Finlight Research - Market Perspectives - Oct 2014

Market Perspectives
October 2014
Oct. 10th, 2014
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Executive Summary: Global Asset Allocation
The stock market is off its peak and bond yields are extremely
low, and the economy seems to be going nowhere.
Global economic issues is the focus, and the general tone is
negative. But expansionary monetary policies, low interest rates
and abundant liquidity are keeping us from moving to an
underweight on equities
Growth in Europe is at a great risk. Germany, which is its
economic engine, is showing increasing signs of weakness. The
odds for a triple-dip recession are still heading up.
China’s trend growth rate has fallen and there are downside
risks from the property and financial sectors
Like others, we ask whether major moves in bonds, inflation,
oil, and small caps (vs large caps) are canaries in the
coalmine that signal a reversal
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 summarize our views as follows
3

MACRO VIEW
The Good
Despite the lack of wage growth, jobless claims remain strong. They stand near a 14 year low.
The unemployment rate fell below 6.0% for the first time since 2008
ISM report is very positive and may points to GDP gains exceeding 4%.
There were signs of stabilization in China’s economy in September after fading momentum in
August
The Bad
Home prices edged lower according to the Case-Shiller index. Real prices and price-to-rent ratio
have declined in July.
Growth in Europe remains at risk of a return to recession in the near term. Eurozone economic
data has been poor with sharp falls in German industrial production and factory orders and weak
exports from both Germany and France
Weaknesses in small caps are more and more obvious and may eventually bleed over into mid /
large caps
The Ugly
Main systemic risk resides in China : 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. Economic effects have been limited so far, but the
picture may get worse rapidly…
4

ISM Report
With services index at 58.6 and the manufacturing index at 56.6, the ISM report is very positive and may
points to GDP gains exceeding 4%.
The new orders component (indicator of future activity) fell to 60 but is still very strong.
5

Employment
Part time employment is on a decreasing trend. The crossover is close but the picture is still considerably
different from the period before the Financial Crisis.
6

The overall picture had been one of slow recovery, but there is no indication of a recession using the
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Big Four Economic Indicators
indicators monitored by the NBER.

8
GS – Global Leading Indicator (GLI)
The Sep. GLI came in at 2.6%yoy,
down from last month (3.1%).
Momentum decreased to
0.15%mom from last month’s
reading of 0.29%mom.
GLI places now the global
industrial cycle clearly in the
‘Slowdown’ phase (defined by
positive and decreasing
momentum)
Only 4 of the 10 underlying
components improved in
September
We’ve been thinking for a while
that the current acceleration
remains quite modest for a
typical expansion phase. More
data are needed to confirm our
fears about the current economic
situation.

Major Economies
Schwab team’s graph summarizes the major economies as follows: US is weakening, Europe is flirting
with another recession, Japan is trying to pull itself out if its long-standing bad situation, and Chinese
growth is missing expectations to the downside
9

Major Economies
It is worthwhile noting that the outperformance gap between the US economy on one hand, and its
developed peers(Eurozone, Japan, UK) on the other hand, is closing. The US economy is hardly doing
better than other developed economies.
10

Real Estate
The Case-Shiller Composite 20 index was up 6.7% YoY in July. This is the smallest YoY increase since
Nov. ‘12 .
In nominal terms, the Case-Shiller Composite 20 Index (SA) is back to Sep.2004 levels
In real terms, it is back to Jun. 2002 levels
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The weakness we have seen in stocks over the last month could have further to run in the short
term. But we still think that it’s just the start of a normal correction (off ~10%) rather than the start of a
new bear phase.
shifted to defensive areas and large caps. The decline accelerated, along with a dramatic increase in
volatility, at the beginning of October. The sell-off was led by the Russell 2000 and the energy and
materials sectors.
Contributing to the recent selloff was a package of weaker-than-expected economic data (decline in
consumer confidence, softer housing data and manufacturing surveys) and the absence of new
commitments by ECB. Stocks should keep rising on bad news because bad news implies more central
bank stimulus, and more cash injection.
We stick, however, with our view that risk-reward trade-off points to a more cautious approach
12
EQUITY
Stocks again pulled back but the uptrend is not yet broken. Stock market leadership has now
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.

