Red Flag Warning

Just days after our latest blog post, Bump in The Silk Road, some very interesting comments from central bank governor Zhou Xiaochuan were posted on the central bank’s website. Here is a snippet from Bloomberg.

Latent risks are accumulating, including some that are “hidden, complex, sudden, contagious and hazardous,” even as the overall health of the financial system remains good.

 “High leverage is the ultimate origin of macro financial vulnerability,” wrote Zhou, 69, who is widely expected to retire soon after a record 15-year tenure. “In sectors of the real economy, this is reflected as excessive debt, and in the financial system, this is reflected as credit that has been expanding too quickly.”

 The latest in a string of pro-deleveraging rhetoric from the PBOC, Zhou’s comments were speculated to have contributed to a rout in Hong Kong shares. They signal policy makers remain committed to the campaign to reduce borrowing levels across China’s economy. Concern that regulators may intensify this drive after last month’s twice-a-decade Communist Party congress helped push yields on 10-year sovereign bonds to a three-year high. 

https://www.bloomberg.com/news/articles/2017-11-04/china-s-zhou-warns-on-mounting-financial-risk-in-rare-commentary

You can feel the pressure building in Washington DC. Republicans are scrambling and their candidate in the Alabama Senate race is in hot water. A loss to the Democrats in the Senate could make passing legislation that much more difficult. That could force Republicans to negotiate more aggressively with the Democrats if they want their tax bill passed. Complicating matters, the government’s current funding agreement expires Dec. 8. While the last agreement just punted to December the next agreement will have a lot more on the line. Also, members of Congress could be distracted by anger emanating from their constituents surrounding health insurance. The window just opened 10 days ago for 2018 and the increases are outrageous. We are hearing it from contacts looking for advice on how to proceed. The open enrollment period ends December 15th. 16 days earlier than last year. The pressure is building. It is going to be an interesting December.

The market seems a bit on edge as everybody knows it can’t just go higher EVERY day. The S&P had its first down week in 8 weeks and even BitCoin went down! Japan was up 23 out of the last 25 days. It broke. Whether the machines broke or investors broke is the question. Investor’s answer was to sell first and ask questions later. It just shows how on edge investors are with the market seemingly up every day everywhere.

We told you things can get weird when the President is out of the country. Saudi Arabia didn’t waste any time announcing their purge. That got oil and oil related stocks hopping. West Texas is at prices it has not seen in 2 years as oil remains in the mid $50 a barrel range with $60 in its sights. High yield bonds have seen huge outflows and that is a red flag warning sign for stocks. The ten year yield bounced higher late in the week to get back to the 2.4% level. The red flag there is its performance in the post Japan mini melt down. Yields jumped higher. Logically, you would think that yields would head lower in a flight to safety. Instead, it appears to be a flight to deleveraging. It is sign that there is too much risk and leverage in the system. If yields and stocks go down together that will be a problem as risk parity funds as they will be forced to cash in some bets. If there is a meltdown that is where it where we will see it start. That boat, that includes the volatility selling crew, is just too crowded.

There are rumors of more indictments when Trump gets back into town. Political uncertainty, rumors of the Saudi king abdicating over the weekend, Japanese flash crashes, and the tax cut bill seems to be DOA for now.  S&P 500 is exhibiting signs of slowing its ascent as the rally is showing some cracks. The bulls could use a time out. The animal spirits are unpredictable and still in control. Gotta be in it to win it but, maybe just a little less in.

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

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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Bump in the (Silk) Road?

With each passing day, week and month we are more in awe of this market. It just keeps plugging along higher and higher. There is no predicting when the momentum will shift so we continue to be invested but just a little less so. The winning strategy is to recalibrate our investing, downshifting in our risk while seeking better risk adjusted returns. It is not our job to prognosticate but to keep an eye on what could upset the apple cart and how to profit from it. Our latest worry is China. China has just completed its most recent 5 Year Congress. Every 5 years the leaders in China get together to elect leadership and formulate the next 5 year plan. Xi Jinping continues to consolidate his power and his grip on one of the great economic engines on the planet. Leading into the congress the leadership there chose stability over change. Now that the congress is over Xi can get back to work. We are looking at China to see if, now that leadership has another 5 years in charge, change is about to come to China. Will China now try to reel in shadow lending in the country and its rampant real estate market? Will they allow a more rapid depreciation in the Yuan? If change comes to China it will reach our shores soon enough as the economic ripples will be felt worldwide.

From Cashin’s Comments this week comes some interesting facts cited by the sharp eyed Bob Pisani from CNBC.

