October Ghosts?

For the last few years the time to take profits has been when volatility shows up. When volatility calms down it is time to ride markets slow grind higher. We have been warning for months that volatility would rise as the Federal Reserve exits its QE policy this month. We had this to say in our blog post back titled Riding the Waves back in July.

The central theme here is that investors should be expecting an increase in volatility as the Federal Reserve tries to exit its loose monetary policy. We expect trading bands to widen over the coming months as Fed officials warn of approaching volatility. The bankers are asking for it and the Fed is ready to let it happen. We intend to be prepared. http://terencereilly.wordpress.com/2014/07/07/riding-the-waves/

Our bearish thesis has been playing out over the last two weeks. Bears have pushed the bulls back as the Russell 2000 ETF (IWM) has reached an oversold level and support at 110. We have postured that the failure of small caps to confirm the new highs in large caps was precipitating a period of higher volatility and a move to the downside in equities. Friday’s oversold bounce helped the bulls take back some ground but I believe that the bears are still in charge. For now we are in a range between 110 and 118 on the Russell 2000 ETF (IWM). A close below 108 on the IWM will auger in a very quick move down to 96. That would be a move of 13.5% lower from current levels. Large caps will not fall by as much but it could change the trend of the market and that could last for months. A move above 118 on IWM is our stop loss and that would mean that the bulls are back in charge.

Beyond the recent volatility and downdraft in equities we think that the major story is in Foreign Exchange volatility. The changes in Central Bank policy around the world are causing more than merely ripples on the pond as central bank policy is getting investors all wet. The US Dollar has roared higher the last several weeks as the US Federal Reserve tries to get out of the money printing business while Europe and Japan ramp up their efforts. Mohamed El Erian former head of PIMCO and the Chief Investing Officer of the Harvard Endowment had this to say when recently queried on the subject.

Q: Meanwhile, the dollar has been soaring.

A: This is an issue that’s completely off the radar screen that should be of interest to all investors. I warned about this much earlier that at some point volatility will return to the currency markets. And it’s returning for three very valid reasons.

First, the U.S. is on a different economic track than Europe and Japan. The U.S. isn’t growing as much as we’d like it, but it’s growing and continues to heal. Japan and Europe are going the other way.

Second, policy is starting to diverge. The ECB is stepping harder on the stimulus accelerator while the Fed is slowly easing off the accelerator.

Third, the geopolitical tensions affect Europe a lot more than the U.S. So what we have seen is a major move in the dollar versus both the yen and the euro. This is key because it means the return of volatility in the foreign exchange market can undermine central banks’ effectiveness in limiting volatility elsewhere, which is one of their objectives. (Emphasis mine.)

Here is the link to the full interview that appeared in USA Today. http://www.usatoday.com/story/money/business/2014/09/13/bartiromo-mohamed-el-ehrian-scotland-vote-economy-pimco/15507249/

How to proceed? I came across this assessment of current markets by Josh Peters over at Morningstar. Josh holds his CFA and writes the Morningstar Dividend Investor which I find a very worthwhile read.

My chief strategy along these lines is to exercise patience, particularly while being compensated with yields that are well ahead of the market average. A speculative strategy that goes out of style might never come back, but when growing, moat-protected, soundly financed firms fall out of favor, they’re bound to rotate back into favor eventually. To let a prolonged period of underperformance from solid businesses drive us to chase bigger returns elsewhere would be a terrible mistake. Far better to wait things out. – Josh Peters CFA Director of Fixed Income/Equity

A rising dollar is going to hurt multinationals profits and put a damper on commodity prices. Watch the US Dollar. Watch the Russell 2000 for clues to equity prices. October is always a nervous month for investors. Hang on. It could be a bumpy ride as the FOMC exits QE.

I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

Euphoria and Scrambled F-15’s

Unresponsive plane. Scrambled F-15’s. Something went horribly wrong. Those were the headlines last week when a single prop plane suffered a sudden and catastrophic loss of cabin pressure. We have a colleague who is a very astute investor with a lifelong connection to flying, the aviation industry and the investigation of plane crashes. According to our colleague, a plane flying at 31,000 feet needs to be pressurized in order to protect it from the outside elements. A cabin that loses pressure can quickly turn into a death trap. Typical procedure when faced with a loss of pressurization would be to declare an emergency and reduce your altitude to 20,000 while donning an oxygen mask. The pilot’s other choice would be to declare an emergency and proceed to 10,000 where he/she could breathe without assistance. It may be speculation at this point but it appears that last week a pilot with over 20 years experience lost pressurization over the eastern United States and F-15 fighter jets were scrambled in response. According to air traffic controller transcripts the pilot stated “We have an indication that is not correct on the plane”. He proceeded to reduce his altitude to 28,000 feet.

“Not correct on the plane.” As humans we have a tendency to go with our gut or ignore warnings signals because all looks or seems fine. Why didn’t a pilot with 20 years experience declare an emergency? Why didn’t he quickly descend to 20,000 feet and put on his oxygen mask or just go straight to 10,000 and avoid danger completely as his signals were indicating? One of the symptoms of not receiving enough oxygen is a feeling of euphoria. Was it pilot error due to the loss of oxygen or was he simply ignoring the indicator light? As humans we tend to ignore things that get in our way. We may not want to come down from 31,000 feet because the air is thinner and we will get to our destination faster. Managing your investments is like being a pilot. It is about managing risks to get to your destination.

