The Market Timing Model: 2014 Outlook

Regime Change? Or stuck in Transition?

Dec 2013

John P. Cuthbert BA, MA, MSc, JP Cuthbert Consulting Ltd, Independent Financial Economist john@jpcuthbertconsulting.co.uk

The Market Timing Model: 2014 Outlook

OVERVIEW: A YEAR THAT DEFIED THE PESSIMISTS
2012 was quite a year, but, wow, what a surprising year 2013 has been. And just how surprising it has been can be seen if we briefly revisit investors main expectations in January. The global consensus viewpoint began 2013 with global investors less optimistic about the outlook for DMs and DM earnings than in 2012 (after all this is a low return environment, isnt it?), equities were expected to be very volatile driven by policy and political machinations, few were less than very negative on the Euro-zone (and UK growth), many were more than positive on EM equities and EM Bonds, and whilst there had been some repositioning in Yield plays (Credit in general, and HY in particular, was considered Overbought and set for little upside), few emphasized anything like an acute short duration outlook in US Treasuries. So how well did the consensus do? In fact, in 2013, all these consensus calls proved to be wrong. Far from correcting, and in spite of meagre earnings improvement, we witnessed one of the greatest years in US equity multiple re-rating this century (according to Adam Parker at Morgan Stanley). DM equity volatility collapsed, EM equities and EMBs vol soared as prices got pummeled, managing duration in fixed interest was key, credit was up (and some areas became very frothy), and European growth got back into positive territory by H2. Japan aside, the play of the year was perhaps Euro-zone Banks. In short, as one Morgan Stanley strategy note put it: it was a year that defied the pessimists. Much of this failed to surprise this author (although the Feds early Taper talk and the extent of the concomitant EM Crash were notable exceptions). In fact, we actually headlined our 2013 prospectus as Risk-On: Transitioning to a more stable risk environment. The key to our 2013 outlook was the combination of a fundamental shift to lower risk coupled with the eventual transition to better macro conditions. Both elements were not priced in December 2012. A multiple re-rating was due!

Looking Ahead into 2014 Heading into 2014, this time round investors look more optimistic than pessimistic. This optimism is well represented, I would argue, by BoAMLs global view that sees the US environment shifting from High Liquidity/Low Growth to High Growth/Low Liquidity or Absolute Strategys view of regime Change. If BoAML are right, High Growth/Low Liquidity would indeed mark a substantial sea-change. And a sea-change that is well prefigured.

There is also a considerable weight of sentiment behind Europe and Yen equities, but less enthusiasm for Resources, Commodities (particularly Gold), and GEMs, though fund flows appear to be recovering. Investors have also been exiting Sovereign Bonds, but not in Great Rotation volumes. Looking at these dispositions and how crowded they are, we continue to hold fast to the view that too many investors continue to misunderstand at least four things: the underlying economic fundamentals; the scope and importance of policy and policy effectiveness (most noticeably with regard to Fed Tapering); the dynamics of the commingled relationship between underlying economic fundamentals and asset prices; and, finally, how the key is not strategic certainty since this is not obtainable (the dynamics are just too intractable), but to trust to portfolio and tactical flexibility. Indeed, as we have said so many times, so long as many investing voices persistently characterize the current investment environment as one thing or another (Bull, Bear, New Normal or take-off, and, for that matter as High Growth/Low Liquidity), theres little room for the nuance of detail that we think is key to understanding market dynamics. In short, although a year of DM growth acceleration, EM economic stabilization, and continued monetary policy accommodation looks as likely to us as it does to Morgan Stanleys 2014 Global Outlook, the translation into market effects is much more complicated. For our part, our Quantitative forecasts suggest that many of the key consensus trades are heading for considerable difficulty. In our view, this difficulty is the natural consequence of two things: First, the valuation compression of 2013; and second, the intractability of transitioning from an emergency policy environment to a standard mid cycle with MP normalization. Our view is that this is unlikely to be pulled off without policy error, that policy accommodation is and should be as much a part of fundamentals as earnings, so long as deleveraging is in place and deflationary risks remain present. Obviously, the US is to the forefront of such concerns, but in our view, both Japan and the Euro-Zone are equally notable tests as to whether our radical observation of emergency policy as part of the fundamentals fabric holds any water. We have no faith that Abenomics can be truly made to work, or indeed that ultimately the Euro-zone can avoid a type of deflationary trap or Japanification, as MS call it. 2014 will tell us a great deal about the tractability of these deep concerns We of course recognize in our Outlook for 2014 that regime change in US monetary policy, and the re-pricing of expectations about the sustainability of growth in China, the Emerging Markets, Europe, and Japan will remain to the van, as they should. Our cavil is that market views and portfolio positioning on these concerns is misplaced. Indeed our key ideas, in these regards (though note our forecast horizon is 6 months), follow in bullet-point next

