FinLight Research - Market Perspectives May 2014

Market Perspectives
May 2014
May 3rd, 2014
www.finlightresearch.com
Sell in May and go away?

“The Fed has lost any semblance, any wispy remnant of humility,
introspection, caution and historical perspective. It is all cameras and
applause […]
The Fed (along with other central banks) is fully immersed in fiscal
policy, arrogating more and more responsibility for the functioning of
the global economy, picking winners and losers in purchasing financial
assets, directing the allocation of credit and making ever-bolder
predictions ever-further into the unknowable future. […]
In effect, it is achieving total political power in a political vacuum,
without the accountability of being elected. […]
If you open a faucet in the winter and only a trickle comes out,
what do you do? Easy! Open it wider. In fact, open ALL the
faucets! Brilliant! Now they are all trickling. But when the pipe
blockage comes unstuck or the ice melts, you will have a flood”
Hedge-fund manager Paul Singer
2
FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation
Low volatility is no panacea: the fall in volatility in bond, equity,
and commodity markets is eliminating caution, favoring excess risk
taking and leverage. Our view is that volatility rarely stays this low
for long
We are muddled by the divergent signals we see in the market
(High beta stocks ugly performance, outperformance in Govies
and weakness in US$ despite good economic news, equity / FX /
rate vols drifting towards all-time lows)
Is something more fundamental is going wrong in the world
economy ?
Is the market signaling concern about the economy in a post
QE world?
Many signs point to a global slowdown: China's sudden decline
in exports, downward revision to their economy's growth rate,
stalling of Europe's recovery and risk of deflation
We continue to see the main systemic risk coming from
China.
We summarize our views as follows
3

MACRO VIEW
The Good
Economic data have been trending positively
The 0.4% decline in the US 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
Expected earnings growth remains strong
Michigan Consumer Sentiment final number for April was the second highest reading in almost
seven years.
Chicago PMI and ISM Manufacturing report both came in stronger than expected. Leading economic
indicators were also strong (up 0.8%)
April flash PMI for Eurozone surprised on the upside. German IFO for April was also surprisingly
strong, in particular the expectations component.
The Bad
Q1 GDP growth was near zero. Is that a weather exception?
Eurozone is probably just one adverse shock away from going into deflation.
Treasuries are rallying despite Fed tapering, signaling something is wrong with the global picture
China's growth remains disappointing.
The collapse in the price‐to‐book ratio of Chinese banks emphasizes the China's bad non-performing
loan picture.
Geopolitical risks are high, but actual effects on markets have been small, so far.
The Ugly
A sustained slowdown in Chinese growth below 7% YoY.
4

5
Big Four Economic Indicators
The global picture is always that of a slow but consistent recovery.
The data for Feb and Mar. are back to green
Among the 4 indicators, two (Real Retail Sales and Industrial Production) have already reached their all-
time highs. Nonfarm Employment remains on a positive trend. Only Real Personal Income is still
struggling.

6
Personal Income
At 0.54%, the Personal Income March MoM is the largest since Dec. ‘12 spike (explained by income
strategies in anticipation of tax increases)
The March MoM decreases to 0.34% when we adjust for inflation and Transfer Payments.
On a YoY basis, Real Personal Income less Transfer runs at the hardly exciting level of 2.15%

7
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

8
Employment – An Unbalanced Recovery
According to a recent report from the National Employment Law Project, the employment growth during
the recovery appears to be concentrated in lower-wage industries
The report shows that job losses and gains have been skewed: “Higher-wage industries shed 3.6 million
positions during the recession and have added only 2.6 million positions during the recovery. But lower-
wage industries lost two million jobs, then added 3.8 million.”

9
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

10
Retail Sales vs PCE
Real retail sales fell to near recessionary
levels before rebounding in March
A similar pattern was observed on durable
goods spending
This is fully in line with the flat GDP report.