Being long the market seems to be bringing feelings of euphoria as the market marches ever higher. All systems go. Let’s not let the feelings of euphoria take over us. Let’s make sure we are paying attention to our warning indicators. The indicator lights are flashing red in the markets. If we come down from 31,000 feet we may get to our investing destination a little slower but at least we will still get there. Let’s make sure we get to our investing destination. Is it time to come down to 20,000 feet and put our oxygen mask on?

This is what we had to say in our last blog post and not much has changed on the technical front. The Russell 2000 has moved below some of its moving averages and that has us leaning even more towards our bearish thesis. A move above 118 on IWM is our stop loss and that would mean that the bulls are back in charge.

 The chart I am watching is the Small CAP Reversal chart I attached below. It is a textbook reversal pattern. Having said that, nothing right now that is happening from a monetary perspective is in the textbook. Watch the Russell 2000  (IWM). If it closes below 108 it should go to 96 very quickly. That is a 17% drop from current levels. Large caps will not fall by as much but it could change the trend of the market and that could last for months. 

 Hope this helps. If you can keep your head while…

 I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

Published in: on September 13, 2014 at 8:47 am  Leave a Comment  
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Do You Remember? Dancing in September

September. A month when thoughts turn to returning to school and the weather cools as investors and traders return from the beach. The relaxation of summer is quickly replaced by the feelings of anxiety. There are no months that strike fear and anxiety in the hearts of investors more than September and October. This year will be no different. The two worst performing months on the calendar are the aforementioned months. The reminder of September 11th for traders who were there only serves to heighten the anxiety felt. As you know we find that the seasonality of markets to be a reliable source of alpha as human beings refuse to change their well worn patterns. From Arthur Cashin and Jason Goepfert comes some fresh research on the where we stand on the upcoming seasonality and what next month may hold in store.

 1.Volume on the NYSE has been well below average, which is not unusual for a pre-holiday week. When stocks hit new highs on below-average volume, they tend to under-perform a bit longer-term, relative to when they hit new highs on above-average volume.

 2.If the S&P 500 closed August with a gain of 3% or more, then it added to its gains in September 36% of the time. If it also closed at a 12-month high in August, then September was positive only 1 out of 12 times, averaging -2.6%. If August closed with a gain of 1% or more, and a 12-month high, then September was positive only 3 out of 19 times, averaging -1.6%. All data since 1928. - Jason Goepfert Sundial Capital Research

As you know we have felt that the bond market still had legs in its rally in 2014. (2015 may be a different story.) Also by way of Arthur Cashin are the following notes from Barry Habib who has nailed the bond market and its course so far in 2014.

 Here are some additional reasons to support a continuing decline in US yields.  Foreign investors, especially those in Europe, will likely be attracted to investing in US Treasuries.  Not just because of the obvious and wide spread between the US 10-year Note and German 10-year Bund.  There is an added currency play which could greatly improve the returns.  As QE3 comes to a close, we have already seen the Dollar strengthen against the Euro.  This trend should continue as tapering is finalized.  Adding to the Dollar strength against the Euro is the strengthening US economy against the sluggish Eurozone. – Barry Habib

Arthur goes on to mention that another reason to be long US Treasuries is because everyone else is seemingly on the other side of that trade and short US Treasuries. There is massive money short US Treasuries which is a bet that Treasuries will lose their value and have prices head lower. For most of 2014 that trade has been a loser. The thought being that with the Fed ready to start raising rates it would be a no brainer that Treasuries would lose value. Not so much.

Keep your eyes on Us Treasuries as any geopolitical rumblings or deflation in Europe may push more money into bonds. We will find out in the next two months as to how much the Federal Reserve’s QE policy has held up stock prices. Those purchases are being eliminated in the next 60 days. This is where the rubber meets the road. It is ironic that the Fed policy is being withdrawn at the worst point seasonally for stocks. The anxiety level of investors for September and October will only be heightened. Gold keeps trying to break out but is being held back.  As for stocks here is a note we sent to a friend this week.

 Just for kicks – the high in 1987 was put in the day after Labor Day. 

 The chart I am watching is the Small CAP Reversal chart I attached below. It is a textbook reversal pattern. Having said that, nothing right now that is happening from a monetary perspective is in the textbook. Watch the Russell 2000  (IWM). If it closes below 108 it should go to 96 very quickly. That is a 17% drop from current levels. Large caps will not fall by as much but it could change the trend of the market and that could last for months. 

 Now the good part. No problems. Only opportunities. Take a look at the 2nd chart – Dow Jones Bull Bear Cycles. The last two Bear cycles lasted 17 & 18 years. We are 14 years into the current Bear Cycle. Take a look at the 1970’s bear cycle. I expect much the same to happen here. The last major move down is expected by investors and therefore should be much shallower than the previous moves in the Bear Cycle. Investors are prepared this time. (The old – they are not going to get me again!) Granted monetary policy is a bit experimental and anything can happen. I just think a major dip this late into a Bear Cycle will need to be bought. 

