Market perspectives - July 2014

Market Perspectives
July 2014
July 4th, 2014
www.finlightresearch.com
The sea is calmest before a storm.

“... it is hard to avoid the sense of a puzzling disconnect between the markets'
buoyancy and underlying economic developments globally.... Despite the euphoria
in financial markets, investment remains weak. Instead of adding to productive capacity,
large firms prefer to buy back shares or engage in mergers and acquisitions.
As history reminds us, there is little appetite for taking a long-term view. Few are
ready to curb financial booms that make everyone feel illusively richer. Or to hold back
on quick fixes for output slowdowns, even if such measures threaten to add fuel to
unsustainable financial booms. Or to address balance sheet problems head-on during a
bust when seemingly easier policies are on offer. The temptation to go for shortcuts is
simply too strong, even if these shortcuts lead nowhere in the end.”
BIS - Bank of International Settlements
2
FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation
US data remains supportive of the theme that the
economic recovery is a slow and steady one.
The wide divergence between US job growth and economic
growth remains an enigma for us
The hope of the Fed (as other Central Banks) is that they
can keep the markets afloat through forward guidance as
they slowly reduce their liquidity support
Economic growth and company earnings volatility are at
historic lows. Uncertainty is bound to rise in the future
Our concern is that long-risk strategies are justified, not
by strong growth, but instead by unvirtuous
combination of low growth, low volatility and low cash
rates
Risky assets are not priced for any alternative scenario than
the optimistic one. We do not want to be exposed to such
a biased situation..
We continue to see the main systemic risk coming from
China.
We summarize our views as follows
3

MACRO VIEW
The Good
The Conference Board consumer confidence (at 85.2), as the Michigan Sentiment (82.5) have
beaten expectations. Small business owners’ mood is also on an upside trend.
Buybacks within the S&P500 are heading to their previous record highs of Q3-2007, and continue to
support the equity bull market.
S&P500 forward earnings estimates continue to surprise by their stability and lack of volatility
By all indications, the labor market is continuing to mend.
The Bad
With the stunning decline in Q1 GDP, the health of the US economy has once again taken center
stage
Looking at the 3 month rate of growth, personal income appears to be trending up when consumer
expenditures continues to trend down
The most recent S&P 500 correction greater than 10% was the 19.4% selloff in 2011
Margin Debt & Credit Balance deliver the same warning message on stocks
The S&P 500 price/sales ratio is approaching tops last seen during the dot.com fiesta
The Ugly
The unresolved rise in leverage in China
The unexplained fall in Q1 GDP and the wide disconnection between US job growth and economic
growth
4

5
Big Four Economic Indicators
There is no indication of a recession using the indicators monitored by the NBER, even during Q1-2014
Although Real Retail Sales for May were hardly encouraging, the May Industrial Production
strengthened the optimistic view about the US economy.

6
Consumer Confidence
The Conference Board consumer confidence (at 85.2), as the Michigan Sentiment have beaten
expectations. They are now on levels last seen in H2-2007

7
Business Confidence
According to the NFIB Business Optimism Index, the mood of small business owners is also on an
upside trend.

8
Home Sales
The housing crisis opened the "distressing gap" between existing and new home sales. This gap is
mainly due to distressed sales.
As the number of distressed sales declines and new home sales increase, this gap is expected to slowly
close. This is confirmed by the ratio “Existing to New Home Sales” which has been trending down (it’s
back to its Nov. ‘08 levels).

9
GS – Global Leading Indicator (GLI)
Little improvement since last
month.
According to the GLI, global growth
is no longer decelerating, but there
is no significant positive
acceleration.
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 June, like in May
We still note the extreme
difficulty the GLI has to move
more decisively into expansion.

10
Economic Surprises
GS MAP Indices for macro data
surprise remain in positive territory
However, MAP indices signal a
decrease in US and European data
surprises towards neutral levels.

11
EM Economy
Relative macro momentum seems to
shift in favor of EM versus DM
EM growth forecasts are stabilizing
when those for DM are still heading
south

12
Chinese Leverage
In China, debt is rising much faster
than the economy
But the government is obsessed by
maintaining growth around 7% -
7.5%
deleveraging the system is
perpetually delayed
the ultimate risk of a systemic
credit crisis is increasing.
We are a few months to 2 years
from the final breakup

