Finlight Research | Market Perspectives - Sep 2014

Market Perspectives
September 2014
Sep. 3rd, 2014
www.finlightresearch.com
Sucked into the Draghinomics bullish vortex…

“Insanity is trying the same thing over and over again and expecting different results.”
Albert Einstein
“You can always count on Americans to do the right thing, after they've tried everything else.”
Winston Churchill
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FinLight Research | www.finlightresearch.com

Executive Summary: Global Asset Allocation
Economic news has been mixed with week consumption, but
yet strong confidence. Demand growth is far below what the US
economy is accustomed to.
Eurozone financial markets can hardly be read other than as
anticipating a triple-dip recession
Risky assets are not priced for any alternative scenario other than
the optimistic one. Current market sentiments are way too
optimistic. We do not want to be exposed to such a biased
situation..
Equity markets are near record highs, but there are warning
signals that should not be ignored. Stocks keep rising on bad
news because bad news implies more central bank stimulus, and
more cash injection.
We continue to see the main systemic risk coming from
China. China debt crisis still remains to unfold in our opinion.
We remain neutral on global equities and think earnings growth
should be the only driver of markets from here. We remain
overweight commodities (but with a dispersion in views across
the sectors as individual fundamentals matter) and underweight
credit and government bonds. We continue to bet on USD
strengthening and on a spike in the VIX
We summarize our views as follows
3

MACRO VIEW
The Good
US Q2 GDP rebound was confirmed by the second estimate. Q3 Growth seems on track for 3%.
Durable goods orders have been strong, regardless of the fact that most of that strength was due to
a surge in Boeing's aircraft orders.
Business and consumer confidence are at, or near, post-crisis highs..
Any way you look at it, the 2014 Q2 earnings season has been very positive
The Bad
The picture is worsening for the euro zone : Its strongest economy is weakening, its inflation came in
at a frighteningly low 0.3% and German consumer morale fell for the first time in 18 months
MA and IPO activity are getting close to 2007 peak levels. Stock buybacks seem to be declining
Bullish sentiment (interpreted as a contrarian indicator) has spiked again, according to the latest AAII
Sentiment Survey
Personal income and spending were below expectations. US consumption actually declined in July.
On a 3 month real growth basis, both personal income and expenditures continue to trend down
New home sales report for July was weak
The Ugly
Geopolitics remain a wild card: A war between Russia and Ukraine is by far the biggest danger.
China’s economy continues to be supported with credit and stimulus, strengthening the problem of
excess capacity and deflating the PPI. Without this support, Chinese economy will sink. China debt
crisis still remains to unfold in our opinion
Ebola epidemic is spiraling out of control…
4

There is no indication of a recession using the indicators monitored by the NBER, even during Q1-2014
The average of these 4 indicators seems to suggest that the economy is moving sideways
When adjusted for inflation, retail sales appear to be flattening since March. This is rather
5
Big Four Economic Indicators
disturbing for us.

Even capital goods orders (that exclude transportation and defense sectors) have increased by over
Growth in US nonresidential fixed investment rose 8.4% during Q2, with investment in commercial
6
The Good: Durable Goods Orders
July durable goods orders rose by 22.6% thanks mainly to a surge in aircraft orders
8% yoy.
buildings up 9.4% and equipment investment up 10.7%.
All theses figures confirm the positive trend in US growth

7
The Bad: PCE
Real personal consumption (PCE ~70% of GDP) grew at annual rate of just 2% in July.
PCE current range is 1% lower than the one that was prevailing before 2007 crisis
PCE rate of growth has been on a negative trend since Mar. ‘14

8
Eurozone Deflation Risk
Deflationary forces are proving more
persistent than previously thought,
according to ECB President Draghi, who
also said “within its mandate [the ECB] will
use all the available instruments needed to
ensure price stability over the medium
term”.
In the Eurozone, short and medium-term
inflation are plunging. 5Y5Y inflation swaps
(one of the measures used by the ECB to
gauge medium-term inflation expectations)
has already slided below 2%

According to the large gap between potential and actual GDP, Fed seems a long way from adopting a
9
Fed Policy
restrictive policy…
The Fed should keep an accommodative stance until the gap is eliminated.