 Hope this helps. If you can keep your head while…

 bigcharts.com 

 Small Cap Reversal August 2014

 Dow Jones Bull Bear Cycle

 

I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

Waiting on the Fat Pitch

Geopolitics continue to call the tune as markets move on every twitter feed out of the Ukraine. The movements of troops are moving the troops on Wall Street as nervous investors look to stay ahead of the machination of politicians in the eastern bloc. This is the nervous time of year after all. Investors are very cognizant that summer markets are very thin and can move on very little news as traders sun themselves on beaches before the kids head back to school. Back to school usually brings some sort of stress test as Se[ptmeber and October have a history of ugly turns in the market. It is no wonder we are seeing investors such as George Soros and David Tepper hedge long positions in the stock market. With valuations at such high levels, troops at high alert and investors highly anxious about what the fall may bring it may be a prudent strategy to continue to build investing defenses. Even Warren Buffet who hates carrying substantial amounts of cash on his books is currently at his highest level of cash in over 40 years.   http://www.bloomberg.com/news/2014-08-04/buffett-waits-on-fat-pitch-as-cash-hoard-tops-50-billion.html

One of Mr. Buffett’s investing axioms is, much like a baseball batter with unlimited strikes might do, is to wait for the fat pitch. With over $50 billion on hand at Buffett’s Berkshire Hathaway that is one fat pitch indeed. Below by way of dshort.com comes Buffett’s favorite market indicator – Market Capitalization to GDP. As a signal the market is overbought when the indicator breaks 100% and is oversold when it goes below 60%. We are currently at 126% of GDP. Markets can advance farther than one thinks but this indicator is certainly flashing a yellow caution light.

 

The above chart, also from dshort.com, is the Q Ratio. The Q Ratio was developed by James Tobin, Nobel Laureate from Yale University. The Q Ratio measures the combined market value of companies to their replacement cost. A ratio below one indicates that the value of the company’s stock is cheaper than replacement cost while a ratio higher than one indicates that the company’s stock value is higher than the replacement cost. From this one can see that markets and investors don’t listen to yellow caution lights and sometimes just sail on through. The Internet Bubble of 2000 pushed right on through the highest levels of Q Ration ever recorded. Flashing caution at over 1.0 this metric currently stands at 1.17. High levels but one does not know when a bubble breaks.

Having aid that we do believe that the Federal Reserve’s action of continued monetary policy have induced these high levels of asset prices. Any further reduction in monetary heroin may induce less than euphoric feelings from the marketplace. In July the reduced asset purchases began to have an effect on markets and those purchases are planned to cease in October of this year. We continue to expect volatility to increase into that time frame and prepare for the opportunities that may rise from the change in monetary policy.

Equity markets have seen increased volatility, which from our perspective, limits upside potential in markets. Equity markets have seen higher upside since 2008 when markets are stable and not volatile. We believe that this volatility will continue into the fall of 2014. The Ukrainian situation and Portuguese banking crisis presented volatility and a selloff of risk in equity markets. That extended selloff was afforded a bounce in prices this past week. That bounce may have run its course. Friday’s action in the market provided clues that the bulls short run has ended as bears took control in the afternoon on Friday at critical resistance points. This week may be critical in the future near term course of the market as everyone awaits Janet Yellen’s Jackson Hole speech on Friday.

We continue to use small caps as our map while US Treasuries and Gold continue to be our risk temperature gauge. For the moment 1960/68 is key resistance in the S&P 500. If the bulls can leap above this level the run can continue. On the downside, the Russell 2000 needs to hold 1100.  Also keep an eye on the VIX index. As it spikes the Fed may try to calm fears.

I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

Published in: on August 16, 2014 at 8:46 am  Leave a Comment  
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Contagion

Volatility is back and so are the caution flags. You know the list. It includes geopolitical issues such as the Ukraine and Gaza. Economic issues like inflation and jobs reports. A default from Argentina and a runaway virus like something out of a science fiction movie. The thought of an Ebola contagion was not the only contagion making the rounds. A European banking contagion may have stoked more fear this week than the Ebola Virus. Portuguese banking issues sent European stock markets reeling.

One issue that has had our attention for weeks is the drawdown of Federal Reserve purchasing in the marketplace. Each month the Federal Reserve has cut back its purchases by $10 billion in an attempt to exit the monetary easing business. That tapering of purchases has not had an immediate effect on the market until this month. The Fed’s purchases, while steady, actually had an increasing effect as the supply of bonds shrank along with the US fiscal deficit. The Fed was actually purchasing a larger percentage of supply each month. This month is the first month of the tapering where the percentage of Fed purchases actually shrank and it may not be a coincidence that we also saw the market shrink.

How bubbly are we? From Richard Fisher President of the Dallas Federal Reserve comes this speech given on the campus of the University of Southern California on July 16th of this year titled Monetary Policy and the Maginot Line.

To get a sense of some of the effects of excess liquidity, you need look no further than Neil Irwin’s front-page, above-the-fold article in the July 8 issue of the New York Times, titled “From Stocks to Farmland, All’s Booming, or Bubbling.” “Welcome to … the Everything Bubble,” it reads. “Around the world, nearly every asset class is expensive by historical standards. Stocks and bonds; emerging markets and advanced economies; urban office towers and Iowa farmland; you name it, and it is trading at prices that are high by historical standards relative to fundamentals.” Irwin’s comments bear heeding, although it may be difficult to disentangle how much these lofty valuations are distorted by the historically low “risk-free” interest rate that underpins all financial asset valuations that we at the Fed have engineered. http://www.dallasfed.org/news/speeches/fisher/2014/fs140716.cfm

Just about every asset class is overvalued but if history is our guide as the Fed exits QE bonds will hold steady while equities put in a bit of a retreat. For hints on that retreat we refer to the small cap space as the canary in the coalmine. The Russell 2000 is showing signs of a classic double top. A double top is a cute way of saying that we got to the highs twice and lacked the conviction to break through. We now need to test the lows of its recent range and the bull’s conviction. The Russell is now at 1114.89. A close decisively below 1090 would indicate a move to 970. A move 12.9% lower which would develop rather quickly. Keep one eye on the Russell 2000.

