Top ideas

Just Fade It
5/16/2017
Teddy Vallee
Tv@pervalle.com
917-797-5018
The views expressed below are my own and do not reflect that of my employer.

Teddy Vallee| 917-797-5018| Tv@pervalle.com 2
 The market continues to misprice the strength of the US consumer due to the misleading nature of the unemployment rate, which fails to capture those that have left
the labor force. We can see this by backing into the current unemployment rate given average weekly earnings and discretionary consumption, as it indicates the real
rate is closer to 6-7% versus the quoted rate of 4.3% today. That said, we see participants changing their optimistic views in the back half of the year, as the breadth
of the labor market is indicating non-farm payrolls will turn negative in the next 6-8 months. (p.9)
 The focus on falling unemployment has overshadowed the rising signs of consumer stress that have historically preceded consumption downturns. Based on our
leading indicators below, we should see credit card and auto delinquencies continue to rise over the next year. This will adversely affect consumption, as credit
expansion has been one of the primary drivers of retail sales and the key funding source of rising core expenses [shelter, health care, financial services]. (p.13-16)
 There is evidence that the recent industrial and commodity rebound was a result of China’s large scale stimulus efforts from June 2015 – June 2016 [~$4.3T in credit
creation]. This led to a rally in commodities, which in turn drove the US industrial economy higher, along with the ISM. (p. 21-23) Given that China’s credit creation
leads the economic data by 7-8 months, we should see a swift move lower in commodities and the ISM into years end.
 Technically, we are beginning to see signs of weakness, as the percentage of stocks below their 50 and 200 day moving averages have diverged from price near all-
time highs. (p. 31-32)This is at a time when excess liquidity - or the dollars freely able to move into markets - has turned lower and participants are positioned
aggressively long. In addition, we have also seen multiple upside Demark exhaustions across the broader indices, as well as the top 10 performance constituents of
the S&P, indicating the probabilities favor a move to the downside.
 Given the thesis outlined below, there are four trades that are actionable today:
1) Sell S&Ps [S&P 500]
2) Buy TLT [Barclays 20+ Year Treasury Bond]
3) Sell XRT [ S&P Retail ETF]
4) Sell DBB [Powershares Base Metals ETF]
Overview
PERVALLE

The True Rate of Unemployment

4
The unemployment rate, while a lagging indicator, has historically provided a reliable
read on the state of the US economy. Today, the rate stands at 4.4%, a level that is
consistent with a tight labor market and wage growth. At face value, this thesis seems
to be true, but digging deeper it is apparent it is flawed.
This point can be illustrated by the historical relationship between the employment-to-
population ratio and the unemployment rate, shown below. Since 1976, the two have
been strongly correlated, however this broke in 2011. The divergence can primarily be
attributed to those that have left the labor force, as these individuals are no longer
counted in the unemployment rate, which in turn drives the dark blue line lower, while
those employed remains constant.
The street has attributed the deviation to retiring baby boomers, and while not
entirely false, the chart below provides an alternative view – that is, a material
portion of those that have left the labor force are part of the working age
population (25-54), while those over 55 (baby boomers) are unchanged.
This is likely due to the lack of job opportunities following the crisis, which
forced the younger graduating generations to remain with their families.
Teddy Vallee| 917-797-5018| Tv@pervalle.com
PERVALLE
Source: Pervalle, BLS

5
That said, the lack of wage growth following the crisis favors the labor market
having materially more slack than what participants currently believe.
We can see this below by the percentage of 25-34 year olds living with their parents,
which increased materially since 2008.
If we assume that the street is correct in that the divergence is solely due to the
baby boomers leaving the work force, we must then bring down forward growth
estimates, as a retiree spends 25% less than a working individual according to
Wells Fargo, shown below.
This was recently confirmed in a report from the US Census Bureau finding that 25%
of the millennial population (2.2mm) are neither enrolled in school nor working.
Given the material trend higher in core living expenses, it is also very likely that a
large portion of the 25-34 year old's [that are working] are living at home due to cash
flow deficits.
PERVALLE
Source: Pervalle, Census Bureau