10
Individual Investor’s Sentiment
According to the latest AAII Sentiment
Survey,
bullish sentiment topped 50% for the first
time since end of 2013
bearish sentiment fell below 20% for the
first time this year.
Both figures are more than one standard
deviation away from their respective historical
averages.
According to this data, there are not many
buyers left

11
Individual Investor’s Sentiment
The “herd mentality is in action…
Individual investors’ exposure to stocks is the
highest since 2007. Cash reserves are the
lowest!
As stocks are hitting record highs, the level of
cash held by mutual fund managers is also
hitting record lows (3% of assets in June,
according to Ned Davis Research). This is
lower than previous market tops in 2000 and
2007

12
Consumer Sentiment
Michigan Consumer Sentiment for August came in at 82.5.
The Conference Board Index is reflecting the same optimistic mood…

The pattern of the NFIB Business Optimism (capturing the mood of small business owners) Index looks
13
Business Sentiment
similar to the Michigan Index.

14
Any Financial Stress?
There is no stress at all within the system!

15
GS – Global Leading Indicator (GLI)
Little improvement since last
month. The Aug. GLI came in at
3.1%yoy, flat from last month.
Momentum increased to
0.29%mom from last month’s
reading of 0.25%mom.
GLI places now the global
industrial cycle clearly in the
‘Expansion’ phase (defined by
positive and increasing momentum)
but close to border with
‘Slowdown’.
6 of the 10 underlying components
improved in August
We continue to think that the
current acceleration remains
quite modest for a typical
expansion phase.

16
US GDP
The second estimate of Q2-2014 US GDP
was announced at 4.2%, confirming the
weather-related rebound . This is a good
number but still leaves the first half of
the year hardly better than 1%.
In our view, reaching 2% is still a
challenging target for 2014
The increase in Q2 real GDP is mainly due
to positive contributions from PCE and
private inventory investment,

Current GDP is far from filling the gap the financial crisis opened below the pre-crisis trend.
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Current GDP vs Pre-crisis Trend
This gap is still widening…
U.S., like Eurozone, real GDP stands 15% below the pre-crisis trend.

According to Capital Economics, the latest Chinese data suggest a significant loss of momentum in
18
Chinese Economy
China's economic growth coming into Q3.
Growth in electricity output seems to point to a deceleration in industrial activity.

China’s housing market has reached a top at the end of 2013 and, since then, has been going down
19
Chinese Economy
at an accelerating pace.
In July, home prices fell in 64 of the 70 cities the Chinese government tracks

20
Chinese Economy
Another sign of weakening fundamentals
is the SHIBOR interest rate curve.
The curve has become inverted while
declining in level.

Last month, we had argued that the correction of late July was the beginning of a typical technical
correction with modest fundamental support, and that a fast rebound should follow unless medium-term
The dip of last July / early August was recovered and the SP500 closed above 2000 for the first time
Weak economic outlook is offset by good company earnings (especially in the US), lower bond yields
We stick, however, with our view that risk-reward trade-off points to a more cautious approach
We remain Neutral equities. Our prop. trading model is now short targeting 1947 with a stoploss
at 2021. 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 keep our UW
on Europe vs. US. We remain neutral to UW on Japan.
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EQUITY
supports were broken.
ever this week. Big gains in US and European stocks came on hopes for new ECB stimulus.
and lower risk premia.
to the equity markets, at least tactically on the near term.
We continue to think that any further upside on the SP 500 should be driven by earnings
growth rather than P/E expansion. But the return potential for equity markets looks corrupted by
limited room for valuation and margin expansion.
Given the point in the credit cycle, we favor equities over corporate bonds.
Bottom line :

We made the losing bet of underweighting EM stocks since early 2014. Since then, and after
Tactically, we are now positive again on EM equities, as the EM cycle continues to strengthen.
We like Brazil (fueled by the prospect of political reforms) and India. We remain bearish on China
despite the recent rebound in stocks, as recent cyclical data have been mixed (July credit and
August manufacturing PMI)
We favor an UW in US small caps vs large caps because of the relative expensiveness of the
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EQUITY
having spent 2013 in the red, the MSCI EM Index has gained 8.5%
former. We are aware that the momentum is currently against us.

The Q2 earnings season is over. Per FactSet, earnings grew at 7.7% yoy and sales grew 4.5%
Earnings growth rate for the SP 500 was 7.7% in Q2. Combined with the 2.1% growth rate for
Q1, that averages out to less than 5% for the first half of 2014. We expect around 7% growth for
2014 in full. Thus, SP 500 is trading today at 17.4 times 2014 expected earnings.
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US Equity - Earnings
Any way you look at it, the Q2 earnings season has been very positive
Sustaining 7% earnings growth when sales growth is just 4.5% requires more margins.
Source: Factset

24
US Equity - Earnings
Peaking earnings does a good job at predicting market peaks
Are earnings near a peak? Only time will tell…

25
SP500 Technicals
The SP500 is currently testing
the very important psychological
2000 level.
The ability of the index to
continue its upside trend will
depend greatly on the price
action around this major pivot.
Just keep in mind that the last
move up was mainly driven by
the BCE dovish statement.
The market looks stretched but
bullish sentiment may drive
higher on no/bad news!
On the downside, only a clean
break of the Nov. ‘12 uptrend
may change the global
(constructive) picture.