Fisher wants less accommodation but Yellen, as seen in her Humphrey Hawkins testimony below, plans on being quite accommodative. In this battle Yellen wins for now. Look to Fisher for the truth but look to Yellen for the Fed’s next move. The market seems to be siding with Fisher for now and fears that the Fed may be behind the curve.

“We need to be careful to make sure that the economy is on a solid trajectory before we consider raising interest rates,” … “I think the forward guidance that we have provided in the policies that we have put in place are providing a great deal of accommodation to the economy to make sure that it is on a solid trajectory.” Janet Yellen – Humphrey Hawkins Testimony Congress July 2014 http://www.cnbc.com/id/101836922

Small caps are our map while US Treasuries and Gold continue to be our risk temperature gauge. Also keep an eye on the VIX index. As it spikes the Fed may try to calm fears.  

I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

Published in: on August 2, 2014 at 2:25 pm  Leave a Comment  
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Riding the Waves

I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

For years our mantra has been – build investing scenarios and trade accordingly. It is akin to the Boy Scout motto. Be prepared. Lloyd Blankfein, the Chief Executive Office of Goldman Sachs, states it very well in the above quote when he compares his firm to contingency planners. Indeed, he is correct in that we cannot predict the future but what we can do is prepare for it. In this preparation we are currently finding the lack of volatility to be very unsettling. Less and less volatility tells us we may be overdue for an approaching storm. Let’s take a look at the facts from the folks over at the Bespoke Investment Group. On June 17th they released this research note.

In fact, it has been two months (42 trading days) now since the S&P 500 last had a move up or down of 1% or more.  To put that in perspective, you have to go back nearly 20 years to 1995 to find a period where the S&P 500 went longer without a move of that magnitude.

 Since 1928, there have been 30 other streaks that lasted longer than 40 trading days.  While extended streaks have been rare in the last twenty years, it hasn’t always been that way.  For example, from the early 1950s through the early 1970s, there were numerous periods of extended calm in the market.  In fact, the years 1963, 1964, and 1965 each saw streaks of more than 100 trading days without a 1% move (the 1965 streak ended in February 1966).

http://www.bespokeinvest.com/thinkbig/2014/6/17/1-moves.html

Could we be in for an extended period of calm in the markets as the one that took place from the early 1950’s until the inflation years of the early 1970’s? Perhaps, but we feel that the pace of change is accelerating in the Internet Era and too many high level officials have interests in seeing higher volatility. Let’s look at what some of those high level officials have been saying in recent months.

VOLATILITY – Resurgence?

Over the last two months we have seen a steady parade of Investment Bankers, CEO’s and Federal Reserve officials, both past and present, come to the microphone to argue that volatility must rise. For investment bankers and CEO’s of financial trading firms volatility is a must. Banks like CitiGroup, Goldman Sachs and JP Morgan need volatility in order to provide value to clients and make profits. Here is a partial list of the lineup of bankers preaching about the current lack of and need for volatility.

On May 7th of this year Jeremy Stein, in one of his last speeches as a Federal Reserve governor, warned that the central bank may face more bouts of market volatility as it winds down the most aggressive easing in its history.

Some investors may be “underestimating the degree of uncertainty about the future path of policy and are placing levered bets accordingly,” Stein said yesterday in a speech to the Money Marketeers of New York University. “So we may have some further bumps in the road as this all plays out.”

In response to an audience question, Stein said “it’s important that we not get goaded into thinking we’re responsible for minimizing market volatility.” -Bloomberg 5/7/14

We see this as a not so subtle shot across the bow. We take this as a warning that the Fed knows that volatility is coming as they exit from Quantitative Easing (QE) and that they want markets to be prepared. Stein’s answer to the audience’s question seems to intimate that given renewed volatility upon their exit the Fed may remain on the sidelines and allow greater volatility.  A 10% correction could easily morph into a 20% correction as the Fed tries to remain on the sidelines in the event of a market retreat.

Comments from FOMC members carry different weights. New York Federal Reserve (NYFRB) President Bill Dudley’s comments carry more weight than most. While we believe that volatility will rise and that the Fed may be encouraged to sit on the sidelines at some point the Federal Reserve will intervene and backstop any market slide.  In late May Dudley made comments that suggested that very same concept. Dudley volunteered that the Fed will be more aggressive in raising rates if markets allow and less aggressive if they do not. From that comment we believe that Dudley infers that the market will be calling the tune and the Fed will apply the brakes or the gas depending on the market’s reaction to Fed policy. Welcome to Goldilocks monetary policy. Not too hot. Not too cold.

Jon Hilsenrath is considered to be a mouthpiece for the Federal Reserve and is charged with helping get the committees thoughts and the correct perception of those thoughts into the mainstream. In a piece in the Wall Street Journal (WSJ) on June 3rd of this year Hilsenrath proffered a belief that Federal Reserve officials, looking out at mostly calm financial markets, are starting to wonder whether tranquility itself is something to worry about.