11
GS – Global Leading Indicator (GLI)
According to the GLI, global growth
is no longer decelerating, but there
is no significant positive
acceleration.
After 6 months of continuous
slowing, the GLI continues to
locate the global industrial cycle on
the frontier of the expansion phase
(defined by positive and increasing
momentum)
5 of the 10 underlying components
improved in April
We note the extreme difficulty
the GLI has to move more
decisively into expansion.

12
US Real GDP
The recovery out of the last recession looks disappointing compared to earlier recoveries
This is the slowest recovery over the U.S. post-World War II period
This is mainly due to the weakness in consumption in services and non-durables.

13
Eurozone Recovery
At 54, the April flash PMI for Eurozone is now at a 3 year high and at a level consistent with 2% GDP
growth.
But at this stage, Eurozone Industrial Production is everything but spectacular…

14
Eurozone Inflation
Eurozone inflation continues to raise
concern, as it systematically undershoots
the ECB’s forecasts
Draghi’s rhetoric “inflation expectations
remain well anchored” is simply no longer
true.
Eurozone is probably just one adverse
shock away from going into deflation.
This should prompt ECB to further monetary
easing, and probably to implement a QE
program over the near term

15
US Inflation
Inflation continues to surprise to the
downside.
Consensus inflation forecasts have been
falling as real growth forecasts have been
rising. Volatility of inflation is also going
down.
This is probably one of the reasons for the
sideways range in government yields

16
Consumer Sentiment
The University of Michigan Consumer Sentiment final number for April came in at 84.6
This is the second highest reading in almost seven years.
This is still below non-recessionary average level of 87.4

17
Housing
The private residential investment's share of GDP has bottomed.
Case-Shiller home prices were up almost 13% YoY, softening question marks on other recent home
sales data.
As goes housing, so goes the economy.
Source: Bespoke Invest.

18
China’s Growth
China's growth remains disappointing.
The Manufacturing PMI has been in the contraction range for the last 3 months.
The PPI inflation rate has been negative on a YoY basis for the past 26 months through March, probably
due to excess capacity
According to Ed Yardini, China’s crude oil flat demand suggests that “growth may be slowing even faster
than suggested by GDP and production indicators”.

19
China NPL Problem Matters…
Non-performing loans have increased dramatically since 2008 (exceeding one trillion dollars) as a result
of the massive expansion of credit to the non‐financial and household sectors
The collapse in the price‐to‐book ratio of Chinese banks emphasizes the China's bad NPL picture.
The biggest challenge for Chinese authorities is to contain the NPL problem and avoid contagion to one
of the Big 4 banks

20
EQUITY
On the S&P500, we witness a certain exhaustion of the trend at its highs. But we need clearer signals
to expect a deeper consolidation. The first real sign of momentum loss would be given by a break
below Nov 2012 uptrend.
On the Nasdaq and Russell2000, odds are increasing for a downside resolution
The large divergence between the S&P500 on one hand and small caps / high beta stocks on the other
hand, is painting a strange defensive-oriented picture.
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 reverse our view on Japan from
OW (as we were proven badly wrong!) to Neutral/UW
We might switch more constructive on Europe if the ECB QE materializes. This would be bullish
for equities, especially financials, cyclicals and periphery.
We keep our bias to defensive high-yielding stocks. A severe unwind seems to be underway in
high-beta areas like Biotech and Social Media.

21
Earnings
The forward 4-quarter estimate for the SP 500 has increased to $123.19, implying a YoY growth rate
of 8.21% (the highest since Jan ‘12)
However, earnings estimates were lowered in all key regions.
The consensus MSCI Eurozone EPS growth expectations Ytd are on a negative trend similar to that
experienced during each of the last 3 years.
MSCI Eurozone

22
Earnings
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

23
Earnings / Revenue Estimates
While the earnings estimates beat rate (62%)
has been normal so far this season, the
revenue estimates beat rate (50%) has been
clearly weak.
Source: Bespoke Invest.

24
Small Caps Divergence
A large disconnect is happening in the market currently.
As the Dow is testing new all-time highs, the Russell 2000 seems to be heading to its major support at
100!