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Trading Model - SPX
Our prop. Short-Term trading model went short on Aug. 18th at 1971.74 on the index
The model targets 1941 - 1903 and stops its losses at 2021

27
Emerging Markets
EM stocks are just recovering from the
losses they experienced since early 2013.
MSCI EM Index is up 8.5% YTD after
having spent 2013 in the red
We expect EM equities to keep pace with
DM equities (including US equities) and
probably to outperform as they are
supported by strengthening growth and
supportive financial conditions
The downside risk on this view is linked to
China’s cycle and global risk appetite. EM
stocks are usually the first to suffer a
pullback when conditions get less friendly.
Tactically (for one or so), we are positive
again on EM equities

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FIXED INCOME CREDIT
We stay underweight on government bonds. We keep our short positioning on UST and expect
10-year yields to reach 2.90%-3.20% over next months, because of sustained US growth, increasing
US inflation. Only a material weekly/monthly close below the 2.40-2.30 range could make us change
our mind.
A sell-off in Govies will, in our view, induce a sell-off in equities.
We continue to OW Eurozone vs. US and UK given continued policy divergence and BCE action.
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.
We remain neutral Peripheral vs Core as we see lasting spread compression to be very limited.
Our view on TIPS breakevens is unchanged. We remain bullish on them and keep our 5y-TIPS
breakeven wideners.
Over 12 month horizon, we expect 10Y HICP swaps to move up 20-40 bps. Thus, we go long 10Y
Euro HICP inflation swaps
As a tail hedge, we keep our 10y bund swap spread receiver swap

29
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
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
Spreads are now so tight that carry and additional spread compression is not enough to compensate for
the rise we expect in government yields (especially in the US). Despite this risk (which normally has a
bigger relative impact on IG then on HY), we continue to prefer IG over HY on a risk-adjusted basis
Intra credit, we keep our Neutral stance between the US and Europe. European credit has the
potential to outperform its US counterparty. But the tail risk of systemic shocks in European financials is
too big to be ignored.
Bottom line : Still UW Govies, UW credit, OW TIPS and HICP Inflation, UW High Yield vs High Grade

30
FIXED INCOME CREDIT
This has been a minor move higher in spreads thus far, but as credit typically leads, one that
should not be ignored.
We also like emerging market high yield corporates because they have relatively strong balance
sheets and low expected default rates. Inflows into emerging market bond funds have also been
positive, therefore generating positive price momentum for this asset class.
Weak growth, low inflation, and easy money have all been very supportive for yield seeking strategies.
We favor seeking extra yield in the higher-yielding government bond markets, both outright and as a
spread to core markets: periphery Euro area, Australia, New Zealand, and Brazil). These are followed
by select FX carry positions in EM, earning roll in energy futures
Our caution on credit is that spreads are already near past cycle lows and credit tends not to perform
well in later stages of the cycles as corporates then typically start re-levering their balance sheets

31
US Yields
The long-term trend for
10y UST yield remains
clearly to the downside.
But we detect signs of a
trend exhaustion.
10y UST yield stands at a
major support and should
bounce higher from this
point
We keep our UW on UST
for the moment. Only a
material weekly/monthly
close below the 2.40-2.30
range could make us
change our mind.

32
German Yields
The 10y German yield
has broken below its
prior cycle lows, without
showing any base
formation.
The downtrend should
continue over the short
term.

33
Euro HICP inflation
Given last Draghi’s statement and potential BCE QE next year, we think that Eurozone headline
inflation has reached a trough in Aug. at 0.3%
Over 12 month horizon, we expect 10Y HICP swaps to move up 20-40 bps. Open long
position in 10Y Euro HICP inflation swaps
EUR HICP Inflation Swap EUR HICP Inflation Swap
Source: Bloomberg

34
High Yield
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 our weak total return forecast
Spreads are now so tight that carry and additional spread compression is not enough to compensate
for the rise we expect in government yields (especially in the US). Despite this risk (which normally has
a bigger relative impact on IG then on HY), we continue to prefer IG over HY on a risk-adjusted
basis
Euro HY IG Total Return
Euro HY Total Return by Rating

35
High Yield – Monitoring Ratings and Default
On an issuer base, rolling twelve-month default rate is bottoming
In the same time, upgrade to downgrade ratio seems to be bouncing. We should keep an eye on this
ratio to detect the relapse we expect given the point where we stand within the credit cycle.