Other measures of risk aversion and market volatility show an especially striking sense of investor calm. The VIX, which tracks expected stock-market fluctuations based on options trading, has gone 74 straight weeks below its long-run average—a run of steadiness not seen since 2006 and 2007.

Moreover, the extra return that bond investors demand on investment-grade corporate debt over low-risk Treasury bonds, at one percentage point, hasn’t been this low since July 2007. The lower this “spread,” the less risk-averse are bond investors.

The worry at the Fed is that when investors become unafraid of risk, they start taking more of it, which could lead to trouble down the road.

http://online.wsj.com/articles/fed-officials-growing-wary-of-market-complacency-1401822324?KEYWORDS=hilsenrath

 By way of none other than Lloyd Blankfein, CEO of Goldman Sachs, comes his take on the lack of volatility.

While stock market volatility has dropped to a seven-year low as major indexes continuously rise to record highs, that blissful investing state can’t last forever, … The luxury of a steady, calm, quiet market” might continue for a period, but will ultimately halt,…

“At the end of the day, it’s not a normal condition to have interest rates at zero,”… “Eventually people will acknowledge higher [economic] growth. Money as a commodity will start to cost something again. . . . That in itself will produce a shock to the market.”– Lloyd Blankfein CNBC Interview June 11, 2014 http://www.cnbc.com/id/101749844

With great complacency comes the possibility that the market will be surprised by an exogenous event and given the degree of complacency the greater the impact of that event as investors are not positioned accordingly. If everyone is on one side of the boat when the wave hits the greater the chance that one or more get thrown overboard.

The central theme here is that investors should be expecting an increase in volatility as the Federal Reserve tries to exit its loose monetary policy. We expect trading bands to widen over the coming months as Fed officials warn of approaching volatility. The bankers are asking for it and the Fed is ready to let it happen. We intend to be prepared.

INFLATION VS DEFLATION The Debate Rages again

The inflation trade is making its way back to the forefront of investor’s minds in the aftermath of the Federal Open Market Committee meeting in June. In Chairwoman Janet Yellen’s press conference traders got the feeling that the FOMC is a bit too complacent when it comes to recent inflation statistics which seem to be heating up.

When inflation talk heats up we look to gold and the 10 Year US Treasury for clues. Traders bid up the inflation trade across asset classes as gold/silver rallied and Treasury yields rose while the yield curve steepened. Is inflation back? Gold bounced off of its lows very aggressively this week in the aftermath of the FOMC meeting. We may now be looking at the top end of that range to see if that can repel the gold bulls. $1400 is going to be a key number. Can it break out of its recent range of $1200-$1400? A break through $1400 on the upside would ignite a new round of short covering and perhaps foretell a move back into inflation trade winners. US 10 year Treasury yields are also up against resistance and at key levels.  Over the course of the next quarter we will be keeping a close eye on gold and the 10 Year US Treasury. If investors begin to move back towards the inflation trade things could change quickly. A move towards rising inflation would push us to reduce bond holdings and garner a larger allocation towards precious metals and oil producers.

VALUATIONS

BIRINYI

Laszlo Birinyi called the bottom in stocks in March 2009 and has remained unabashedly optimistic ever since. Birinyi has an amazing track record and is considered the consummate bull.  Last month he was quoted by the WSJ as saying that he felt that the bull market may be its last phase – the exuberance phase.

http://blogs.wsj.com/moneybeat/2014/05/27/laszlo-birinyi-sp-500-to-1970-this-year/

GRANTHAM

Another voice that we always stop and listen to is that of Jeremy Grantham founder of Grantham Mayo and manager of over $100 billion in assets. In an interview in Fortune Grantham and his crew over at GMO in Boston were asked about their extensive work on bubbles going back throughout investing history. Grantham’s research indicates that most bubbles go to at least two standard deviations above the market’s mean valuations. Grantham feels that a bubble in the overall market would not exist until the S&P 500 hit 2,350 although his models suggest negative returns over the next 7 years based on current valuations.

We do think the market is going to go higher because the Fed hasn’t ended its game, and it won’t stop playing until we are in old-fashioned bubble territory and it bursts, which usually happens at two standard deviations from the market’s mean. That would take us to 2,350 on the S&P 500, or roughly 25% from where we are now.

We invest our clients’ money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns. The next bust will be unlike any other, because the Fed and other central banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before. Assets are overpriced generally. They will be cheap again. That’s how we will pay for this. It’s going to be very painful for investors.

Another note on current market valuations came to us just last week from JP Morgan that shows the current level of Price Earnings ratio of the S&P 500 based on trailing earnings. The latest numbers show that the market has only been more richly valued on this metric in 10% of its history. As you can see from the chart below that shows P/E levels since 1983 a good portion of that 10% happened between 1996 and 2007. That timeline encompasses the period that Alan Greenspan cited irrational exuberance in the stock market, the Internet Bubble and the Real Estate Bubble of 2007. Are we just in a phase in the market where Federal Reserve polices engender higher P/E ratios? Could markets go even higher? We think that the answer to both is yes but we must be prepared if the answer to those questions turns out to be no. Two things that money managers are taught from the time they can crawl and considered always dangerous to believe. 1. It is different this time. And 2. We are in a period of permanently higher price levels. It is never different and nothing is permanent.