Technology is so strong this month that it accounts for 75% of the gain in the S&P 500, according to Standard & Poors. Without Tech, the S&P would only be up roughly 0.5%. It’s worse than that: five stocks are most of the gain. Big tech this month Facebook up 15.5% Amazon up 12.5% Apple up 8.2% Google up 6.1% Microsoft up 6.0%…Those five stocks accounted for 52% of the gain in the entire S&P 500. What happens if we look at the S&P 500 and equal weight all of the stocks? A very different picture. There’s an ETF for that: the Guggenheim S&P 500 Equal Weight ETF (RSP) is up 1.1 percent for the month. That is exactly half the gain of the regular S&P 500. 

Investor sentiment is always hard to gauge but we keep an eye on it to try and delve where the animal spirits reside. Market pundits have described this rally from 2009 as the most hated rally ever. Most hated maybe because investors have been behind the curve the whole time chasing it ever higher. Also from the NYSE’s resident sage, Arthur Cashin, comes this opinion on market sentiment from Peter Boockvar at the Lindsay Group. Maybe investors have now caught the tiger by the tail. 

This boat is now standing room only. Investors Intelligence said Bulls rose 1.2 pts to 63.5, that is the highest in about 30 years. It peaked at 65 in 1987. Bears fell to 14.4 from 15.1 and that is the lowest since May 2015. The spread between the two of 49.1, is just below the 1987 peak of 50.5. I’ve said this before, when sentiment gets this stretched, markets tend to consolidate its gains.  Given those figures, it’s tough to claim that this is the “most hated rally in history”.

The market has finished higher ten months in a row!! In a era of monetary extremes this is one for the ages. We have never had a year that the market closed higher for the first ten months of the year. Never. By way of Deutsche Bank’s Jim Reid, we see that the record is 12 months in a row set in 1949-1950 and 1935-1936. We grow concerned that the rally is growing even more stretched and more narrow in its rise. The techs are in charge as the Big Five accounted for half of the gains last month. A rally that grows more and more narrow is not a healthy market. S&P 500 shows signs of slowing its ascent. The market could use a consolidation period. It makes for a much stronger foundation. The bulls are still in control but with the President out of the country we tend to get a little nervous. We still see 2600 as logical resistance for now. The animal spirits are unpredictable and still in control. Gotta be in it to win it but, maybe just a little less in.

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

 

 

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.

My Name is Mario and…

We have talked about the rise in central bank balance sheets and how those balance sheets may be THE most important metric when investing in this era. The European Central Bank (ECB) made an announcement this week and it seems that central bankers while promising to cut back and reduce balance sheets are already hedging their bets. The ECB, while slated to end their form of QE in December, announced that they will continue to use until September of 2018. But they are promising to cut back their monthly usage in half. Like an addict that says that they will quit just not right now. This form of monetary heroin is responsible for the rise in asset prices and it is causing distortions like European High Yield yielding less than the US 10 year. This is the height of lunacy. We are not happy being right. It is our job to make money so while central bankers print and buy assets we stay at the party. The bigger question is will central bankers ever stop printing?  While we see that the G-4 central bank balance sheets are slated to stop growing in 2018 we question the will of central banks to stop the monetary heroin.

We are stuck in our thesis on the concept of the “Fed Put” and how that is going to evolve and effect asset prices. One of the drivers of this relentless march higher is the idea to BTFD. Buy the Dip. Every dip in stock prices is bought because you don’t’ have to worry because if there is a real crisis the central banks will come in and back stop the market. So you find yourself asking, will prices ever go down? That alone has us nervous. If something cannot continue forever it won’t. The market will go down at some point. It always does and it is never different this time.

Tech stocks had a phenomenal week as we saw Amazon up 13% and Intel up 7% on Friday alone. It is starting to feel like a mania as the animal spirits have taken over. The broader market did show some technical signs of weakness. A warning shot across the bow perhaps? We still think that a tax plan passage is a sell the news event.

This is a one way market and investors need to recognize this and take steps to manage risk. Recalibrate. Market structure is responsible. The market is flawed in its design as its automated structure puts the momentum players, the market makers and algorithms in control. While it is pleasurable to see it go up every day it will be much quicker and painful when the market goes down in a one way fashion. For every action there is an equal and opposite reaction.