25
Small Caps & High-Beta Stocks Blood Bath
Small caps and high-beta stocks are getting hammered as a logical result of the reversal of the Fed's
zero interest rate policy
The performance of high beta stocks relative to defensive stocks points to a deterioration of market's
tolerance for risk since Mar.14
Both underperformances are painting a defensive-oriented picture.

26
Market Sentiment
Treasuries are rallying despite Fed tapering…
The behavior of long USTs relative to intermediate duration can point to coming risk-off periods and
higher volatility for stocks

27
Sell In May…
The seasonal effect is real… at least on average.

28
Sell In May? Just wait for clearer signals…
On the S&P500, we witness a certain
exhaustion of the trend at its highs. But
we need clearer signals to expect a
deeper consolidation.
The most notable support from here
stands at the uptrend from Nov. 2012
(1,833)
Breaking through this pivot would
likely be a concerning signal.
An other concerning signal is already
here: The Russell2000 has already
broken its Nov. 2012 uptrend
Russell2000 weakness would be
confirmed by a clean break of 1114
support (200 daily MA)

29
Trading Model – S&P500
Our prop. Short-Term trading model is now neutral to slightly short on May. 2nd at 1881 on the index
The model targets 1847 – 1756 and increases its shorts above 1885

30
Japanese Equities
The latest BoJ outlook report seems to
indicate that QE is put “on hold” for the
moment, leaving Nikkei and USD-JPY
vulnerable.
Another move higher in stocks needs more
policy stimulus
We cut Japan to Neutral / UW from OW.
A correction seems underway et may
last several moths with a target 1000 Pts
lower.

31
EM Equities
During April and after a substantial
improvement against DM, EM resumes
its underperformance as:
EM GDP growth continues to be
revised to the downside
EM EPS are also revised down
We remain UW EM stocks against DM
stocks.

32
FinLight Research
Risk Aversion vs Equities
At -0.32, the RAI remains in neutral territories. The correction is not significant. Equity 6m-momentum
is too high (and completely disconnected from risk aversion) to be sustainable.

33
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.
Government yields continue to trade in a narrow range, with low volatility encouraged by low inflation
and disappointing data. Stable yields and low volatility help periphery, EM sovereigns and credit.
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.
Within the Eurozone, we stay neutral Peripheral vs Core as we see lasting spread compression to be
very limited if any.
We stay neutral on TIPS breakeven but 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

34
FIXED INCOME & CREDIT
In corporate credit, investors appear to be seeking out risk on the margin, moving down in quality in
search for yield.
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.
Issuance quality has started to deteriorate
Expected ECB potential QE should be supportive to credit but less than Fed QE.
Given the rising government bond yields, 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 are Neutral 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.
On a risk-adjusted basis, we continue to prefer IG over HY. We were proven correct specially in
the US credit.
Bottom line : Still UW Govies, Neutral credit, neutral TIPS, UW High Yield vs High Grade

35
US Treasuries
In contrast to our strong expectations for higher
yields, we’ve rather seen sideways move in
Govies, so far in 2014.
Concerns over Ukraine more than outweighed
the strong employment report, pushing
Treasury yields down and flattening the curve
UST yield continues to trade in a narrow 20bp
range, as it did over the last 3 months
We stay near term bearish and think that the
range low will hold given the tapering move
But the repeated failure to close above 2.80%
presents a risk to our view.
The major question remains: Is the market
signaling concern about the economy in a
post QE world?

36
Implied Inflation - Eurozone
1y and 5y implied inflation continue their slide down… The inflation curve is steepening
Shorting 5yx5y Eurozone inflation seems a good hedge against the risk of Eurozone deflation.

37
Implied Inflation - US
We remain neutral on TIPS breakeven

38
Issuance Quality
In European HY space, issuance quality has started to deteriorate with only 18% of April issuance
being BB-rated, 54% used for releveraging and 14% of issuance in CCC
Among the 32 bonds issued in April, 27 were rated single-B or less.
GCP: General Corporate Purposes

39
Market Inflows
We see a global context of slowing inflows into HY bonds and leveraged loans
European high yield retail inflows had started to moderate.
US leveraged loan inflows turned negative for the first time in two years , while US high yield bond
inflows are near zero.