The Market Timing Model: 2014 Outlook

Key strategic ideas for H1 2014; Higher DM Growth yes, but NOT necessarily higher equities. The outlook remains very dependent on the interaction between Fed Tapering (and its policy effects) and economic growth. But we think Fed Policy is flawed. The Fed first talked about Tapering, and now has acted, long before the type of economic conditions necessary for the Fed to act with clarity actually prevail. We are baffled by their observation that markets confused tapering with tightening after Bernankes May comments. We beg to differ. We think that the Fed has it the wrong way round! For us, recent evidence from US Mortgage rates, mortgage REFI, and new housing starts, confirm that Tapering is Tightening! And Tightening means that the US economy will slow (curiously the Fed seems to agree, and lowered their 2014 growth expectations again..) These curiosities in Fed decision-making, and their simultaneous insistence on data dependency (a flawed policy tractus if ever there was one) and forward guidance leaves markets trapped guessing simultaneously about the short run and the long-run. How does that help? Ultimately, we think that a Yellen-led Fed is likely to shift the policy focus onto fundamental economic questions, such as the US economys long-run sustainable growth capacity. This will be an added and unwanted complication. It will render it difficult for markets to price forward guidance. Moreover, we think that growth sustainability is unlikely. Indeed, the primary characteristic of the US cyclical expansion is not New Normal but Mini-Cycle. In other words, the US economy experiences sharp bursts of growth, followed by sharp slowdowns (as it has latterly with Q412 annualized GDP of 0.1% and Q313 at 3.6%), followed by a further mini-cycle. In our view Tapering is tightening, and on our outlook the Fed will be tapering/tightening through H1 2014 as the US economy slows sharply into its latest minicycle slowdown. Thats bad for risk assets.. Worst of all, Equities are not just no longer cheap, on our model the relationship with risk is statistically very stretched implying that risk/reward is as bad as it has been for some time. Indeed, one main model forecast is for a difficult period ahead for equities that involves several sell-offs, and for global equities as a whole (in GBP terms) possibly no upside in H1 2014; Our main Risk Model however suggests that risk overall will remain fairly subdued (implying the equity sell-offs will be modest, say -5% ), whilst subdued risk essentially means that the longer-run remains positive for risk assets. From the forecast late spring lows, our Models indicate a sharp rally for equities in particular; But even though overall returns will be more subdued than 2013, because DM asset markets are trying to transition to mid-cycle type conditions, some sectors (Tech and Industrials) will offer equity duration opportunities. In a limited credit environment, however, Mid-Cap and Small-Cap will remain more cyclically sensitive Equally, because the impact of Fed Tapering is going to be more growth-negative than markets expect, this has profound implications for both Sovereigns (a better but more rotational H1) and the USD (its heading down, rather than up as the consensus expects). Whilst Gold and Global Emerging Markets are likely to benefit substantially on the other side of a weakening USD trade;