13
EQUITY
The risk-reward trade-off points to a more cautious approach to the equity markets, at least
tactically on the near term.
On most equity indices, we see the potential for probably capturing another 3-4% on the upside versus
a 10-15% correction on the downside
Valuation is also a concern for us, especially in the US. Everything is priced for the central optimistic
macro scenario. Equity sentiment indicators are in euphoria territory. No buffer is there to absorb any
macro disappointment. The US is, in our view, very vulnerable to any chock.
European stocks have succeeded in tracking US equities despite poor fundamentals
We believe the return potential for the equity market is corrupted by limited room for valuation and
margin expansion.
We continue to think that any further upside on the S&P 500 should be driven by earnings
growth rather than P/E expansion
The first real sign of momentum loss on the S&P500 will be a clean break below the uptrend since Nov.
2012.
Bottom line :
We remain Neutral equities. Breaking through the 1850 pivot on the S&P500 would likely be the
signal we wait for to go short stocks
We keep our UW on Europe and EM vs. US. We remain neutral to UW on Japan

14
Buybacks
According to Yardeni Research, during Q1-
2014, buybacks within S&P500 reached
$637 billion at an annual rate, not far from
the previous record high of Q3-2007.
As earnings yields exceed corporate bond
yields, corporations have a tendency to
borrow in the bond market and buy back
shares Supporting the bull market and
artificially boosting earnings per share
whether without any improvement in
company’s fundamentals.
But when corporate cash flows will
decrease and bond rates will go up,
buybacks will dry up and accelerate the
move down on stocks.

15
Earnings
Momentum in European / EM earnings
growth remained modest over the past few
months.
In the US, the YoY EPS change has been
stable around 6%.
The “forward 4-quarter” estimate of the SP
500 stands at $122.97, implying a P.E ratio
on the forward estimate of 16x
We will soon roll into Q3-2014 and get the
quarterly bump in the “forward 4-quarter”
earnings estimate Probable target ~125

16
Margin Debt
Margin debt seems to soar during market bubbles. In 2000 and 2007, it peaked a few month before the
market.
We’ve seen an acceleration in margin debt growth since end of 2012 and probably a peak formation
in Feb ’14 followed by a sharp decline (-3.9% in March, -3.2% in April, +0.3% in May)

17
Credit Balance
Credit Balance on the NYSE = Free Credit Cash Accounts + Credit Balances in Margin Accounts –
Margin Debt
Credit Balance deliver the same warning message than Margin Debt

18
Where do we stand?
The number of trading days where the S&P 500
Index has had an intraday move of 2% or more
points to a state of serenity last seen in 2006
The current bull market has returned around
175% (the 3rd best overall since 1932) over a
duration of 266 weeks (the 2nd longest since
1932) Caution is needed…

19
Where do we stand?
The number of trading days the S&P
500 has spent above its 200-day is the
highest ever!
We are in the longest period of
positive sentiment in the history of
markets.
All news, even bad news, are treated
as positive by the market or simply
ignored
“Every day that goes by where risk
is ignored brings us closer to a
moment when panic will return”

20
S&P Long-Term Valuation: Q-Ratio
From a LT perspective, the current Q-Ratio clearly signals a market top.

21
S&P Short-Term View
The S&P500 remains in a Bullish
configuration as far as 1925-1940 area
is preserved.
Although stretched, the index has room
to extend from current levels to 1980-
2000
However, the price pattern and
divergences on the momentum seem
to warn of trouble. Breaking 1900 will
be an additional sign in that direction
and would open the door for a broader
correction back to 1844,1833 and 1822
(200d MA) important supports
The first real sign of momentum loss
on the S&P500 will be a clean break
below the uptrend since Nov. 2012
around 1850

22
Trading Model – S&P500
Our prop. Short-Term trading model is now significantly short (as of July 3rd, spot=1985.44)
The model targets 1961 – 1942 – 1903 – 1847 (a level similar to that given by the uptrend since Nov.
2012) and maintains its shorts till 2021!
According to the model probabilities, the risk from here is biased to the downside

23
FIXED INCOME & CREDIT
We keep our short positioning on UST and expect 10-year yields to reach 2.90%-3.20% over next
months.
We continue to OW Eurozone vs. US and UK given continued policy divergence and BCE activism.
An improving Eurozone growth outlook and ECB credit easing measures should induce further
Peripheral-Core spread convergence. We see, however, reasons to be cautious as the current low
volatility environment is encouraging complacency , especially with the periphery. We remain neutral
Peripheral vs Core as we see lasting spread compression to be very limited.
We remain bullish on TIPS breakevens and keep our 5y-TIPS breakeven wideners
We stop the short 5yx5y Eurozone inflation we took as a hedge against the risk of Eurozone deflation.
As a tail hedge, we keep our 10y bund swap spread receiver swap
Rising Treasury rates would be disruptive to high yield technicals. We expect the high yield market
to slow its advance in the near term, even if default rates remain contained

