone more hawkish than expected of the Fed
Despite the market rally and the good US data, there are reasons
to be cautious. October was one of the most tumultuous months for
equities in several years. Europe and China are slowing, and their
troubles could drag down the market. Risk factors re-emerge, driving
market volatility higher.
But expansionary monetary policies, low interest rates and abundant
liquidity are still keeping us from moving to an underweight on
equities. We remain neutral on global equities and think earnings
growth should be the only driver of markets from here.
Commodity markets were mixed, Nevertheless, we still like them (for
diversification purposes and as a risk hedge) but with a dispersion in
views across the sectors as individual fundamentals matter.
We remain underweight government bonds and corporate credit
overall (but with an intra-asset class preference for IG), and
Overweight US dollar.
We summarize our views as follows
40

41
Disclaimer
This writing is for informational purposes only and does not constitute an
offer to sell, a solicitation to buy, or a recommendation regarding any
securities transaction, or as an offer to provide advisory or other services
by FinLight Research in any jurisdiction in which such offer, solicitation,
purchase or sale would be unlawful under the securities laws of such
jurisdiction. The information contained in this writing should not be
construed as financial or investment advice on any subject matter.
FinLight Research expressly disclaims all liability in respect to actions
taken based on any or all of the information on this writing.

About Us…
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perspective, on Portfolio Construction, and all related quantitative aspects and risk management issues.
Our expertise expands along 3 axes:
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carry, volatility), real assets (real estate, infrastructure, farmland, timberland and natural resources).
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