Monday, 24 September 2012

GLOBAL ECONOMY (September 24th 2012): QE3 vs Economic Data, and Why We Won't Chase Risk

Since March 2012, global economic data in terms of quality leading indicators, has deteriorated in a strongly negative trend. The market gave us plenty of opportunities to sell the rallies once we got to this stage if we chose to. Even our leading market breadth indicators, the Bullish Percentage charts, wisely guided us to bearish conclusions in April, telling us to fade rallies and avoid buying the dips.

This broadly coincides with what you'd normally expect the market and economic data to do together. As Global PMI stats, business surveys and other (more mainstream) Unemployment stats start to peak, and fail to make higher highs, the market eventually stops making higher highs and pulls back, until the reverse is true. We usually get plenty of warning, and support from our market indicators, to allocate our portfolios appropriately.

However, the market is quite capable of ignoring economic altogether when choosing a direction. We saw this on a large scale in 2002, when the market became embedded in a negative mindset, the result of a confidence-dampening bear market from 2000 onwards. When it does this, it is often better to stand aside than attempting to pick market tops and bottoms, simply wait until the signals are stronger. In 2010, with the advent of QE2, it took at least a couple of months for the data to confirm the improvement in conditions (you'd have missed the bottom, but you wouldn't have been gambling on an unprecedented program working out).

Nevertheless, we're approaching the end of a frustrating summer for quantitative analysts, concerned with the ongoing decline in macro data from China, Europe, Japan and the United States, with Global PMI in it's worst state since 2009. Despite this, the market has surged ahead, troughing in June and rallying to new highs.

The explanation, of course, is Central Bank easing. The market knows that the Fed's actions rip up the sheets of negative economic data we're seeing today - at least, that is what the market expects. Indeed, knowing it may take three months for QE's effects to show up in the data, the market is rallying with no concern at all for economic conditions today.

At Big Macro Picture, as we've highlighted in recent months, the economic data hasn't gotten better. In fact, it has gotten considerably worse in some regions, which previously weren't a major concern. This remains to be true - although we remain glued to the data for signs of this trend reversing.

Despite this, our view is to appreciate the market's expectation of QE3's success. The last two versions of QE were constructive in reversing negative trends in US data. We don't want to follow that expectation without seeing proof in the data ourselves - the market could be set up for a considerable fall if QE fails to arrest the slump in US and Global economic conditions.

However, to draw directly bearish conclusions on the market based on today's data is not insightful, as of September 13th with the QE announcement. It isn't that the market is failing to see the poor quality economic data, it is simply reading past that, with the assumption that Global PMI will be positive again by November.

The market guessed correctly we would receive more Fed easing, and is also guessing that this easing will boost global economic conditions. Standing in the way of the market would have been unprofitable from June onwards - we feel that the reward for playing along in this guessing game is unfavourable compared to the risk.

As such, we continue to preach caution in having too much bullish or bearish exposure until the data confirms what the market indicators have been saying since June, whether QE works or otherwise. Even at the risk of missing out on further market gains, or at risk of missing a market shorting opportunity. It is foolish to overexpose yourself when the signals are conflicting, when the indicators are no longer leading the market, and when even top economists can't figure out what the real effect of QE3 will be.

It is worth noting that our favourite leading market indicator, the BPNYA, gave us the go-ahead to mark a new MEDIUM TERM bullish cycle beginning in early August. Our more sensitive version of the indicator gave us the signal to buy dips in relevant stocks from mid-June. Despite this, the conflicting bearish economic data has tempered our excitement towards the rally - and we feel no pressure in chasing performance amidst speculation and uncertainty.

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