The ten year Treasury broke through 2.4% and closed the week at 2.416%. We are looking for a new range between 2.4% and 2.6%. Above 2.6% and the warning lights will come on. The bulls are still firmly in control. 2600 on the S&P 500 is the next logical stop. Much as 666 loomed large in early 2009 the number 2666 now looms large for the S&P 500 and is less than 4% away from current levels. Wall Street and investors are a superstitious lot. The animal spirits are unpredictable and in control. Gotta be in it to win it but, maybe just a little less in.

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

Very Superstitious

There is no getting around the 30th Anniversary of the Crash of 1987 and all of the attendant media coverage this week. We ourselves have been writing about it all year. While history doesn’t repeat it does rhyme and we fancy ourselves not as divine prognosticators but as contingency planners for your wealth. That is why we are slaves to history and attempt to continually create plausible scenarios and investing thesis.

When we look back on the Crash of ’87 we can learn several things. The overarching lesson is that it is never different this time. You can read more on that in our recent quarterly letter here. Here is a quote from Howard Marks and his experience on that October day in 1987. Marks was the Head of the High Yield Department at The Trust Company of the West at the time.

 Portfolio insurance convinced people that they could somehow own more stocks without increased risk, which is fanciful. And like all silver bullets, it didn’t work.

-Marks

 It is never different this time. Risk is still risk and the widely accepted reason for the excessive price action that day was portfolio insurance. The selling of volatility and risk parity are today’s version of portfolio insurance. Investors are selling volatility with abandon. That creates a lower implied risk environment. Those figures go into automated strategies that take on more and more risk as stocks rise and volatility falls. More stocks with less risk- Great idea! In the next sharp market move volatility will be the driver as investors scramble to cover their shorts wiping out many involved in that trade.

 One of the drivers of this relentless march higher in stock prices is that there seems to be a consensus that there is no reason to fear the Federal Reserve. After all if stock prices do come crashing down the Fed will be there to support markets. Right?! So why ever sell? You just buy more if prices fall because the Fed has your back. What could possibly go wrong?

Trump’s tax plan is looking to be moving along. A passage of that tax plan in an economy which is already at full employment could tip the Fed into aggressive tightening mode. A passage of this tax package may be “ill timed” to quote NY Federal Reserve’s Bill Dudley. Dudley is considered the second most powerful person at the Federal Reserve. His remarks mesh very well with Michael Hartnett’s recent comments over at Bank of America. Hartnett has been calling for a melt up this year as we have. Hartnett is looking for that end with a spike in wages and inflation. If Trump’s tax package is passed that may be just what we get. Higher wages and inflation may force the Fed’s hand to tighten more aggressively than planned and investors may again be shocked into “fearing the Fed”. Hartnett’s call is for a 10% correction and not a 1987 style crash. For the record, we also do not think that markets will crash because of the fervent belief in the “Fed Put” but a correction is well overdue.

The ten year Treasury is still stuck between 2.1 and 2.4%. If it breaks through 2.4% then 2.6% is the new area of resistance and that should be a tough area to get through. Why are we harping on the 10 year lately? It should be our canary in the coalmine for equities. Higher interest rates could break the back of this equity market. The question is what is the magic number? A decisive break through the 2.7-2.8% level could mean that rates are headed higher longer term breaking the 30 year down move.

The punch through 2500 on the S&P 500 still has the bulls in control. Like a running back that has open field in front of them the S&P is taking off. There are no real resistance points as it is all theoretical now. 2600 is the next logical stop. Much as 666 loomed large in early 2009 the number 2666 now looms large for the S&P 500. Wall Street and investors are a superstitious lot. The animal spirits are unpredictable and in control. All is still going according to our thesis of a 1987 type melt up. The tax agenda from the White House could be a “sell on the news” event. Gotta be in it to win it but, maybe just a little less in.

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

 

 

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.

It’s Never Different This Time

 IT’S NEVER DIFFERENT THIS TIME

“I learned early that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again. I’ve never forgotten that.” – Jesse Livermore

Jesse Livermore was a legendary Wall Street trader and his biography “Reminiscences of a Stock Market Operator” is a must read for anyone that is in the investing game. As an investor one of the most important things to remember is that it is never different this time. As much as we think that our time or era is unique to history we are all still human. We react psychologically to whatever stimuli are present at any given time just about the same way that our caveman predecessors did. The names change but the game stays the same.