36
High Yield – Issuance
Easy access to credit has a tendency to increase
defaults
The global picture is driven by the search for yield.
Investors are moving down in quality and
accepting less protective convenants.
Convenant-lite loan new-issue volume ($Bln)

37
EXCHANGE RATES
The US dollar is broadly higher against the major and emerging market currencies, mainly driven by the
divergence between the US on one hand and the euro area and Japan on the other
We continue to expect the USD to strengthen against the major crosses.
The ECB’s dovish rhetoric and action should gradually drive the Euro weaker. US GDP surge to 4.2% in
Q2 gave another sign that the US and Eurozone economy are diverging. The EUR-USD underlying
structure looks very negative.
On EUR-USD, we remain UW and continue to target 1.31 - 1.28 and ultimately 1.25 – 1.23
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, after a consolidation phase during which we moved from UW to Neutral (please see
our previous report), we switched from Neutral to OW with 105.45 as a target. (please see our
previous report). As we are close to the target, we keep our OW position but set a close stoploss at
104.84 and wait for a clear break above the big monthly pivot at 105.6 (that stands on the primary
downtrend from 98)
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

38
EUR-USD
The string of weak
activity data in the Euro
area is clearly weighing
on BCE and EUR
Over the short term,
EUR-USD seems to be
close to a first support at
1.3105 – 1.3115, on
which we may take some
profit on our previous
short views.
Breaking this level
should bring EUR-USD
to 1.28, our next target.
Over the long term, the
picture remains very
skewed towards 1.23

39
USD-JPY
A set of disappointing data
recently released for July has
reinforced the doubts about
Abenomics economic impact.
Additional easing should be
negative for JPY.
Last month, we saw USD-JPY
breaking higher through
a triangle consolidation
pattern and set 105.45
(January high) as a
reasonable short-term target.
As we are close to the target,
we keep our OW position but
set a close stoploss at 104.84
We still wait for a clear break
above the big monthly pivot
at 105.6 (that stands on the
primary downtrend from 98)

40
COMMODITY
We have been OW commodities since end of June, with a preference for energy and base metals and an
UW on agriculture and precious metals. Unfortunately, commodities are down another 1.6% over August
(and a substantial -6.8% QTD : from Jun.30 to Aug. 29) led lower by energy (-7.5% QTD) and agriculture
(-9.4% QTD). Our tilted position has made money vs. the benchmark because our losing bet on
energy was counterbalanced by our UW on agri, and because we were also UW Precious metals (-3.3%
QTD) and OW Industrial Metals (+3.5% QTD)
We continue to like owning the GSCI energy index. Prices have fallen too far in our view
We continue 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 maintain most of our previous views: OW on energy (on geopolitical tensions), favoring
commodity futures with steep backwardation (for positive carry). We also remained UW on
agriculture (except on premium coffee and cocoa) and precious metals.
We become UW on base metals as Chinese manufacturing PMI has now fallen for two months in a row.
Within the industrial metals complex, we prefer Zink, Nickel and Aluminium to copper and Iron Ore,

41
COMMODITY
We choose to keep our OW bias on energy (especially crude oil) for strong roll and as a hedge for
geopolitical risk in Ukraine and Middle-East, as well as supply risk in Lybia.
.Among base metals, we still prefer Aluminium, Zinc and Nickel as these metals suffer from a low
supply growth following years of underinvestment
Over the second half of 2014, we continue to 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
SP500 and the US dollar move higher. We expect precious metals to resume their downward trend
(targeting 1170-1150 on gold and 17 and eventually 12.50 on silver)
Among base metals, Copper is expected to underperform sharply over a 3-12m horizon, due to
sluggish demand growth, especially by the construction sector in China. We target 6400 (Q3-2014),
and ultimately 6000.