6
The lack of wage growth is not apparent by looking at the headline average
hourly earnings (AHE) rate, as it is currently moving from the lower left to the
upper right, as shown the far right chart below.
And while the assertion that the chart is moving higher is correct, the
premise that it is due to tightness in the labor market is false due to a
misinterpretation of AHE, which is not a payment for a given unit of work or
time, but a derived ratio from two separate BLS surveys.
The survey is based on two principal inputs:
1) Average weekly earnings – which is the aggregate amount of total weekly
payments from an employer to its employees; and
2) Average weekly hours – the total amount of hours that employers are
reporting employees are working
The Misconception of Average Hourly Earnings
From this calculation, the most relevant number is aggregate pay, shown
below in the bottom left chart, as it is the total amount of income to
consumers.
Hours are relevant in the sense that it gives an indication of labor demand,
but when used together, it materially distorts the picture.
For example, holding aggregate pay (AWE) constant, declining hours result in
rising AHE, but employees are not making more, as it is not a payment for a
given unit of time or work, but a derived ratio.
This is what we are seeing today as average weekly earnings growth has
been flat, while hours recently have declined, leading to growth in average
hourly earnings.
PERVALLE

7
This point can be illustrated by the negative correlation between average
hourly earnings (-40%) and retail sales ex autos and gas, shown below. This is
to say that as consumers make more per hour, they consume less.
Referring to the primary driver – average weekly earnings – we find there is a
48% positive correlation to retail sales, shown below.
(8.00%)
(6.00%)
(4.00%)
(2.00%)
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
01/31/199401/31/199701/31/200001/31/200301/31/200601/30/200901/31/201201/30/2015
Retail Sales Versus Average Hourly Earnings
Series1
PERVALLE
Source: Pervalle, BLS, Census Bureau Source: Pervalle, BLS, Census Bureau

8
Given the data, it is evident that the labor force is not as strong as participants
believe, which is also apparent across alternative measures such as the year on
year change in job openings and hires, both of which are rolling over.
So while average hourly earnings have been rising, leading to policy tightening,
average weekly earnings – the primary driver of consumption – have essentially
been flat. This is consistent with greater amounts of labor market slack and is
further supported by historical precedents.
For example, since 1960 when the unemployment rate touched 4.7% (seen in May
2016), the next 11 months saw average weekly earnings growth of 4.1%, as shown
below.
Over the past 11 months, AWE rose at an average pace of 2%, or a 45% discount to
the prior three periods. If we were to back into the current unemployment rate
given AWE, it would imply the rate stands around 6.1% which closes the gap on
the employment-to-population ratio shown on slide 4.
Given the recent softening, there is a strong probability that the labor market
deteriorates further over the next eight months, outlined below.
PERVALLE
Source: Pervalle, BEA

9
Participants see non-farm payrolls (NFP) continuing to grow, which under the
assumption that the labor market is tight, will lead to higher wages. This is quite
optimistic given current labor market trends, which favor an appreciable move
lower in both income and NFP over the next 6-8 months, shown via labor market
breadth (LMB) in the chart below.
Labor Market Breadth
LMB is a proprietary indicator that captures labor market momentum via non-farm
payrolls. Historically, it has had a strong hit rate and is currently indicating that wages
and salaries should roll over the next 6-8 months.
This will also adversely affect non-farm payroll growth, which should continue to
roll, adding to the current levels of slack.
PERVALLE
Source: Pervalle, BLS Source: Pervalle, BLS

10
We are already beginning to see this weakness across an array of industries, as shown below.
PERVALLE

11
That said, durable and non durable goods have both recently bounced along with
manufacturing.
With finance and real estate job growth holding its current pace. However, it is
likely that these categories slow as the industrial rebound fades, and consumer
weakness weighs (outlined below).
PERVALLE