40
Credit – HY vs IG
Spreads for both the European and US indices
have tightened in line, with HY underperforming IG,
specially in the US.
The US HY/IG spread ratio has not been this high
since November 2012

41
EXCHANGE RATES
We keep our view for a stronger USD index in 2014 based on higher US rates and non-US
fundamental weakness
Investors have already capitulated on the long USD view (but not us !) initiated with the beginning of
tapering. This should support the dollar as far as the US economy does not disappoint.
As expected, the EUR-USD traded sideways so far in Q2. We remain Neutral and wait for a clean break
below 1.3675 to become UW and target 1.31 - 1.28.
We may see 1.40 soon, but the exhaustion pattern is already here. In order for our EUR bearish view
to realize, the spot should hold below the trend across the highs since Feb. 2012
The latest BoJ outlook report seems to indicate that QE is put “on hold” for the moment, leaving USD-JPY
(like the Nikkei ) vulnerable.
On the USD-JPY, a corrective phase seems underway, with a reasonable target around 99.50. The
uptrend should resume from there. we become UW and use the area 103.93-104.34 as a stop loss.

42
EUR-USD
Contrary to our past expectation, April performance has probably materialized a clean break above the
2008 downtrend.
But we still see an exhaustion pattern developing, coupled with a lack of momentum
The 1.3833 and 1.40 levels should be watched very closely. In order for our EUR bearish view to
realize, the spot should hold below the trend across the highs since Feb. 2012

43
EUR-USD
The strength of the Euro might be explained by large current account surplus and net capital (portfolio
and FDI) inflows.

44
EUR-USD
Yield differential between US and Germany implies a forex in the 1.20 – 1.25 range
The divergence is the widest since Mar. ‘13

45
US Dollar Volatility
The G10 FX 1-month implied volatility has moved very close to its cycle lows from Jun. ‘07
With weekly oscillators at their extremes, it seems reasonable to argue a base developing in 1-month
implied volatility.

46
US Dollar Volatility
G10 FX volatility appears too low when looked at within the business cycle!
Compared to the average performance of 3-month realized volatility across G10 currencies (trade-
weighted dollar) around that last four Fed tightening cycles, the present G10 FX realized volatility
shows a shocking pattern, with an astonishing undershoot of the pre-tightening norm
We are approaching the undershoot we’ve experienced in 2007 pre-Lehman.
We expect a rise in FX volatility (probably on better than expected US economic news), driving up
speculative USD positions from their lowest levels in over a year

47
Carry Strategies
Currency managers are again long EM carry trades after being short in Q1-2014 The risk
aversion on EMs has vanished
They are still flat to slightly short on G10 carry

48
COMMODITY
Investors are getting back to commodities as a portfolio diversifier. Flow data showed renewed investor
interest in the asset class.
Last month, we’ve decided to move commodities from OW to UW on the short run. We keep this
view.
Over the short run,
We remain Neutral on Energy. Crude oil prices could be threatened by a higher US production and
inventories.
We become Neutral to moderately OW on Agriculture, especially crops (Adverse weather, greater
expectations of an El Niño later this year) and remain OW premium coffee and cocoa
We switch from UW to Neutral on base metals as a certain optimism has returned to these markets
in recent weeks.
We stay UW precious metals (targeting 1180-1150 on gold and 17 and then 12.50 on silver)
because of rising real interest rates and strengthening of the dollar.
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.

49
Commodity Flows
The data for both flows and AUM suggest a rebound in prices after a particularly negative 2013.
According to Citi Research, retail and institutional commodity AUM grew 11% in the first 2 months of
the year to $375 Bln
Investors are coming back to commodities as a portfolio diversifier: $6bn in new monies flew into
the sector over Q1-2014
Commodities are taking a pole position across macro asset classes for the first time since H1-2008.