Up-and-down cycles are usually triggered by changes in fundamentals and pushed to their extremes by swings in emotion.  Everyone is exposed to the same fundamental information and emotional influences, and if you respond to them in a typical fashion, your behavior will be typical: pro-cyclical and painfully wrong at the extremes.  To do better – to succeed at being contrarian and anti-cyclical – you have to (a) have an understanding of cycles, which can be gained through either experience or studying history, and (b) be able to control your emotional reaction to external stimuli. – Howard Marks Founder Oaktree Capital

The Federal Reserve and central banks around the world have added and drained liquidity over and over again repeatedly over the last century. What is slightly different this time is that the Federal Reserve and central banks around the world have added more liquidity than they have ever done in history and in concert. That is different but the results are always the same. When central banks add liquidity asset prices will soon follow suit and rise with the new found liquidity. When the Fed subtracts liquidity the market will also soon follow in negative course. You cannot predict when or how far the market will move but there is no point in fighting the Fed. Whatever they do the market will do in time.

I am not saying that the market will crash. I am saying that as the Fed and other central banks remove liquidity then markets at some point will begin to price that into the equation. I can’t tell you how far markets will move because I cannot tell you how far the central banks will move. It was the former NYSE President and Fed Chairman William McChesney Martin who coined the phrase that is was the central banks job to take away the punch bowl when the party was just getting started. Central banks around the world are now hinting that it is time to think about removing accommodation and draining the punch bowl. The Federal Reserve has raised rates twice in 2017 and it looks like they may do it one more time in December of 2017.

Along with these rate hikes committee members have voted to start reducing the Fed’s balance sheet this month. What does that mean exactly? The Federal Reserve will be mopping up some of the liquidity that has been splashing around markets and enabling inflation in asset prices. Eventually, (QT) Quantitative Tightening will have the desired effect from the Federal Reserve. The other major central banks around the world are still adding liquidity but the Bank of England and the European Central Bank (ECB) appear ready to at least stop adding liquidity. The Bank of Japan is charting its own course and continues to add liquidity. The US Federal Reserve has begun draining liquidity as its journey has been mapped out and begins this month. The pace is slow and steady but there will be a tipping point where the reduction in liquidity will impact asset prices. When is that tipping point? That is the $4 trillion question.

While the Federal Reserve is trying to extricate itself from its monetary experiment the first place we will look for clues to the trajectory of asset prices will be the US Dollar. As the quote below from Ambrose Evans Pritchard explains the US Dollar is our barometer and we do expect it to generate a headwind for equity and credit alike.


“The message from a string of BIS [Bank of International Settlements] reports is that the US dollar is both the barometer and agent of global risk appetite and credit leverage.
Episodes of dollar weakness – such as this year – flush the world with liquidity and
nourish asset booms. When the dollar strengthens, it becomes a headwind for stock markets and credit.”

Ambrose Evans-Pritchard International Business Editor of The Telegraph.

In the last several weeks the US Dollar has headed higher and the yield on the 10 Year US Treasury has headed north of 2.35%. If the US dollar continues to rally as the Fed takes away the punch bowl and tightens policy then we may see a reversal of what has transpired so far in 2017. Small and mid cap stocks may outperform while gold and emerging markets under perform. 

THE BEAR CASE

It is getting harder and harder to make the bear case. That alone is troubling. Markets have shrugged off a potential hot war with North Korea, US Presidential investigations, and the complete and utter failure of Republicans to pass any legislation of consequence in Washington DC.  But if we were to point to any one thing that the bears can hang their hat on it is the historically high valuations in asset prices. The most astounding valuation that we have seen is that European High Yield debt now yields less than US Treasuries of the same duration! European junk debt is less risky than US government debt? Incredible. While valuations alone do not a bear market make, historically, valuations in the highest percentiles portend lower than average returns in the future. Here are some of those excessive valuations.

  • The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
  • The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16.  This multiple was exceeded only in 1929 and 2000.
  • The “Buffett Yardstick” – total U.S. stock market capitalization as a percentage of GDP – new all-time high last month of around 145, as opposed to a 1995-2017 median of about 100.
  • The lowest yields in history on low-rated bonds and loans.
  • All time low yields on emerging market debt.
  • The CNN Money Fear & Greed Index of market-based risk-appetite gauges is at 95 on its 100 scale.
  • S&P 500’s Longest streak without a 5% drop of over 330 days
  • Institute of Supply Management’s manufacturing Index above a reading of 60 and highest reading since 1994.

Equity markets are in the midst of a multiyear run as seen by the rise in values since the Great Financial Crisis (GFC) in 2008-09. Those valuations have risen to historical levels and are now in the 90th percentile historically. Research shows us that returns in the 90th percentile run below average. Investors are acting as if there is no risk in holding assets. The definition of investing lies in the risk return tradeoff and that is seemingly being ignored.