We remain Neutral equities. At this stage, expansionary monetary policies, low interest rates and
would likely be the signal we wait for to go short stocks, as that could lead to a temporary sell-off
But a clean break of 1805 (Oct. ‘11 uptrend) will give the signal of a BIG reversal on stocks.
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EQUITY
Bottom line :
abundant liquidity are keeping us from moving to an underweight on equities
As said in our previous report, breaking through the 1900-1920 pivot area on the SP500
in equities.
We keep our UW on Europe vs. US. We remain neutral to UW on Japan.
We remain UW in US small caps vs large caps

14
Earnings
According to long-term indicators, equities
look expensive. But this situation could
persist as long as earnings expectations
are met
Earnings growth should be the only driver
of markets from here. Earnings will
provide the reality check we need to
update our positioning on stocks
Source: JP Morgan AM

15
Earnings
Profit margins are still high but seem to
have reached a plateau in all regions.

SP 500 Sector Breadth Levels
According to Bespoke, only 32% of stocks in the SP 500 are currently above their 50-day moving
averages.
The most defensive sectors (Utilities, Consumer Staples, Health care) stand out as having very
positive breadth
On the other side, Energy is suffering with only 2% stocks above their 50-days MA.
16
Source: Bespoke

Small Caps Warning Signal
The profile of small caps is starting to deteriorate in a way not seen in 2013.
Russel 2000 has broken down showing growing causes for concern.
17

Small – Large Caps Divergence
Small caps have undergone an unbelievable
relative collapse
The momentum on the Small-to-Large Caps ratio
is quite negative on the downside
The MA cycle has slowed and small caps should
benefit less as targets
18

19
US Equities vs QE
The correlation between QE and the SP 500 performance has been amazingly strong since the
financial crisis.
Ultimately, less QE should weigh on stocks

20
VIX
The Volatility Index has moved
sharply higher in the last few
weeks as the market has had
some very large moves higher
and lower.
The VIX seems to be closing the
week near 19, and clearly above
its 200-days A (~17.5) for the first
time since Aug. ‘11
The past two instances when this
MA was breached resulted in
sharp spikes.

SP 500 Picture
The SP500 is ticking
below its Nov. ‘12 uptrend.
As said in our previous
report, 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.
The 200-days MA at 1905
is the important level to
watch. Closing below will
probably induce an
acceleration on the
downside.
A clean break of 1805
(Oct. ‘11 uptrend) will give
the signal of a BIG
reversal on stocks.
21

Our prop. Short-Term trading model went massively short on Aug. 18th at 1971.74 on the index, did
some gamma-positive adjustments between 1940 and 1970, and finally switched to neutral on Oct.
9th close (1928)
22
Trading Model - SPX
The model targets 1903 and 1847 on the downside and 1942-1961 on the upside

23
FIXED INCOME CREDIT
We’ve been UW on 10y-UST for a while now, expecting 10-year yields to reach 2.90%-3.20% over
next months, because of sustained US growth, increasing US inflation. As said in previous reports,
only a material weekly/monthly close below the 2.40-2.30 range could make us change our mind.
We are now questioning our underweight positioning, as U.S. 10-year yields are currently ticking
below the 2.40-2.30 range. Below 2.25, we move to Neutral.
Falling inflation expectations, disappointing growth and the outlook for low official rates largely explain
the level of eurozone yields. While we are neutral on German yields, we think US yields are too low
for the current growth and inflation outlook.
We continue to OW Eurozone vs. US and UK given continued policy divergence and BCE action,
despite the dovish tone in the FOMC minutes. The ECB will not buy corporate bonds directly, but its
purchases of asset-backed securities and covered bonds may lead to investors adjusting portfolios
towards this asset class.
Our bullish positioning on 5y-TIPS was a disaster as TIPS was the worst performer within the FI asset
class (~-3%). We stop our losses on the 5y-TIPS breakeven wideners and become Neutral on
TIPS. The lack of demand could prevent breakevens from widening over the near term. Inflation
expectations sit at their lowest levels since 2011
Over 12 month horizon, we still expect 10Y HICP swaps to move up 20-40 bps. Thus, we keep our
long 10Y Euro HICP inflation swaps
As a tail hedge, we keep our 10y bund swap spread receiver swap

24
FIXED INCOME CREDIT
Our previous monthly reports have pointed out our caution on corporate credit as the spreads have
already reached past cycle lows and credit tends to perform badly in later stages of the cycles
As expected, the tide has begun to turn in credit and specially in high yield
Credit spreads are already pushed wider by continuing weakness in US high yield and a strong
issuance in September.
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
We continue to prefer IG over HY on a risk-adjusted basis and keep our Neutral stance between
the US and Europe.
Bottom line : Still UW Govies, UW credit, Neutral TIPS and OW HICP Inflation, UW High Yield vs
High Grade