The US Consumer

13
Over the past six years, the consumer has faced material increases in core
expenses such as health care, financial services & insurance, taxes, and housing.
This has led to a contraction in the consumer cash flow margin [Personal income –
core expenses/personal income], as it has fallen from 46.5% in 2013 to 44% today,
shown below.
The US Consumer
We can see this financing relationship below via the consumer margin and
revolving credit growth (inverse). This is to say that as core expenses grow,
consumers finance current consumption [or the cost increase] with credit
and pay down outstanding balances to repair balance sheets as margins
move higher.
Historically, the consumer margin has been a very good leading indicator of
retail sales over the longer term; however, the initial downturn is not
actionable as margin compression is financed with short term debt.
PERVALLE
Note: the large spike (divergence) in 2013 was due to one time dividends prior to tax hikes.
Source: Pervalle, BEA
Source: Pervalle, BEA, Federal Reserve

14
This can also be illustrated by the dollar spread between revolving credit and
retail sales versus the consumer margin(inv), i.e. as core expenses increase
consumers expand credit to cover costs, which fails to find its way into retail
spending.
And while revolving credit has been the primary source of funding for a large
group of consumers squeezed by higher health care and rental expenses
(86% of margin dilution), there are indications that this is turning as well.
For example, the percentage of domestic banks tightening credit standards
for credit card loans has been moving higher, which has previously pressured
delinquencies.
PERVALLE
The Stressed Consumer
Source: Pervalle, Census Bureau, BEA, Federal Reserve
Source: Pervalle, Federal Reserve

15
And the probabilities favor a continued rise, as shown by the leading delinquency
indicator below.
This has recently shown up in the 30 day delinquency rates of the largest credit
providers, which has historically given us a directional lead on retail sales. It is
important to note that once delinquencies turn, they typically trend in that direction
for 2-3 years.
Note: The Y/Y change in delinquencies is off a much lower base than in the past, so the divergence has the possibility to
play out over a few more months.
PERVALLE
Source: Pervalle, Bloomberg, Census Bureau Source: Pervalle, Federal Reserve

16
The auto market has also seen a material uptick in delinquencies over the past year,
as levels approach prior highs both in prime and subprime. This is weighing on auto
sales, which in April came in at a seasonally adjusted annual rate of 16.88mm, down
5% y/y to the lowest level in 29 months.
This softness may be the driver behind the recent drop in gasoline demand,
which as shown below has historically been a leading indicator of discretionary
consumption.
PERVALLE
Source: Pervalle, BEA, EIA

17
With auto rates subdued, gas prices low, and incentives nearing historical highs
(below), the lack of auto demand is likely a function of an exhausted consumer,
as she is no longer able to expand expenses or credit, leading to a rise in
delinquencies.
We are beginning to see this show up on the consumption side, with food service
and drinking places – a discretionary item to the consumer – recently moving
lower.
PERVALLE
This was recently confirmed by the senior loan officer survey, as demand for
credit cards and auto loans fell 10% and 13.3% y/y to the lowest levels since 2011
when the data became available.
Source: Pervalle, Census Bureau
Source: Goldman Sachs

18
As well as clothing and footwear. In total, recent consumer weakness led to only 30 BPS of GDP growth from
consumption (70% of GDP) in the first quarter, the smallest amount since 2009.
PERVALLE
Source: Pervalle, Census Bureau Source: Pervalle, BEA

19
There are a few additional leading indicators that are also pointing to a move
lower in consumer spend. For example, building permits are indicating that retail
sales will disappoint from now until the end of FY17.
From a longer term perspective, consumer margins are also pointing to a move
lower over the next few years, as short term financing becomes more scarce and
cash flow is pulled from consumption to repair balance sheets.
Building permits provide a good forward indication of consumption given nearly
all subcomponents of retail sales find their way into households – furniture,
building materials, general merchandise, clothes, etc. Therefore, greater permits
to build results in increased demand upon completion in the future, and vice
versa.
PERVALLE
Source: Pervalle, Census Bureau Source: Pervalle, Census Bureau, BEA