 RIDING THE WAVES OF VOLATILITY

The market continues to make new highs even as investors seem as reluctant as ever to buy those new highs. Small caps may hold the key to the market. We have noticed of late that investment managers have been piling into Mid Cap S&P stocks. That gives them the chance to catch up if they have been underperforming the market but are not fully exposed as they would be if they piled into small caps and their higher risk profile. While large caps have risen back to all time highs small caps have not quite confirmed that move. What we may be seeing here is that institutional investors are forced to invest client’s money and are placing that money into safer assets like mid and large cap stocks while a stealth bear market takes place underneath in small caps. When confusion reigns we turn our eyes to the bond market. The bond market is not playing along with a new high in equities as 10 Year US Treasury rates hover between 2.5 and 2.65%. It gives us reason to pause when equities seem to be ignoring clues emanating from bond market.

While we are not discounting that this could be a late stage market breakout, if small caps begin to fail and push down through recent lows the broader market may follow suit. For the time being investment managers are almost paralyzed in their decision making. While not being able to discredit the new highs in large caps managers are concerned by stock valuations, a lack of volatility and lack of confirmation of recent S&P 500 highs from small cap stocks.

BOY SCOUTS

The Federal Open Market Committee (FOMC) Minutes from the April 29-30 2014 meeting were released last month and the committee noted that a couple of participants felt that conditions in the leveraged loan market had become stretched. We were early into leveraged loans the past couple of years and that served us well. Some clients will now see a reduction in that area in the coming months as we wish to back away from any repercussions associated with a possible bubble in leveraged and covenant lite loans.

While officials and bankers are prepping the investing climate for volatility we continue to prepare our portfolios accordingly. While we do not know if the stock market is in a late stage breakout or breakdownwhat we can say, is that a major market top is likely to be preceded first by increasing volatility, or expanded trading ranges. We feel that battening down the hatches as we approach what is seasonally the weakest part of the market cycle is a prudent idea. Battening down the hatches would see us continuing to invest in less beta sensitive parts of the market including utilities and telecommunications while also maintaining exposure to inflation sensitive issues such as precious metals and oil in case inflation raises its head. We intend to be prepared for any and all outcomes as we are your contingency planner.

 

Blackthorn is an investment adviser registered in the state of Georgia. Blackthorn is primarily engaged in providing discretionary investment advisory services for high net worth individuals.

 All information provided herein is for informational purposes only and should not be deemed as a recommendation to buy or sell securities. All investments involve risk including the loss of principal. This transmission is confidential and may not be redistributed without the express written consent of Blackthorn Asset Management LLC and does not constitute an offer to sell or the solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential offering memorandum. 

Inflation and Volatility Making a Comeback?

We have been saying for the past couple of weeks that volatility has been nonexistent and is due for a comeback. By way of none other than Lloyd Blankfein, CEO of Goldman Sachs, here is his take on the lack of volatility.

While stock market volatility has dropped to a seven-year low as major indexes continuously rise to record highs, that blissful investing state can’t last forever, says Goldman Sachs CEO Lloyd Blankfein.

The luxury of a steady, calm, quiet market” might continue for a period, but will ultimately halt, Blankfein told CNBC

“At the end of the day, it’s not a normal condition to have interest rates at zero,” he said. “Eventually people will acknowledge higher [economic] growth. Money as a commodity will start to cost something again. . . . That in itself will produce a shock to the market.”

The danger constantly lurks of “some exogenous event . . . that’s going to cause people to have to reset their portfolios,” Blankfein noted.

“There is always something coming that we don’t know about because nobody know what is the future is,” he added.

How long and how low has volatility been? The folks over at Bespoke Investments were kind enough to share this research for us.

 

In fact, it has been two months (42 trading days) now since the S&P 500 last had a move up or down of 1% or more.  To put that in perspective, you have to go back nearly 20 years to 1995 to find a period where the S&P 500 went longer without a move of that magnitude.

 Since 1928, there have been 30 other streaks that lasted longer than 40 trading days.  While extended streaks have been rare in the last twenty years, it hasn’t always been that way.  For example, from the early 1950s through the early 1970s, there were numerous periods of extended calm in the market.  In fact, the years 1963, 1964, and 1965 each saw streaks of more than 100 trading days without a 1% move (the 1965 streak ended in February 1966).  –Tuesday June 17, 2014

 http://www.bespokeinvest.com/thinkbig/2014/6/17/1-moves.html

The inflation trade is making its way back in the aftermath of the Federal Open Market Committee meeting this week. In Janet Yellen’s press conference traders got the feeling that the FOMC is a bit too complacent when it comes to recent inflation statistics which seem to be heating up. Traders bid up the inflation trade across asset classes as gold/silver rallied and Treasury yields rose while the yield curve steepened. Is inflation back? It would change the game a bit. Keep an eye on gold.

Gold bounced off of its lows very aggressively this week in the aftermath of the FOMC meeting. We may now be looking at the top end of that range to see if that can repel the gold bulls. $1400 is going to be a key number. Can it break out of its recent range? A break through $1400 on the upside would ignite a new round of short covering and perhaps foretell a move back into inflation trade winners. US 10 year Treasury yields are also up against resistance and at key levels.  Keep a close eye on gold and the 10 Year US Treasury. A move back towards the inflation could be a game changer.