25
UST Yield Curve
As of Sep. 30th, speculative positions on the UST
curve were the shortest over the past8 years.
Some short-covering is currently taking place,
weighing on yields. We think, however, that this
is more about a temporary risk-off move than a
change in the underlying persistent short bias.
Over the short term, only a material
weekly/monthly close below the 2.40-2.30
range could make us change our bearish view
on USTs.
The market remains oriented toward higher yields
over the medium term , at least in the US.

26
US 10y Yields
The downside move has
already gone further than
initially expected. No sign of
a material bounce is
showing.
We are now questioning
our UW positioning, as
U.S. 10-year yields are
currently ticking below the
2.40-2.30 range.
A material weekly/monthly
close below this range
would make us change our
mind and move Neutral,
and even OW on US
Govies.

27
US Inflation
Inflation expectations have declined to
their lowest levels since 2011
This should have a dovish Fed
implication

High Yield
The correction is under
way in corporate high
yield…
According to JP Morgan’s
European HG investor
survey, investors are the
most OW credit ever in
the history of the survey
while cash balances are
very low
Underlying credit
fundamentals are still
supportive, but the very
tight level of spreads
makes the risk/return
profile unattractive
We remain UW high
yield.
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EXCHANGE RATES
Over the medium term, we continue to expect the USD to strengthen against the major crosses.
Nevertheless, it looks like the US dollar is due for a pullback.
Despite the fact that EUR-USD underlying structure still looks very negative, EURUSD is entering a
corrective phase.
We change our positioning from UW to Neutral on EUR-USD and will remain so as long as the
pivot remains between 1.25 and 1.28.
Additional Abenomics should weigh on JPY. But a correction is now developing on the pivot
Our previous targets of105.60 and 108 were reached.
We move from OW to Neutral on USD-JPY and wait for a break above 108 or below 106.10 before
tilting our position again by going OW or UW, respectively.

30
EUR-USD
Our first target of 1.28
was reached (and even
broken) on EUR-USD.
Nest target stands at
1.25. The break of this
pivot will open the door
to 1.23
EURUSD is entering a
corrective phase. We
change our positioning
from UW to Neutral on
EUR-USD as long as
the pivot remains
between 1.25 and 1.28.
Over the long term, the
picture remains very
skewed towards our
ultimate target of 1.20

31
USD-JPY
Additional Abenomics should
weigh on JPY. But a
correction is now developing
on the pivot
USD-JPY appreciated to 110
versus the but has since
retreated. Is that a market
reversal?
Our previous targets
of105.60 and 108 were
reached.
We move from OW to Neutral
and wait for a break above
108 or below 106.10 before
tilting our position again
The next big pivot to watch is
110. Our LT target stands at
125!

32
COMMODITY
Commodity prices fell further in September, mainly because of rising US dollar, supply gains in some key
commodities, and falling demand caused by reduced economic expectations around the world, in
particular in China.
Our bearishness on agriculture commos (except Cocoa and premium coffee) was justified. During the
month, the wheat price fell 13.2% and is down 35% since its peak in May. Soybeans fell 10.8% and corn
12.1%.
We have been proven right in going UW base metals : The iron ore price fell 11% and is now down 39%
since the start of 2014. Nickel (-13.2%), aluminium (-6.5%), lead (-6.3%), copper (-4.5%).
Our first target on silver at 17 was reached. The recent lows in gold (~1190) were very close to our target
of 1150-1170.
But we were completely wrong about energy.
We continue to like owning the GSCI energy index, and 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 continue to favor commodity futures with steep backwardation (for positive carry).

33
COMMODITY
We maintain some of our previous views: UW on agriculture (except on premium coffee and cocoa),
and base metals (we prefer Zink, Nickel and Aluminium to copper and Iron Ore).
Without changing our MT bearish view on precious metals (targeting 1170-1150, 17 then 12.50 on silver),
we move tactically OW gold and will remain so as long as the spot is above 1223. ST target ~1330
Our dilemma is about energy, and especially crude oil!
The drop in oil price is disconcerting as we had not foreseen it.
The current correction is impressive but still falls within the norm of recent corrections.
Breaking the $80 support zone would be a very bad signal for crude oil
At this stage, there is no sign of OPEC action to stop the bleeding
We choose to keep our OW bias on energy as long as the $80 support zone is not clearly broken.