Market Divergence and China

21
Market Divergence
Based on the prior information, the probabilities favor an economic slowdown
through the end of FY17. This is currently not priced into the US equity
markets at all time highs, with valuations across an array of metrics in their
98th and 100th historical percentiles.
Looking at forward estimates, it is evident that the market is optimistic about
growth, which has given participants some justification for current valuations.
That said, visualizing the next 6-18 months relative to what is priced in, it is
appears the market is offsides.
This divergence is the result of a few factors that have progressively built on
each other, such as the inaccurate reading of the consumer; but at the core is
China.
______
In June 2015, in response to slowing domestic growth, the Chinese enacted a
$4.3T (39% of GDP) stimulus program that lasted roughly one year.
The market missed this due to the focus on total social financing, which fails
to include credit to non-bank financial institutions and local government bond
issuance – where the majority of the growth came from.
Given that the Chinese economy is industrially driven, the policy choice led to
increased demand for commodities, which began to take shape in February of
2016.
We can see this below by the relationship between credit creation and Bloomberg’s
commodity index.
PERVALLE
Source: Pervalle, Bloomberg

22
The expansion had a notable effect on the price of crude, as shown in the chart
below, which was then further aided in November by OPEC’s decision to cut
production by 1.2mm bbls/day.
And given that crude has a very strong correlation with the ISM, its recent move
higher has led participants to believe the US industrial economy is rebounding.
Chinese Credit Creation
PERVALLE
Source: Pervalle, Bloomberg Source: Pervalle, Bloomberg

23
However, this is set to fade over the next 7 months, as the stimulus that drove the
transitory US rebound, fades.
We are beginning to see early signs of this in commodity prices, which recently have
pulled back from their highs, in line with the y/y credit effects.
Chinese Credit Creation
PERVALLE
Source: Pervalle, Bloomberg, Federal Reserve Source: Pervalle, Bloomberg

24
Divergence
And this is now coming through the economic data, as estimates miss
their mark.
The probabilities favor this fading over the next 6-8 months as the labor market follows its
declining breadth, leading to lower job and wage prospects, and in turn a reduction in
consumption.
That said, the industrial rebound provided participants evidence that the economy
was rebounding, which was further supported by the election of President Trump, as
it sent consumer confidence to the highest levels since the end of 2000.
PERVALLE
Source: Pervalle, Factset

25
That said, participants see the move in consumer confidence and positive expectations
as a catalyst for higher consumption given that there has historically been a strong
relationship; but so far this has failed to manifest.
Digging into the data, it is evident that consumers are very optimistic about the
future, as business conditions, employment, and income 6 months hence all
move materially to the upside.
Consumer Confidence
PERVALLE
Source: Pervalle, Factset, Census Bureau Source: Pervalle, Factset

26
We are also seeing an exceptionally strong move from the 55+ cohort, who tend
to be Trump supporters, and as previously illustrated spend less than the
working age population, which may be another reason for the divergence.
However, the mainstream media may have something to do with the exuberance,
as ‘the percentage of respondents providing unsolicited favorable comments on
news heard about government economic policies’, makes an unprecedented move
higher.
Therefore, what consumers are listening to and reading may be the driver behind
their perception of future job prospects, business conditions, and income rather
than their own view, causing the divergence between thought and action.
Consumer Confidence
PERVALLE

27
Other data confirms that the gains have primarily been republican based. With those regions that voted for President Trump producing the largest
increases in consumer sentiment.
Consumer Confidence
PERVALLE

