Oversold Rally And The Global Economy

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Includes: ACWI, EEM, EFA, EWA, EWJ, FEZ, FXI, SPY
by: The Short Side Of Long

I hope many of my readers, in particular the Asian ones, enjoyed the recent Lunar New Year holidays. We are approaching end of February, and within a month, the end of the first quarter. Personally, it feels as if 1st of January New Year celebrations were only a handful of days ago... I guess time flies when one is having fun. So we continue from where we left off about a month ago. We focused on the US stock market breadth, which were showing extreme oversold readings from a short-term perspective. We experienced the largest spike in 52-week new lows since the August 2011 crash, AD line and UD volume (averaged over two weeks) at most the oversold since August 2011, and once again, we saw percentage of stocks above their respective 50-day moving average within the S&P index move into single-digit readings. The US broad index bottomed within the day of my post (good timing), posting a slight rebound into late January, which was followed by a retest of the lows into last week.

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An interesting point to make about the start of 2016 is that when averaged over 21 business days or one trading month, selling pressure measured by the number of stocks registering 52-week new lows on the NYSE has been the strongest since the Global Financial Crisis of 2008/09. In other words, US indices, mainly supported by the technology darling FANG stocks, are masking the actual weakness that almost all individual stocks have experienced for a year now (in some cases, for a few years already). Moreover, it is important to state that even during strong downtrends and powerful bear markets, such selling pressure cannot last indefinitely without a relief rally to work off oversold conditions. This is precisely what we have been witnessing over the last three trading days.

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Additionally, sentiment became very negative throughout the early part of February. In some instances, various indicators have fallen to levels of pessimism rarely seen over the last three decades, while others match the fear seen during the depth of the Global Financial Crisis in 2008. Surveys, such as AAII or Investor Intelligence, recently touched rock-bottom levels. Retail investors (dumb money) have been heavy buyers of put options, while market participants around the world have piled into safe havens such as Treasury bonds, the Japanese yen and gold. All three of these asset classes have moved up in vertical fashion over the short term - a clear indicator of fear. Finally, various credit spreads and credit default swap indices have also spiked sharply (usually seen near intermediate or major market lows).

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If one was to only observe the US indices, it is easy to come to conclusion that the market has barley corrected from the May 2015 highs. However, other global markets (priced in US dollars) have had meaningful... and I repeat... meaningful adjustments in price, time and valuations. Focusing on the chart above, we can see that since the March 2009 lows, Emerging Markets, and in particular Asia-Pacific equities, have underperformed significantly. It is worth noting that the China H Shares Index traded at price-to-book value of 0.79 last week, and at the same time, was only 20% above its March 2009 lows. As an example, for the S&P 500 to trade at such a heavy discount or that close to its last major trough, the price level would have to be below 1,000 points on the index - pretty much a 50% sell-off from current levels (not necessarily my prediction as of this moment).

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The truth is, the Chinese economic slowdown continues to affect a majority of the Asian economies, in particular South Korea, HK, Macau and Singapore. As I have mentioned many times on the blog, it is difficult to trust government publications, especially the Chinese government data. This is why I prefer to use South Korean export strength to gauge Asian as well as global growth. Let us remember that the South Korea is an export powerhouse which is leveraged towards both new and old economic activity. Major exports include semiconductors, petrochemicals, machinery, automobiles, ships, steel, LCD and wireless communication devices, while its major trading partners are China, the ASEAN region, United States and the European Union. Therefore, if we assume that South Korean export data is a decent barometer of the overall global economy, the latest drop of 18.7% from a year ago should be quite worrying. Furthermore, when averaged over three months, exports continue to be at the most depressed levels since the 2008 recession.

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United States' economic activity has also slowed down considerably, according to the Philadelphia Fed General Activity Index, which I prefer to use when monitoring the strength of the worlds largest economy. The indicator clearly showed depressed sentiment and recessionary behaviour during 2001 and 2008. It also displayed that the US economy experienced a considerable slowdown during the prolonged Eurozone Crisis episode from early 2011 into late 2012. At present, the current conditions closely resemble the slowdown of the 1998 Asian Financial Crisis, and my best guess is that the US economy is not in a recession just yet. However, I would like to add that without any notable recovery from here onward, we could very well be on the cusp of one.

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Consumer sentiment has been rather high in Developed Economies (the US, the EU and Japan) over the last few quarters. From a contrarian perspective, confident consumers usually signal that retail spending is at its peak, and therefore, future stock market performance will most likely disappoint as corporate earnings come below perma-bullish Wall Street analysts' expectations. Hence, the recent stock market sell-offs, from US to Japan and the eurozone (chart above), should not be a surprise to any of us.

Personally, I will closely be monitoring the recent stock market rebound and how it behaves in the days and weeks ahead. When coming out of extreme pessimism and oversold conditions, like we saw in mid-January 2016, a strong follow-through usually (but not always) indicates positive performance for the medium term as well. On the other hand, sharp and swift failure of the current relief rally would indicate that the downtrend is still in progress, and that the economic activity might deteriorate somewhat more.

Wishing you all a wonderful February... as for me, it's time to enjoy some Vietnamese Phõ!

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