34
Commodities
The fall in commodity prices was
obviously driven by the rise of the
dollar
We think that US dollar is due for a
pullback. Commodities downward
trend is expected to reverse.

35
Gold
Like in Jan. ‘14, Gold seems
to be ready for a bounce
(preceding the final leg down)
momentum is starting to turn
higher from extremely
oversold levels
Without changing our MT
bearish view (targeting 1170-
1150), we move tactically
OW gold and remain so as
long as the spot is above
1223. ST target ~1330

36
Crude Oil
The current correction is impressive but still falls within the norm of recent corrections.
Breaking the $80 barrier would be a very bad signal for crude oil

Energy Sector
The SP 500 Energy sector has experienced a breakout back below its 2007 highs, and is now breaking
below its 2 year uptrend line.
The next uptrend line to watch is that initiated at 2008 lows.
37
Source: Bespoke

38
Commodity Performance
Speculators

39
ALTERNATIVE STRATEGIES
Within the hedge fund complex, we’ve been OW Equity Market Neutral, CTA, Global Macro and Vol
Arb.
Two months ago, we decided to move from OW to Neutral on Event-Driven, as MA activity was
calming down, volatility was expected to bounce, and geopolitics were threatening…
Most of our bets have paid off handsomely in September :
The HFRI Macro Index gained +1.8% for the month, led by contributions from Multi strategy (+1.8%),
Systematic Diversified/CTA (+2.6%) and Currency (+1.3%) sub-strategies
Long Term CTAs were among the best performers during the month as they made money out of their
long rates (still long govies, despite a reduction in the past few weeks), short EUR/USD and
aggressively short commodities.
CTAs and Equity Market Neutral are now the best performing strategies on a YTD basis, thanks to a
strong Q3
HFRI Event Driven Index declined -0.95%, when Equity MN was flat on the month.
HFRI Macro: Discretionary Thematic Index is -0.2% on the month. The strategy was hurt on its long
exposure on commodities, as well as on their short U.S rates. These losses were mitigated by the
gains on their short EUR exposure.
According to HFR “The Macro resurgence accelerated in September, leading industry performance as
equities, bonds and other hedge fund strategies declined. Macro hedge funds, including both trend
following, quantitative as well as fundamental discretionary strategies, have re-emerged recently as
powerful, uncorrelated exposures as US stimulus measures are wound down and the US economy
continues to proceed toward interest rate normalization,”

40
ALTERNATIVE STRATEGIES
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.

41
Are US Pension Funds getting out of Hedge Funds?
CalPERS’ decision to get out of the hedge
fund universe has raised concerns among
other investors.
According to a recent Prequin survey,
however, more US-based public pension
funds than ever before are allocating
capital to hedge funds.

42
CTA
The main driver of CTAs returns was the
commodity sell-off. CTAs have been
increasing their commodities shorts since the
summer.
CTAs also made money out of their still long
positions on Govies and shorts on EUR vs
USD
On the other hand, CTAs generated losses on
long positions on equities

Bottom Line: Global Asset Allocation
The stock market is off its peak and bond yields are extremely
low, and the economy seems to be going nowhere.
Global economic issues is the focus, and the general tone is
negative. But expansionary monetary policies, low interest rates
and abundant liquidity are keeping us from moving to an
underweight on equities
Growth in Europe is at a great risk. Germany, which is its
economic engine, is showing increasing signs of weakness. The
odds for a triple-dip recession are still heading up.
China’s trend growth rate has fallen and there are downside
risks from the property and financial sectors
Like others, we ask whether major moves in bonds, inflation,
oil, and small caps (vs large caps) are canaries in the
coalmine that signal a reversal
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 summarize our views as follows
43

44
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:
Asset Allocation with risk control and/or risk budgeting techniques
Allocation to alternative investments : Hedge funds, rule-based strategies (momentum, value,
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
the different asset classes
FinLight Research is an innovation-oriented company. We target to fill the gap between the
academic research and the investment community, especially on real assets and alternatives. We survey
on a continuous basis the academic literature for interesting published and working papers related to
quantitative investing, non-linear profiling, asset allocation, real assets...
45

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46

Finlight Research - Market Perspectives - Oct 2014

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