28
While participants are looking for higher consumption growth due to the soft
data, the forward indicators previously referenced favor the US economy
slowing through the end of FY17. This is currently not recognized by the market
due to:
• The industrial rebound providing a short term boost to both growth and
sentiment
• Which was then extrapolated and reinforced by rising consumer confidence
due to the President’s economic agenda of material tax cuts and a large scale
infrastructure project.
While both are very probable, the extent to which they get completed is likely
much smaller than what the market is pricing in due to the probabilities favoring
an economic slowdown.
For example, for tax cuts to be revenue neutral or positive, the cut must spur a
degree of economic growth that covers the tax differential. Under the
assumption that the economy slows into year end, the lower rate of growth will
fail to cover the missing revenue in the absolute. So from a budgetary
prospective, slowing growth will hinder substantial tax cuts, which will also likely
increase the deficit.
If this scenario manifests, passing a large scale infrastructure project with an
expanding budget deficit is even less likely - especially given that it currently
stands at 3.2% of GDP.
In addition, the political divide in Washington, as shown by the partisan conflict
index, further reduces the probabilities of passing both a full scale cut and
infrastructure project.
Divergence
PERVALLE

29
What Is The Market Pricing In?
These estimates do not seem probable given the scenario outlined above.
For example, should the labor market and economy material slow over the
next few months, the probabilities favor the Federal Reserve not continuing
its hiking trajectory, which will lead to lower rates and bank profits.
The same is true for crude EPS, which are estimated to grow 296% y/y,
while the average price is only 3.7% higher than 2016. Given the
correlation between Chinese credit creation and crude, the case can be
made that this too will continued to be pressured over the next few
months.
The market however is optimistic on both tax cuts and forward growth, as
illustrated below by Goldman’s estimates of a 15% corporate tax cut leading to
$2,400 on the S&P 500, essentially the level of we closed at today 5/16. This
leaves little room for error and favors downside risk given the scenario outlined
above.
The same is true for FY17 estimates, which are forecasted to come in at $130/
share, up roughly 10% year on year. This is driven by:
1) Financials (+23% of total growth)
2) Energy (+31%)
3) And Information technology (+21%)
Which all together account for 75% of the total gain.
PERVALLE

The Technicals

31
On the technical side, we are beginning to see some weakness, as market
breadth – measured by the percentage of S&P 500 stocks above their 50 day –
rolls over, while the index makes a new high.
The divergence is a result of several names that have had a continuous bid. For
example, 10 stocks have contributed to 46% of YTD gains in the S&P, as shown
below.
Technicals
PERVALLE
Source: Stockcharts.com Source: Goldman Sachs

32
However, this cohort recently had an upside Demark exhaustion – which puts the
probabilities in favor of the leaders following the soldiers lower. (Courtesy of
Tommy Thornton of Hedge Fund Telemetry)
Technicals
PERVALLE
With the market recently having an upside Demark exhaustion as well.
Source: Hedge Fund Telemetry Source: Hedge Fund Telemetry

33
When matched up against leading indicators, we can see that the probabilities
also favor the S&P 500 moving lower, as shown below by credit card
delinquencies.
Labor market breadth is indicating the same thing, with a similar divergence to
the end of 2007.
Technicals
PERVALLE
Source: Pervalle, Bloomberg Source: Pervalle, BLS

34
And given that the ISM has historically had a very strong correlation with the S&P
500.
It is likely the market heads lower, as the primarily driver of the ISM –
China’s credit creation – has rolled.
Technicals
PERVALLE
Source: Pervalle, Factset Source: Pervalle, Bloomberg

35
With auto sales indicating the same thing. Along with iron ore, which over the past year has led nearly every sell off in the S&P,
likely due to fears of a Chinese slowdown, which will likely re-manifest in the near term.
Technicals
PERVALLE