Speaking of inflation. During the financial crisis we have looked to England as the Canary in the Coalmine. England has a much smaller economy and the Bank of England chose many of the same tricks that the FOMC has used here in the US. The difference may be the impact that the BOE had on their much smaller economy. It is akin to turning a speedboat around rather than a battleship.

In the BOE governor’s annual address to bankers in the heart of London’s financial district, Mr. Carney said that rapid growth and tumbling joblessness mean that the time to begin raising interest rates is drawing nearer.

“There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced. It could happen sooner than markets currently expect,” Mr. Carney said, according to a text of his remarks. -6/12/2014 WSJ Jason Douglas

Treasuries and Gold continue to be our risk temperature gauge. Watch the yield on the 10 Year US Treasury and keep an eye on gold. We could be in for an equity melt up here as investors are caught with too much cash. While the FOMC continues to play the music investors are forced to dance.

In Blankfein’s interview on CNBC I thought that he nailed the description of investing and being in the investing business. Build scenarios and invest accordingly.

I think we aspire less to foresee the future and more to be a great contingency planner… you can respond very fast to what’s happening because you thought through all the possibilities, – Lloyd  Blankfein

 

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

 

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

Fed Concerns and Market Melt Up

The last two weeks we have pointed to the preponderance of Federal Reserve officials out and about warning about complacency from investors and the lack of volatility in the marketplace. Even bankers from Goldman Sachs, Citigroup and JPMorgan have complained that the lack of volatility is hurting their business. Jon Hilsenrath is considered to be a mouthpiece for the Federal Reserve and is charged with helping get the committees thoughts and perceptions into the mainstream. Here is what Hilsenrath had to say in a piece this week in the Wall Street Journal.

Federal Reserve officials, looking out at mostly calm financial markets, are starting to wonder whether tranquility itself is something to worry about.

Other measures of risk aversion and market volatility show an especially striking sense of investor calm. The VIX, which tracks expected stock-market fluctuations based on options trading, has gone 74 straight weeks below its long-run average—a run of steadiness not seen since 2006 and 2007.

Moreover, the extra return that bond investors demand on investment-grade corporate debt over low-risk Treasury bonds, at one percentage point, hasn’t been this low since July 2007. The lower this “spread,” the less risk-averse are bond investors.

The worry at the Fed is that when investors become unafraid of risk, they start taking more of it, which could lead to trouble down the road.

 This indicates a great deal of complacency, Richard Fisher, president of the Federal Reserve Bank of Dallas, said in an interview. When you get complacency you’re bound to be surprised at some point.

Fed Officials Growing Wary of Market Complacency WSJ 6/3/14 Hilsenrath

http://online.wsj.com/articles/fed-officials-growing-wary-of-market-complacency-1401822324?KEYWORDS=hilsenrath

Louise Yamada is the Queen of Technical Analysis on Wall Street. She had some thoughts this week on the overall market and gold. We put more stock into her thoughts on gold as gold cannot really be analyzed based on its fundamentals. It has none. Gold is usually traded based on its technical’s. Here is what she had to say on CNBC.

Judging by the market’s short-term trading pattern alone, famous technical analyst Louise Yamada says that the S&P 500 is on its way up to 2,000. Meanwhile, she sees the Dow Jones Industrial Average heading to 17,200.

With the breakouts that are in place for these indices, I think you could move a little higher, Yamada said on Tuesday’s “Futures Now. You may not see something more contractual until into the fall.

In the three-month chart of the S&P, Yamada observes a “continuation” pattern that indicated the S&P’s upward momentum will continue.

The one concern on Yamada’s horizon is the underperformance of the Nasdaq Composite and the Russell 2000.

There’s a little bit of a glitch in the sense that you have a dichotomy in the market. The Russell 2000 and the Nasdaq look a little bit more precarious…When you start to see part of the markets separate from the leaders that generally means that under the surface you’re seeing some deterioration. But that’s not to say that you can’t get some improvement here.  CNBC 6/3/14

Gold’s outlook is not nearly as bright according to Yamada.

Unfortunately, at this time, All the momentum indicators — daily, weekly and monthly, which is the most structural — are looking very negative.

What makes this so troubling is that gold is getting close to a critical level.

Eyeing gold’s trading range between about $1,400 and $1,200, Yamada says that if $1,200 can’t hold, we might flip even to $1,100, and that would actually break the 2005 trend for gold.

Treasuries and Gold continue to be our risk temperature gauge. Watch the yield on the 10 Year US Treasury and keep an eye on gold. We could be in for an equity melt up here as investors are caught with too much cash. While the FOMC continues to play the music investors are forced to dance.

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

And They Danced

Most of the major banks have been out and about in the last week with mea culpas on earnings as Citi JPMorgan and GS are all complaining that low volatility is hurting profits. Who needs bankers and traders when there is no movement in the market? It appears that the Federal Reserve’s monetary policy has dampened volatility and bankers are asking for it back. Building on what Bill Dudley FRBNY President said last week that the Fed is prepared for more volatility in the markets. Volatility is coming. The bankers are asking for it and the Fed is ready to let it happen. Be ready.

Laszlo Birinyi was out and about this week making market calls. Birinyi has an amazing track record and is considered the consummate bull. All bullish all the time. He expressed this week that the bull market may be its last phase – the exuberance phase.