 We do, of course, also recognize that policy certainty on US interest rate direction could (eventually) drastically change the US growth dynamic unleashing substantial pent up demand for capex and consumer spending. That would eventually boost growth and markets, though on our reckoning that would be a 2015 event at the earliest. In this regard, for us the key is the behavior of US capital spending. After all, what markets want (and CFOs too), and perhaps desperately need, is policy certainty. If they dont get that they will remain stuck in a transitional see -saw type of environment. Euro Growth will be topsy-turvy, but EPS will impress because of the extent of operational leverage, particularly in the Banks Japan equities are due a further tactical bounce, but for H1 as a whole they are going to be a shocker as further stimulus gives way to Third Arrow policy uncertainty and a Sales Tax shock induced growth slowdown. China growth looks fragile to us, and the key is continued liquidity support from the PBOC. That said, in the longer-run, we see better growth stability if the shadow banking system fades and the link between monetary policy and growth sustainability with it; Commodities will be back as China, EM, and global growth stabilizes More EM growth/policy differentiation, but some surprisingly large winnersas the emphasis shifts towards EMs that are growth dependent on DMs rather than the other way round as it has been for so many years In the following pages we look at each of these issues through the prism of our quantitative forecast models. These Models consist of several classes of proprietary methods, as follows: Tactical mean-Reversion: This is the short-run model. It measures the performance trend as it fluctuates around a selected moving average. The essential point is that the model has been constructed so as to create key thresholds (upper and lower limits) relative to the moving average of the underlying performance trend. These thresholds roughly correspond to Overbought and Oversold conditions, and so give investment signals. Risk Forecast Model: The main risk model employs a stochastic technique to forecast the rolling risk trend over a forward 6-month period. Information Ratio Model: This is the long-run performance trend or forward curve model. It employs a special case moving average (called the Information Ratio), which we favour because, statistically, its properties tend to follow the commands of the Central Limit Theorem (it is expressed in standard deviations). In other words, at standard deviation limits, the probability of mean-reversion or change in trend direction is extremely high. Expected Return Model: Mean-reversion processes are path-dependent so we employ an independent check on the possible performance path using an Expected Return engine that generates weekly return forecasts over an 8-12 week horizon. It is based on the rsks/return stochastic properties of the Mean-Reversion Tactical Model.

The Market Timing Model: 2014 Outlook

WHATS BEEN HAPPENIN G TO MARKET DIRECTION?
Throughout the 2008-12 period of crisis, recovery and setback, equity and bond asset markets exhibited strongly mean-reverting properties, where mean-reversion behaviour had been highly correlated with economic news-flow. In the latter part of 2013 however, this behavior began to change. Below we set out our main Tactical Mean-Reversion Model for Global Equities vs. Global Sovereigns. The Mean-Reversion Model captures the short-run, week-to-week behavior around the longer-run or moving average trend. This variation tends to have a repeatable signature, and we have drawn in upper and lower bounds (consistent with Overbought and Oversold thresholds) onto the chart to demonstrate their predictability (these thresholds are themselves a function of the underlying risk and return interaction). As can be seen, much of the mean-reversion behavior through 2010-early 2013 has respected these limits. But since the Fed began its Taper-talk in late May, the pricing behavior has been much noisier, albeit less volatile (see area ringed within the yellow circle).

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FTSE World vs. Global Govt Bonds Tactical mean reversion drift model

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normal

% active return
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-10

normal lower

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superdetren
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In our view, this statistical change in behavior reflects an attempt to transition to a different type of asset pricing environment. In this new regime, tail risk is at much lower levels (see chart overleaf), reflecting lower anxiety about structural problems, but markets are drifting because they are searching for more certainty on trend direction. And that direction is intimately related to Fed Policy, Interest Rates, and Duration.