36
Liquidity
In addition to these indicators, we are seeing excess liquidity, or dollars freely available
to move into markets, turn lower, which reduces support for asset prices should the
market begin to move to the downside. Excess liquidity has historically led the S&P by
~14 months.
This is also the case for corporations as buybacks slow, which per Ray Dalio’s
comments last year make up ~70% of the current bid. Yardini illustrates this
below, and while the data from Q1 has not concluded, the initial readings from
Q1 are down 24% y/y.
PERVALLE
Source: Pervalle, Bloomberg, BLS

37
This trend will likely continue as buyback announcements slow.
With positioning over the past year at highs based on Goldman’s sentiment
indicator.
Which increases the probabilities of a downward move in the S&P, as buyers have
already bought.
Source: Floating Path
Liquidity and Positioning
PERVALLE

38
As well as individual cash balances.Resulting in the lowest short interest of the SPY ETF since 2007.
And a reduction in fund manager cash balances.
Leading to one of the largest spikes on record of the percentage of institutional
and retail investors expecting positive returns for the year ahead.
Liquidity and Positioning
PERVALLE
H/t: Urban Carmel

39
And given the lack of fear, as well as the search for yield, participants have begun
to sell protection, driving the VIX to its lowest levels since 1993. This has resulted
in 95% of VIX ETF (VXX) float being sold short per a recent RBC report.
This situation is very ominous given the rise of risk parity funds, which seek to
allocate capital based on volatility. As participants sell volatility, thus driving the
VIX lower, parity funds in turn increase their risk to equities. With the VIX
currently at its lowest level since 1993, a sharp rise in volatility could lead to
forced selling, at a time when liquidity is drying up and participants are
positioned very long.
Volatility
PERVALLE
In addition, investors have materially reduced protection for a sharp fall in the
next three months.
We have also seen this on the institutional side, as roughly 20% of risk premia
strategies are allocated towards selling volatility, with pension funds also
entering this area, by selling puts on the S&P, in turn putting downward pressure
on the VIX.

The Trades

41
 Given the longer term thesis presented above, the highest
probability trade over the next 6-8 months is to sell S&Ps,
with a stop around $2,430 for ~ 1.2% risk. The downside
potential on this trade is ~ 21%, for a risk reward of 17.5/1.
 On the aggressive side, the $235/205 SPY September put
spread for $3.80 is also attractive.
 Reducing equity exposure and increasing cash balances is
the least aggressive, but it may provide the needed
flexibility to increase long exposure for the next leg of the
Federal Reserve’s monetary experiment, which is seemingly
much closer than many believe.
 If the stop is hit, the re-entry will be re-evaluated based on
the information at that time.
While it is very difficult to short the S&P given the
counterparty constituents, the current risk reward is the most
attractive we have seen in the past 5 years.
PERVALLE
The Trade: Sell S&P’s

42
 A separate way to play this is through the DBB , which is a PowerShares base
metals ETF. As you can see to the right, Chinese credit creation has been a
large driver in the recent rebound in the DBB, as it leads by roughly 10
months.
 That said, the recent slowdown gives us an indication of where base metals
will head, and from the chart to the right that is much lower.
Alternative Playbook: Sell DBB
 The risk on the trade is defined at 2.4%, with a potential reward of ~20%, good
for a R/R of 8.3x/1.
PERVALLE

43
 Domestically on the consumer side, the XRT retail ETF has broken down and
looks to be headed much lower. Given the thesis outlined above, the
probabilities favor the consumer materially reducing consumption into years
end. Should this manifest, the XRT could complete its head and shoulders,
leading to a decline of 28%
 The risk on the trade is defined at 3%, with a potential reward of ~28%, good
for a R/R of 9.3/1.
Alternative Playbook: Sell XRT, Buy TLT
PERVALLE
 With slower growth and the likelihood of the Federal Reserve pairing back rate
hikes and possibly reversing course, the long bond (TLT ETF) looks very
attractive here.
 The risk on the trade is 1.5%, with a potential reward of 23%, good for a R/R of
15.3/1.

44
PERVALLE
Just Fade It.
Teddy Vallee
917-797-5018
Tv@pervalle.com

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