The market is not cheap but it is not especially expensive either,” he wrote Tuesday to clients of his Westport, Conn.-based investment management and research firm. Mr. Birinyi, a long-time bull, was among a select group of Wall Streeters who called the bottom in stocks in March 2009 and has remained optimistic ever since.

But his latest price target is far from exuberant. The S&P 500 at 1970 would mark another 3.1% gain from current levels and an overall 6.6% gain for the year. WSJ 5/27/2014

http://blogs.wsj.com/moneybeat/2014/05/27/laszlo-birinyi-sp-500-to-1970-this-year/

For those so inclined here is a more granular analysis on the market internals from FBN’s very astute JC O’Hara.

Perceived Discrepancies with New Highs

 The market once again made a new high. This continues to be a market you cannot bet against. There are many perceived discrepancies between what one would expect to find at new highs vs. what we currently have. Small Caps are lagging, yields continue to decline, new highs are scarce, and the average stock is still -11% from making a new 52 week high. Combine that with depressed readings from the VIX, credit spreads, and other market stress indicators and you have managers that are paralyzed in their decision-making processes. Many market forces and technical studies are giving contradictory signals. At the end of the day we cannot discredit the markets new high.

 Sure, this may be a late stage market breakout, and according to the masses, a pullback is ‘needed’, but money continues to find its way into stocks. Someone likes the market so much they are willing to add exposure at all-time highs. We want to highlight that this is not just a US market rally, but a global developed market rally. The MSCI Developed Market Index just surpassed its 2007 highs. New Highs have the power to quickly change sentiment. We are at multiyear high levels of neutral readings according to AAII. According to NAAIM, the average manager is under exposed to where we would expect them to be positioned at new highs. This creates a market chase scenario which is dangerous. While we do not love our dance partner we are still on the dance floor and the music continues to play…

What a week in the Treasury market! Yields looked to be breaking down below 2.4% on the 10 year with 2.36% as important support. The bond market seemed to be saying that deflation and not inflation was the risk as the economy appeared to be slowing. Equities would have none of that as they rallied through resistance. Who is right? The bond market or the stock market? What makes sense to us is that the economy may be slowing which is benefiting bonds and bond bears are chasing prices higher and moving yields lower. The equity market on the other hand is still feeding at the Federal Reserve trough. As long as the Fed is still injecting money, its current pace is $45billion a month, stocks will continue to ascend. Its slowing of asset purchases has only slowed the ascent of the market. It will be interesting to see what happens when it does stop its purchases. Gold failed at the $1300 level miserably. Intellectually that also lands in the bond camp of a slowing economy and less than normal inflation. Treasuries and Gold continue to be our risk temperature gauge. Watch the yield on the 10 Year US Treasury and keep an eye on gold. We could be in for an equity melt up here as investors are caught with too much cash. While the FOMC continues to play the music investors are forced to dance.

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

 

Volatility and Goldilocks

The Federal Open Market Committee (FOMC) Minutes from the April 29-30 2014 meeting were released this week. While there was not much in the way of surprises in the minutes there were two items that caught our eye. The first was that the committee noted that a couple of participants felt that conditions in the leveraged loan market had become stretched. We were early on into leveraged loans the past couple of years and that has served us well. Some clients will now see a reduction in that area in the coming months as we wish to back away from any repercussions associated with a bubble in leveraged and covenant lite loans.

The second item that caught our eye was the committee’s reference to declining credit spreads which imply an increase in investors’ appetite for risk. The committee also noted that the low level of expected volatility is also implying an increase in investors risk appetite.

While the Technicals of the broader market and the S&P 500 do not indicate any imminent failure small cap stocks continue to maintain their divergence from their large cap brethren. Market participants seem be plowing money into large caps and “safer” stocks while small caps are abandoned. What we may be seeing here is that institutional investors are forced to invest client’s money and are placing that money into safer assets like large cap stocks while a stealth bear market takes place underneath in small caps and biotech. When confusion reigns we turn our eyes to the bond market. The bond market is not playing along with a new high in equities (S&P 500 and Dow Jones) and is indicating a move lower in stocks. It gives us reason to pause when equities seem to be ignoring clues emanating from bond market.

Bill Dudley, the President of the Federal Reserve Board of NY, is a very influential member of the FOMC. When he speaks we listen intently. In a speech this week Dudley noted that he expects rates to stay lower long and well below the historical average of 4.25%. In private meetings Ben Bernanke former Chairman of the FOMC reportedly has stated much the same and that he does not expect rates to normalize in his lifetime. Strong words.

Last week we noted that the summer may be bumpy we think that any retreat by stocks will be backstopped at some point by the Federal Reserve. This week NY Fed President Dudley volunteered that the Fed will be more aggressive in raising rates if markets allow and less aggressive if they do not. The market is calling the tune and the Fed will apply the brakes or the gas depending on the market’s reaction to Fed policy. We think that the Fed will allow some volatility but not just too much. It’s Goldilocks monetary policy. Look for trading bands to widen over the coming months. The last three months have been some of the least volatile since 2006.

The Bank of England is considering whether to raise rates. What happens in England is a precursor to what happens here in the US. Keep an eye on the Bank of England. Treasuries and Gold continue to be our risk temperature gauge. Watch the yield on the 10 Year US Treasury at the 2.5% level and $1300 on gold.

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

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