Just how important tail risk is to this new environment can be seen in the following chart..
48 43 38 33 28 23 trend 18 13 8 3 -2
To 20/12/2002 To 07/03/2003 To 23/05/2003 To 08/08/2003 To 24/10/2003 To 09/01/2004 To 26/03/2004 To 11/06/2004 To 27/08/2004 To 12/11/2004 To 28/01/2005 To 15/04/2005 To 01/07/2005 To 16/09/2005 To 02/12/2005 To 17/02/2006 To 05/05/2006 To 21/07/2006 To 06/10/2006 To 22/12/2006 To 09/03/2007 To 25/05/2007 To 10/08/2007 To 26/10/2007 To 11/01/2008 To 28/03/2008 To 13/06/2008 To 29/08/2008 To 14/11/2008 To 30/01/2009 To 17/04/2009 To 3/07/2009 To 18/09/2009 To 04/12/2009 To 19/02/2010 To 7/05/2010 To 23/07/2010 To 8/10/2010 To 24/12/2010 To 11/3/2011 To 27/05/2011 To 12/08/2011 To 28/10/2011 To 13/01/2012 To 30/03/2012 To 15/06/2012 To 31/08/2012 To16/11/2012 To 1/2/2013 To 19/4/2013 To 5/7/2013 To 20/9/2013 To 6/12/2013 To 31/1/2014 To 18/4/2014

Global Equities vs. Global Govt Bonds tail risk trend and risk forecast

forecast

variance (rolling 52W) actual variance (rolling 36W) forecast

Tail risk fell from a highly elevated to a cycle low and is stabilising at typical mid-cycle levels

The risk model presented above is a substantial forecasting innovation, and the models horizon is 6 months forward. Moreover, the models signals have been powerful predictors of negative and positive total returns for equities and bonds, and it has not failed to predict one significant turn in trend risk direction in and out of sample since 1978. 2013 was a case in point. Right now the signal from the Risk Model is long-run supportive for risk assets, ultimately implying further gains for equities in particular. However, the signal from the Global Equities vs. Global Sovereigns Risk Model shown above has been a little different from the signal for the pure Global Equities Model, indicating the importance of the co-varying relationship with Bonds. In the pure Global Equities Volatility Model, risk rose for awhile in 2013 and has only been contracting since Bernankes Autumn clarifications. Looking into 2014, the Model nonetheless predicts further amelioration in equity market risk conditions...

The Market Timing Model: 2014 Outlook

TACTICAL CALL: SHORT-RUN BOUNCE FOR RISK ASSETS
Sadly, halcyon overall risk conditions do not necessarily imply a lower probability of sharp day-to-day equity sell-offs, but it does straightforwardly imply less mean-reversion. And thats what we see in the Global Equities Mean-Reversion Tactical Model
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FTSE World AA 52W MA : mean reversion drift

% active return
0 -5

Lower BUY threshold

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-15

superdetren

-20

As marked by the ringed circles, each of the last two equity market thrusts have topped out well below the normal mean-reversion threshold. The model suggests, even if equity investors are becoming more bullish (actually Goldman Sachs report that the consensus has been revising down expectations on US Growth from Q3 into Q4), they have been palpably reluctant to seriously chase prices higher. Under-pinning this behavior has been a modest correction in the Cyclical leaders (Industrials, Tech), and a substantial correction in US Mid/Smaller Cap stocks (see overleaf). The synchronicity of many of these positions either at a BUY threshold (actually UK Mid-250 and US Tech began to rally before the Feds taper call), suggests a broad based rally before the next set back. Tactically, the current mean-reversion level for Global Equities constitutes a substantial BUY signal, but the preceding analysis suggests that Risk-On rallies will tend to be smaller in magnitude (c. 4.5% in GBP terms from 13/12/13), but with real strength in Mid and Small Cap.

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% active return

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Russell Mid-Cap vs Russell Large-Cap 52W MA : Tactical mean reversion drift (12W 2nd cycle)

Russell 2000 vs S&P 500 52W MA : mean reversion drift (12W 2nd cycle)