42
Market Sentiment
Accourding to SentimentTrader, market sentiment is at “excessive pessimism” level.
If history is any guide, commodities should bounce from this point
Source: Sentimenttrader

43
Gold
The weak gold demand from China and
India and strong dollar are weighing on
gold prices, On the other hand,
geopolitical events, and gold buying by
central banks are still supporting them.
At this stage, the risk is still biased to the
downside. Our model favor another low
(around 1050-1150) before reaching a
multi-year bottom.
We remain bearish on gold and silver,
but aware that if the situation in Middle-
East or Ukraine deteriorates then gold
prices may break to the upside (above
1350-1400). Under 1170-1150, we start to
accumulate gold, even if an eventual
retracement towards 1000 looks possible
Technically speaking, it’s a matter of
weeks before we see the final
resolution (up or down)

44
Gold Miners
Most of gold miners
underperformance vs. gold
(the commodity) since early
2012 could be explained by
delays in new projects and
cost overruns.
Given the new focus of
CEOs on containing costs
and correctly assessing /
boosting profitability, we
think that gold miners
could outperform gold
going forward, but still wait
for a bounce in gold prices
(after a last leg down) before
betting on that
outperformance.

45
VOLATILITY
We stick to the view that volatility is
bottoming after months of historical lows
through improving economic outlooks. We still
expect an upward pressure on vol over the
coming months, with rising inflation volatility,
rising earnings volatility and increasing default
rates and macro surprises
The rise in implied volatilities we’ve seen in
July has reversed in August, especially on
equities and credit. It was more technical than
fondamental.
On average, implied vols across the 5 asset
classes has fallen to historical lows. But
realized vols has fallen even more making
it very unattractive to be long vol.
Buying hedge funds with volatility positive
positioning is probably the solution

46
ALTERNATIVE STRATEGIES
As markets recouped their losses of early August, Hedge Funds which are overall long risk, recovered
from their previous difficult months.
Long Term CTAs were among the best performers during the month as they made money out of their
long equities, long rates, short energy and short EUR/USD.
Things were more mixed for Global Macro which suffered from long energy positions and made
money from directional trades in the Yen and the Euro
Market Neutral recovered strongly thanks to both positive beta and alpha contribution. They made
gains across factor-based models as well as fundamental and trading oriented strategies, according
to HFRX indices.
Within the Vol. Arb. Universe, the picture was mixed: Only funds with short positioning on volatility
made money.
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.
We keep our Neutral stance on Event-Driven, as MA activity is calming down, volatility is likely to
bounce, and geopolitics are threatening…

47
Event Driven
Event Driven strategies have been the best performing strategy over the last 12 months.
37% of investors surveyed by Preqin in July 2014 stated that Event Driven performance over the
previous 12 months has exceed expectations.
We think that MA activity is calming down. Deals withdrawn or terminated are increasing…
Hedge Fund Strategies Sought by
Investors over next 12 Months

48
Global Macro
In term of performance, global macro
strategies are ahead of where they
were in 2013. Macro was the best
performing strategy in Q2 2014. The
last time it did that was in Q3 2011.
Like CTAs, Macro strategies funds
have clearly failed to meet the
expectations of institutional
investors, with 48% of investors
(Preqin Survey) saying that this
strategy had disappointed.
Nevertheless, we like Global Macro
for their lower volatility, lower
correlation to equity markets, and
their proved ability to mitigate losses
should the tides turn in equity
markets. It’s well known that Macro
hedge funds deliver higher Sharpe
ratios during recessions than any
other hedge fund strategy.
Hedge Fund Portfolio Performance Relative to Expectations
over the last 12 Months by Strategy

49
CTA
CTAs has reduced their exposure to European
equities
CTAs have been also reducing their net
exposure to Energy since June. This move
was beneficial for the performance over
August.

Bottom Line: Global Asset Allocation
Economic news has been mixed with week consumption, but
yet strong confidence. Demand growth is far below what the US
economy is accustomed to.
Eurozone financial markets can hardly be read other than as
anticipating a triple-dip recession
Risky assets are not priced for any alternative scenario other than
the optimistic one. Current market sentiments are way too
optimistic. We do not want to be exposed to such a biased
situation..
Equity markets are near record highs, but there are warning
signals that should not be ignored. Stocks keep rising on bad
news because bad news implies more central bank stimulus, and
more cash injection.
We continue to see the main systemic risk coming from
China. China debt crisis still remains to unfold in our opinion.
We remain neutral on global equities and think earnings growth
should be the only driver of markets from here. We remain
overweight commodities (but with a dispersion in views across
the sectors as individual fundamentals matter) and underweight
credit and government bonds. We continue to bet on USD
strengthening and on a spike in the VIX
We summarize our views as follows
50

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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…
FinLight Research is a research-centric company focused on Asset Allocation from a top-down
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).
Private equity and venture capital should be the next step…
Allocation with a factorial approach built on the understanding (profiling) of the risk/return drivers of
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FinLight Research is an innovation-oriented company. We target to fill the gap between the
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quantitative investing, non-linear profiling, asset allocation, real assets...
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