24
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
Credit spreads are close to pre-crisis lows, issuers are starting to leverage up and credit is likely the
relatively most over-owned asset class.
We believe recent ECB policy action is likely to strengthen the search for yield environment.
The search-for-yield is likely to remain strong and may push spreads a bit tighter over the rest of the
year. But, this is balanced by rising government bonds and significant risk of a liquidity shock
We have downgraded corporate credit to UW on valuation, on position within the credit cycle and
given the weak total return forecast
Intra credit, we keep our Neutral stance between the US and Europe. European credit is supported
by ECB QE, and has a much stronger potential for returns over the short-term 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. Recently, High yield spreads have
underperformed high grade, partly because of recent issuance volumes. We expect the erosion in
returns to be more pronounced in high yield than investment grade, due to the progressive
deterioration in new issue quality.
Bottom line : Still UW Govies, UW credit, OW TIPS, UW High Yield vs High Grade

25
US Treasuries
U.S. 10-year yields push below 2.56%
was short lived
The long term setup is structurally
positive and should remain so as long
as the downtrend from Jun. ‘07 is not
broken to the downside.
We keep our target of 3.0 before year
end.
Things are less clear on 10y Bund as
we get close to Jul. ‘12 lows of
1.12%... We have to wait and see if a
base will develop on these levels.

26
US Treasuries
Over the last weeks, short positions
on US debt securities have gained
momentum within hedge funds of the
Lyxor database

27
Germany - Eurozone Periphery Spread
The spread between German 10y
yields versus periphery (equally
weighted basket of 10-year France,
Italy and Spain) has recovered around
300bps from its 2012 lows
We are now on an important technical
point (76.4% retrace of the widening
from 2005 to 2012) that should be
watched closely.
Our feeling is that tightening is losing
momentum.
We remain neutral Peripheral vs
Core as we see lasting spread
compression to be very limited.

28
FI - Inflation
Inflation seems bottoming globally and the
inflation theme is getting increasingly into
conversations.
10yr Tips Breakevens keep a positive bias
thanks to a macro environment that is
supportive of higher inflation expectations
and inflation risk premia.
We like US TIPS breakeven wideners as
we expect the Fed to maintain a dovish
tone

29
Credit – High Yield
We move UW on credit overall and
specially on high yield.
We are concerned by the deterioration of HY
credit quality.
According to high yield metrics, leverage has
neared its tops, but interest coverage
remains healthy (thanks to low rates)
Easy funding, low funding costs combined
with low volatility encourages the search for
yield and the use of leverage
As credit spreads continue to tighten, credit
performance appears tremendously
attractive to investors, especially when
realized (and implied) volatilities are low.

30
Credit – High Yield
We move UW on credit overall and
specially on high yield.
Carry strategies (partially encouraged by
Central Banks activism) feed on themselves
and have a tendency to exaggerate the
spread tightening (going through fair value
estimates) and to narrow the exit door for
potential leavers.
Credit valuation is getting stretched as
corporates return capital to shareholders
through buybacks and increase their
leverage.

31
Credit – Rating Actions
Credit rating actions, including credit
watches, are increasing at a steady
pace.
More volatility has to come…

32
Credit – US vs Europe
In IG as in HY, Europe has been outperforming the US for a while.
We prefer however to stay regionally neutral as outperformance of European credit is mainly due to
its much higher exposure to banks and peripheral credit

33
EXCHANGE RATES
The June FOMC meeting was less hawkish than we expected. Nevertheless, 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. Further weakening of
the EUR could be triggered by new ECB initiatives (asset purchases and an outright expansion of the
ECB balance sheet )
On EUR-USD, we remain UW and target 1.34 - 1.31 - 1.28.and ultimately 1.25
The ongoing deterioration in Japan's current account deficit , further policy initiatives (including both
additional QE and asset allocation out of domestic bonds), combined with the rise in US yields, should
drive USDJPY higher
On the USD-JPY, the corrective phase has been well supported so far. The rally of the USD should
resume shortly. We are probably in a consolidation phase. Thus, we switch from UW to Neutral.
EM fundamentals still feel less robust broadly speaking: As the Fed continues to taper (without being
hawkish), we expect many EM currencies to remain under pressure versus USD :
Over the short-term, carry trades USD-EM should continue with stable USD and low volatility
Over a longer term (more than 6 months), we get closer to effective Fed tightening and would see
USD gains versus EM currencies and a higher volatility

34
EUR-USD
Our constructive view for USD is
based on the belief that growth and
interest rate differentials favor the
US
Over the short term, the recovery
from the June 12th low seems
exhausted. We expect a return to
1.35.
Medium to long-term picture of
EUR-USD remains heavy with an
obvious lack of upside momentum.
We remain UW and target 1.34 -
1.31 - 1.28 and ultimately 1.25.
We keep this view as long as the
downtrend from Jul. ’08 is
preserved.