To 20/12/2002 To 14/02/2003 To 11/04/2003 To 06/06/2003 To 01/08/2003 To 26/09/2003 To 21/11/2003 To 16/01/2004 To 12/03/2004 To 07/05/2004 To 02/07/2004 To 27/08/2004 To 22/10/2004 To 17/12/2004 To 11/02/2005 To 08/04/2005 To 03/06/2005 To 29/07/2005 To 23/09/2005 To 18/11/2005 To 13/01/2006 To 10/03/2006 To 05/05/2006 To 30/06/2006 To 25/08/2006 To 20/10/2006 To 15/12/2006 To 09/02/2007 To 06/04/2007 To 01/06/2007 To 27/07/2007 To 21/09/2007 To 16/11/2007 To 11/01/2008 To 07/03/2008 To 02/05/2008 To 27/06/2008 To 22/08/2008 To 17/10/2008 To 12/12/2008 To 06/02/2009 To 03/04/2009 To 29/05/2009 To 24/07/2009 To 18/09/2009 To 13/11/2009 To 8/1/2010 To 5/03/2010 To 30/04/2010 To25/06/2010 To 20/08/2010 To 15/10/2010 To 10/12/2010 To 4/2/2011 To 1/4/2011 To 27/05/2011 To 22/07/2011 To 16/09/2011 To 11/11/2011 To 06/01/2012 To 2/03/2012 To 27/04/2012 To 22/06/2012 To 17/07/2012 To 12/10/2012 To 7/12/2012 To 2/2/2013 To 29/3/2013 To 24/5/2013 To 19/7/2013 To 30/8/2013 To 08/11/2013

To 20/12/2002 To 14/02/2003 To 11/04/2003 To 06/06/2003 To 01/08/2003 To 26/09/2003 To 21/11/2003 To 16/01/2004 To 12/03/2004 To 07/05/2004 To 02/07/2004 To 27/08/2004 To 22/10/2004 To 17/12/2004 To 11/02/2005 To 08/04/2005 To 03/06/2005 To 29/07/2005 To 23/09/2005 To 18/11/2005 To 13/01/2006 To 10/03/2006 To 05/05/2006 To 30/06/2006 To 25/08/2006 To 20/10/2006 To 15/12/2006 To 09/02/2007 To 06/04/2007 To 01/06/2007 To 27/07/2007 To 21/09/2007 To 16/11/2007 To 11/01/2008 To 07/03/2008 To 02/05/2008 To 27/06/2008 To 22/08/2008 To 17/10/2008 To 12/12/2008 To 06/02/2009 To 03/04/2009 To 29/05/2009 To 24/07/2009 To 18/09/2009 To 13/11/2009 To 8/1/2010 To 5/03/2010 To 30/04/2010 To25/06/2010 To 20/08/2010 To 15/10/2010 To 10/12/2010 To 4/2/2011 To 1/4/2011 To 27/05/2011 To 22/07/2011 To 16/09/2011 To 11/11/2011 To 06/01/2012 To 2/03/2012 To 27/04/2012 To 22/06/2012 To 17/07/2012 To 12/10/2012 To 7/12/2012 To 8/2/2013 To 5/4/2013 To 31/5/2013 To 26/7/2013 To 30/8/2013 To 15/11/2013

Normal upper

Normal upper

superdetren

superdetren

The Market Timing Model: 2014 Outlook

THE 2014 OUTLOOK: EQUITY WEAKNESS/SELL-OFF
Sadly, the current equity, risk-on rally does not imply a further upside break-out in equity prices. Unfortunately, our long-run model suggests that it will be the last hurrah for awhile. That makes sense to us; many assets have been inflated by QE, and so Tapering is going to tell us which ones. As the chart below makes clear, the current equity market trend is very stretched statistically (the relationship is shown in standard deviations), and, in the statistical model below there have been no occasions in the last 10 years when equities did not correct from this high placed statistical juncture (ringed in yellow). Mathematically, this is an easy read through; if risk is stable as we have seen, then a negative trend direction in our risk/return measure implies return losses. In short the risk/reward ratio for Equities is poor.

FTSE World AA USD Information Ratio & Forecast IR

3

forecast

standard deviations

0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

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IR (52W)

IR (36W) projected

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In fact, in our performance trend or forward curve model above (it shows as the information ratio, a special case trend moving average), the red line is the predictive trend path for equities through to early June 2014 (which is generated by a unique proprietary process), and in the predicted trend there are several sell-offs and rallies. This outlook is not quite consistent with some (e.g. Ned Davis or Marc Faber) who are predicting a 16-20% sell-off for the S&P 500. Our best estimate from the model above is -5% in early January, and then some basing before a further sell-off, with equities essentially down until a spring March/April bottom followed by a sharp rally (see last spike in the chart).