50
Copper
Pessimistic sentiment towards Chinese growth should drive copper
prices to the downside, as China is expected to account for as
much as 60% of copper demand growth.
Refined copper Chinese imports in March were soft
From our point of view, the fall in LME total stocks of copper
does not signal any surge in demand, but rather a simple
movement of metal from LME to other repositories : Estimates of
Chinese bonded warehouse stocks have risen to a record 825kt
With copper trading above $6 700, we think the risk is biased to the
downside.
:

51
Gold – Fair Value Price
Stay Bearish. Medium term technicals remain weak on precisous metals, especially Gold and Silver.
Like on Silver, the bias seems skewed to the downside. The move up we’ve seen recently is
corrective in nature as it remains below the 38.2% retrace of the drop from Oct 2012.
Our theoretical price (implied by US$, sovereign CDS and Real Rates) stands now at 1180 (as of
May 2nd ), versus a market price at 1298. Our fair price should continue its downward movement as
soon as the US$ and real rates resume their move to the upside.

52
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).
During April, Equity Market Neutral performed the best . Equity Long / Short and Macro funds performed
the worst.
YTD, the best performers are Equity Market Neutral, Convertible Arbitrage and Event-Driven. The worst
are Macro and CTAs
For several months now, we have been OW :
Equity long-short market-neutral and Convertible arbitrage. And that was a good deal.
But also on CTAs and Macro funds. And we’ve been quite wrong so far, especially on CTAs.
We keep our OW on Equity Market Neutrals.
We move Neutral on Convertible Arbitrage as most of the performance was due to high yield positions
We are now OW on Event-Driven, as M&A activity is heating up
In spite of their bad (horrible for CTA) performance YTD, we keep our OW on CTA’s and Global Macro as
a diversifier and tail hedge
We still prefer risk diversifiers to return enhancers

53
The case for Trend Followers / CTAs
Things should improve now with the return of trends and the decrease of correlations among
asset classes
After 2 years of disappointing returns (2011-2012)
and a year of mixed fortunes (2013 with high
dispersion among CTAs), trend-following strategies
are starting 2014 in bad shape.
This is clearly not enough to declare the end of glory
of the strategy. Trend-followers have seen similar
difficult times in 2003-04
During the GFC, trend followers fared well, unlike
most other alternative strategies and asset classes.
Mixed / bad performance of CTAs in 2011-2013 is
normal when we consider the difficulty in capturing
trends in an environment that remained:
driven by political intervention needed to
stabilize the financial system
Basically composed of a series of risk-on/risk-off
movements
Unfavorable to the detection and capture of
market trends

54
The case for Trend Followers / CTAs
Despite their disappointing performance, we
continue to defend CTAs as a strategy with:
competitive advantages over other assets in
the long term.
Proven capability to navigate through
different market regimes
Stable de-correlating virtue

55
Event-Driven
M&A activity has surged, naturally (at this point of the cycle) driven by:
High cash balances and healthy corporate balance sheets
The search for external growth (consolidation, expansion, acquisition) as revenues flatten
Easy funding and low credit costs

56
HF Positioning – CFTC Data
Based on CFTC data, hedge funds / large specs:
covered S&P 500 shorts and increased Russell
2000 shorts
decreased their short positions in 10-year and
2-Year
increased Gold and Silver longs but kept
Copper shorts.
decreased their Crude longs and increased
Natural Gas shorts.
decreased their EUR longs

Bottom Line: Global Asset Allocation
Low volatility is no panacea: the fall in volatility in bond, equity,
and commodity markets is eliminating caution, favoring excess risk
taking and leverage. Our view is that volatility rarely stays this low
for long
We are muddled by the divergent signals we see in the market
(High beta stocks ugly performance, outperformance in Govies
and weekness in US$ despite good economic news, equity / FX /
rate vols drifting towards all-time lows)
Is something more fundamental is going wrong in the world
economy ?
Is the market signaling concern about the economy in a post
QE world?
Many signs point to a global slowdown: China's sudden decline
in exports, downward revision to their economy's growth rate,
stalling of Europe's recovery and risk of deflation
We continue to see the main systemic risk coming from
China.
We summarize our views as follows
57

FinLight Research - Market Perspectives May 2014

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