35
USD-JPY
The LT structure looks bullish but
the ST picture is not so clear.
USD dropped to a more than one-
month low against the yen last week
after bad U.S. spending data
The break below the 200d moving
average (~101.75) was notable,
but wasn’t sustained. We are
back above the 200d MA
It is more like a consolidation
picture.

36
COMMODITY
We still think commodities hold value as cross-asset portfolio diversifiers.
Commodities were the best performing asset class in H1-2014. All 5 commodity sectors have contributed
positively to overall index returns.
We’ve been UW since end of Feb. ‘14. Since then, commodities have been rangy.
We upgrade our commodity allocation to OW for several reasons:
Better perspectives for energy and base metals. Many base metals (Zink, Aluminium…) appear to be
making notable breaks higher from a multi-year consolidation
Supply risks in energy. In the energy sector, risks are skewed to the upside in an environment of
elevated geopolitical tensions and very limited OPEC spare capacity
Attractive carry available in a number of commodity futures curves with steep backwardation
rebounding manufacturing data in China
Over the second half of 2014, we see significant downside for :
Agriculture, as there are expectations of record inventory builds for staple cereals. We keep
however our OW view on premium coffee and cocoa because of the risk of El Nino and weather
volatility around the equator
Precious metals: We think that recent gains in gold cannot be sustained as US real rates, the
S&P500 and the US dollar move higher. We expect precious metals to resume their downward trend
(targeting 1180-1150 on gold and 17 and eventually 12.50 on silver)

37
Precious Metals: Silver
Silver has rallied by more than
10% from its bottom in early
June, but we expect a pull-back
as RSI is in overbought status
At 21.12, Silver is approaching a
top (resistance zone
~21.43/22.19) and should turn
down targeting 18.22, and
17.44,

38
Precious Metals: Gold
Gold jumped higher on June 19th as weak U.S. data on consumer spending hurt the dollar.
We are still expecting lower lows in the metals before this 3+ year correction is completed.
We think that Gold is currently topping with price approaching the major resistance zone 1334/1372.
We target a test and a break of 2013 low (1180).
We keep our bearish scenario as long as 1392 (Mar-14 high) is preserved on the upside.

39
Energy: Crude Oil
Large speculators marginally increased their WTI crude oil longs. CTAs and Global Macro managers
provide a hedge against geopolitical risks in the Middle East
We were already OW Crude taking advantage of the high roll return from backwardated oil futures
curves
We maintain our OW on WTI and play a break above the July 2011 high of 104.11. (with a stop at
103.55)

40
ALTERNATIVE STRATEGIES
Hedge funds (especially return enhancers) seem to be getting increasingly long stocks.
We 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. Merger arbitrageurs proved resilient during the recent weakness in global equity
markets.
CTA’s and Global Macro as a diversifier and tail hedge. We proved correct with the Middle-East
geopolitical risks
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.

41
Long/Short Equity Strategy
According to a Pension Partners study, “Over time,
the long/short strategy has essentially morphed into
a lower beta, long-only product that has actually
delivered negative alpha in recent years and shown
an inability to protect capital during market declines.”
The reason behind is probably a combination of
herding and career risk management (with managers
unwilling to bear the risk of not participating in an up
market)
Given its new biases, LS Equity is clearly not
designed to help investors protect their capital
during the next downturn

42
Hedge Fund Industry Overview
It was a good week / month for CTAs. Trend-followers took advantage from Fed dovish
statement, both on their long positioning in LT rates (US & German), in stocks (including energy
stocks) and precious metals
CB and Vol Arbitrage funds took advantage from the strong issuance in June, making money on
opportunities between primary and secondary markets.

43
Hedge Fund Industry Overview
By build-up their long energy positions during the last 3 months, CTAs and Global Macro managers
have provided the needed hedge against geopolitical risks in the Middle East

Bottom Line: Global Asset Allocation
US data remains supportive of the theme that the
economic recovery is a slow and steady one.
The wide divergence between US job growth and economic
growth remains an enigma for us
The hope of the Fed (as other Central Banks) is that they
can keep the markets afloat through forward guidance as
they slowly reduce their liquidity support
Economic growth and company earnings volatility are at
historic lows. Uncertainty is bound to rise in the future
Our concern is that long-risk strategies are justified, not
by strong growth, but instead by unvirtuous
combination of low growth, low volatility and low cash
rates
Risky assets are not priced for any alternative scenario than
the optimistic one. We do not want to be exposed to such
a biased situation..
We continue to see the main systemic risk coming from
China.
We summarize our views as follows
44

45
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.

Market perspectives - July 2014

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