EQUITY SELL-OFF DRIVER: TAPERING IS TIGHTENING

In our view, the Fed has misread the conclusions of the recent market response to the May tapering talk. It is hard not see to see Tapering as Tightening if it is data -dependent, and the recent effects of higher mortgage rates on refi and new housing starts tells us that there are palpable economic effects associated with it too. This analysis is confirmed by three yield asset groups as well as duration sensitive equities. First, US 10 year Treasuries (i.e. duration sensitive) are tactically already heading down.

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US 10Yr Treasury USD 52W MA : mean reversion drift

% active return

normal upper

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superdetren
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And on the 6 month longer-run outlook (IR Model overleaf) there is further to go before a floor is reached (probably at 3.2-3.3%). Some have argued that longer-dated Treasuries already price tapering. This may be true for the T30s, but we are conscious that the historic average premium between T30s and T10s has been 26bps, and with T30s at a 3.9% yield, that suggests that T10s (which are at 2.9%) are hugely vulnerable to substantial changes in growth and interest rate expectations. But note that the tail of the longer-run forward curve (IR) model above for US T10s is up, and that suggests to us that Tapering once again has discernible economic effects that induce the Fed to backtrack in H1, or at least for markets to price such an outcome From the lows, US T10s could rally back to 3%, and as the IR trend line or forward performance curve in the chart overleaf approaches the zero return boundary horizon (as it does in the red forecast trend from the lows), the likelihood of positive returns from Treasuries for H1 as a whole increases. 11

standard deviations
-1.5 -0.5 0.5 1.5 2.5 -2 0 1 2 3 -1

standard deviations
0 1 2 3

.. For now, US Dividend Aristocrats, which have been strong market out-performers, also look set to take a hit before they too eventually can find a floor ..

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IR (52W)

US 10Yr Treasury AA USD Information Ratio & Forecast IR

S&P Hi-Yield Dividend Aristocrats vs. FTSE World USD Information Ratio & Forecast IR

The Market Timing Model: 2014 Outlook

IR (52W)

IR (36W) projected

IR (36W) projected

To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

To 20/12/2002 To 14/02/2003 To 11/04/2003 To 06/06/2003 To 01/08/2003 To 26/09/2003 To 21/11/2003 To 16/01/2004 To 12/03/2004 To 07/05/2004 To 02/07/2004 To 27/08/2004 To 22/10/2004 To 17/12/2004 To 11/02/2005 To 08/04/2005 To 03/06/2005 To 29/07/2005 To 23/09/2005 To 18/11/2005 To 13/01/2006 To 10/03/2006 To 05/05/2006 To 30/06/2006 To 25/08/2006 To 20/10/2006 To 15/12/2006 To 09/02/2007 To 06/04/2007 To 01/06/2007 To 27/07/2007 To 21/09/2007 To 16/11/2007 To 11/01/2008 To 07/03/2008 To 02/05/2008 To 27/06/2008 To 22/08/2008 To 17/10/2008 To 12/12/2008 To 06/02/2009 To 03/04/2009 To 29/05/2009 To 24/07/2009 To 18/09/2009 To 13/11/2009 To 8/1/2010 To 5/03/2010 To 30/04/2010 To25/06/2010 To 20/08/2010 To 15/10/2010 To 10/12/2010 To 4/2/2011 To 1/4/2011 To 27/05/2011 To 22/07/2011 To 16/09/2011 To 11/11/2011 To 06/01/2012 To 2/03/2012 To 27/04/2012 To 22/06/2012 To 17/07/2012 To 12/10/2012 To 7/12/2012 To 1/2/2013 To 29/3/2013 To 24/5/2013 To 19/7/2013 To 30/8/2014 To 30/8/2013 To 3/1/2014 To 7/2/2014 To 4/4/2014 To 30/5/2014

forecast

forecast

The third asset group that indicates that Tapering is Tightening is the forward forecast on US Banks. Banks have been an enormous beneficiary from emergency monetary policy, but the trend forecast (which amounts to a considerable level of under-performance, perhaps in the order of -20%), suggests that short rates do not remain anchored with obvious consequences for net interest margins.

US Banks vs. Global Govt Bonds USD Information Ratio & Forecast IR

standard deviations

forecast

0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

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IR (52W)
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IR (36W) projected

Of course, rises in short rates are hardly consistent with our mini-cycle slowdown thesis, so perhaps all that can be taken away here is significant surprise in US interest-rate expectations going forward.

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The Market Timing Model: 2014 Outlook

THE 2014 OUTLOOK: EQUITY DURATION PRICING
Other models also suggest that a fundamental sea-change in the asset pricing environment is underway. The principal indicator is the behaviour of duration sensitive equities, that is, equities with a greater sensitivity to interest rate and growth/eps horizon expectations. Most notably in the examples that follow, these asset classes are forecast to experience no breakdown in their out-performance trend relative to the main equity index (or equivalent proxy) in spite of a sharp equity sell-off, although that does not imply that total returns will not be negative. Primarily these are Tech and Capital Goods stocks, though, on our forward Models, Consumer Discretionary also fare well (as do Pharmas, albeit for other reasons). Interestingly, Global Autos and Retailers do less well in 2014.

Nasdaq Composite (vs. S&P 500) 52W IR & forecast IR

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standard deviations

0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 6/9/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

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IR (52W)
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IR (36W) projected

Global Industrials (see overleaf) also look well set as a relative out-performer, and although this is not a class that is typically duration sensitive, the level of forecast out-performance in the chart overleaf tells us a great deal about the rebound in global manufacturing, which looks set to strengthen into Q1 2014 consistent with Global manufacturing PMIs..

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MSCI Industrials vs MSCI Consumer Staples information ratio trend & IR forecast

trend

To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

IR (52W)

forecast

15

The Market Timing Model: 2014 Outlook

THE 2014 OUTLOOK: EMS CONFIRM RE-PRICING
Another consensus position is to be underweight Emerging Markets equities, but here, once again, our forward models are suggesting something radically and surprisingly different ahead.

MSCI EMs vs. DMs USD 52W IR & IR forecast trend

1.5

0.5

% standard deviation

0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

-0.5

-1

-1.5

-2

EMs are bounceing from a post-Lehman Bros type low

-2.5

IR (52W)

IR (36W) projected

This is a curious forecast because it flies in the face of conventional reasoning. As the Fed Tapers, the USD should strengthen, and USD strength should be bad for EMs as it largely has been since the Fed began its Taper-talk.. There are perhaps other ways of explaining the signal, most notably that global growth proves to be stronger than domestic growth (thats exactly what global manufactur ing PMIs are currently saying). Or perhaps it would be more obvious to confine the long-EM equity signal above to curiosity or estimate error . That is our concern too. But in actual fact, not only is the above signal measurably outside the bounds of estimates error, it is supported by the presence of the same signal in our models for Copper, Korea equity, and Gold.

...
% standard deviation 0 1 2 3 4 -4 -3 -2 -1
1.5 2.5 1 2 0.5

% standard deviation

-1.5

-0.5

-2

-1

DJ Copper vs FTSE World USD 52W IR & IR forecast trend

MSCI Korea vs FTSE World USD 52W IR & IR forecast trend

IR (52W)

IR (52W) IR (36W) projected

To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

IR (36W) projected

17

The Market Timing Model: 2014 Outlook

THE USD OUTLOOK
As we have remarked, all of this is somewhat curious. But perhaps the best indicator of what is going on is the forward curve performance signal from Gold (see below).

DJ Gold vs Global Equities 52W IR & IR forecast trend USD

2

% standard deviation

Normal upper
0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

-1

-2

normal lower level

-3

-4

IR (52W)

IR (36W) projected

Now, of course, Golds behavior is itself more than a little curious (although we have been a recent bear because of rising real interest rate expectations), but one thing we know is that Golds relationship with the USD is a good example of a numeraire effect. Since Gold is largely priced in Dollars and devaluation in the USD is straightforwardly a re-valuation in Gold (or indeed anything else priced in USD, like Copper), then the primary explanation for the positive Gold signal above is a reversal in the US Dollars performance direction. So whats our take on the USD? Wait for it

USD Currency Index IR & IR forecast trend

% standard deviation

0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 6/9/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

-1

-2

-3

IR (52W)

IR (36W) projected

All of this will be music to the ears for all gold bugs, since once the current pro-risk rally fades, Gold could be the key play of H1 2014. Our take is a little more nuanced. A great many of these calls are difficult to square with consensus expectations. As a devoted analyst, one could spend a great deal of time trying to resolve these relationships, but surely the correct takeaway is that the Models sign that H1 2014 will usher in a period of heightened and substantial surprise. In this regard, we see current consensus as too complacent (just as it was too pessimistic this time last year), and one further crucial example of this is the message from our Japan equity model.

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The Market Timing Model: 2014 Outlook

ONE FINAL THOUGHT: JAPAN
In 2013 Japan Equities have been a fascinating place to be. A radical reversal in BOJ policy, a reformist new Prime Minister, and a sharply higher equity market are some of the key highlights. But our forward performance curve trend Model indicates this is about to be sharply challenged. In the Model below, Japan equities are as statistically stretched (relative to Global Equities) as they have been at any point in the last 15 years. The last time they were this Overbought (early 2006), they under-performed by -17% relative. On our shorter-run horizon model they have some scope of a rally, but coupled with our JPY/USD model (which also points to a sharp correction), something like the 2006 sell-offs order of magnitude is likely this time round too.

Topix vs Global Equities YEN 52W IR & IR forecast trend

3

forecast Normal upper

% standard deviation

0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014

-1

normal lower level

-2

-3

IR (52W)

IR (36W) projected

IN CONCLUSION
Tactical Overview: Equities and risk assets have been drifting in mean-reversion terms since May. This indicates that markets have been in search of reassurance on Fed Policy. The Feds recent Taper move allows for a sharp Global Equity bounce of 4.5% in GBP terms (5.5% in USD). Tactically: There looks to be less mean-reversion scope (a typical mean-reversion bounce from these levels would imply 10% upside), and we think this is consistent with our longer run models that point to further drift through H1 2014... Strategic Overview: Risk reduction is now fully priced, and Global Equities are trying to transition to a new asset pricing environment where equity duration is priced. But, whereas 2013 began with too much pessimism, 2014 will begin with too much Optimism. The balance of risk/reward does not favour reward. Our main forecast is for a period of equity correction. Something much sharper than seen in 2013 (c. 5-8% for US equities in USD terms, -15% for Japanese equities), although this should occur in several phases with the lows occurring in May 2014. This will set equities up for a sharp rally. Strategically: The consensus sees 2014 as an inflection point for US monetary policy and for strengthening growth, at least in the DMs. We see the outlook as much more complicated than this, fraught with substantial scope for policy error (we believe that the Fed has already got it wrong), and our forecast models bear this prospect out. Principally we see Tapering as Tightening which means tapering naturally slows growth. Additionally, we think the US economy is about to head into another 2-quarter mini-cycle period of weakness driven by substantially lower inventories and capex. In other words not only will the economy slow rather than accelerate as the Fed expects (they see 2.8-3.4% growth on the latest fan forecast), the Fed will also find itself tightening into slowing growth. That will drive them to suspend Tapering. Strategic Positioning This is likely to surprise The Consensus and lead to substantial reversals in the most crowded trades (long USD, short Gold, short EMs, short duration). For H1 as a whole we foresee zero TR for Global equities (in USD), ditto High Yield, modest upside for US T10s, and 10-15% upside for Gold (in USD). In H1 we do however see two further important asset pricing effects. First, continued outperformance of duration equities (Industrials, Tech); and, second, increasing differentiation in EM returns. Contact us for more details. John P. Cuthbert BA, MA, MSc, JP Cuthbert Consulting Ltd Independent Financial Economist & Consultant December 19, 2013

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