Another factor in the bear case is the bond market and the possibility of rising yields. In our last quarterly letter we wondered about who was going to be right – the bond market or the stock market. We have always gravitated to the bond market as the older, wiser brother of the stock market.  The bond market is not done giving us clues as we believe that rates, while still mired in the range between 2.1% and 2.7%, may yet break out one way or the other. A rate rise through 2.7% could quickly generate much higher rates and that could douse the enthusiasm of the stock market bulls.

THE BULL CASE

While the shrinking of central banks balance sheets has us cautious we need to remember that, even with the Federal Reserve telegraphing to the market that they intend to shrink their balance sheet, central bank balance sheets worldwide have still grown at 8% year over year. The bulls may keep control of the market if central banks other than the United States continue to expand their balance sheet. It is now the world’s balance sheet that has our attention and not just the US Federal Reserve’s.

As central banks remove the punch bowl they will be telegraphing their moves to the marketplace and moving ever so gently to the sidelines and that may appease markets for now. The conditions for a market crash do not seem to be in place. In contrast, the conditions of a spiraling melt up seem to be more likely as we have said for some months now. Investing is an exercise in mass psychology.  Investors have gotten used to investing gains and see no risk on the horizon. Over inflated valuations have professional investors trimming their sails and cutting equity and bond exposure. We continue to hear the same arguments of distorted valuations and have made those same arguments ourselves but high valuations alone will not stop a raging bull market. While seemingly every investor is expecting a sell off from such high valuations they may find themselves falling behind their client’s expected returns. That may force professional investors to chase returns in the last quarter of 2017.

Jeff deGraaf, chairman and chief technical analyst at Renaissance Macro Research, is telling clients this week the risk of a “melt-up” in stocks is “very real.”

“Given the good economic data, loose credit conditions, benign inflation data and investor’s sentiment, we think the risks of the Fed (and G7 central banks) blowing an asset bubble are above average,” he says. Cyclical indicators such as the ISM purchasing-managers index above 60, with unemployment under 4.5 percent, are arguably “too good,” correlating with poor 12-month returns for stocks. “But until credit conditions deteriorate, we’re holding on to this tiger’s tail,” deGraaf concludes. -CNBC

We will continue to keep a close eye on the bond market. If equity markets were to move drastically lower we believe that the Federal Reserve will act quickly to support the market. It has widely telegraphed its intention to slowly roll down its balance sheet. If that roll off should cause trepidations in the stock market we believe that they will quickly reverse course and, in dire circumstances, perhaps even begin buying equities. The Fed Put is alive and well.

While we have foreseen a 1987 type of market since the election it is impossible to predict the “top”. What makes us most uncomfortable about calling an end to this bull market is that seemingly everyone else is attempting the same. When everyone expects something to happen – something else will. (H/t Bob Farrell)

WHAT TO DO 

It is impossible to know where the top of a market is and no one wants to feel foolish for having left the party too soon. In order to meet our investing goals we cannot afford to leave the party too soon but what we can do is re-calibrate. When historical valuations are in their highest percentile we can move to investments with better risk reward profiles and if that investment is cash, then so be it. Successful investing is accomplished by doing what is unpopular or uncomfortable. 

Even though no one can ascertain when we’re at the exact top or bottom, a key to successful investing lies in selling – or lightening up – when we’re closer to the top, and buying – or, hopefully, loading up – when we’re closer to the bottom. 

“Investing is not black or white, in or out, risky or safe.”  The key word is “calibrate.”  The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive. Howard Marks

 That is why we have taken steps to reduce duration at Blackthorn to very low levels. Duration is a measure of bond holdings sensitivity to a rise in interest rates. Our lowering of bond duration in client’s portfolios will cushion any blow to our portfolios given higher rates from the Fed. In fact, our duration is so low that higher rates could conceivably help our performance in the longer run as we will be reinvesting at higher rates.

September is historically the weakest month of the year. 2017 has not been kind to seasonal adjustments as shown by the market’s strength this summer (Sell In May and Go Away) and evidenced by its strong showing in September. But when a traditionally weak period is strong it gives more weight to the bull thesis. A strong September has been shown to be good for stocks, historically, as they portend a strong 4th quarter. According to the Leuthold Group, an equity research firm, since 1928 there has been 29 Septembers where the S&P 500 reached a 12 month high. In the 4th quarter following those 29 new highs the S&P 500 was up 80% of the time for an average return of 3.7%.

We, at Blackthorn, attempt to achieve excellent risk adjusted returns over a full market cycle and not to mimic a benchmark in the short term. We strive to give the best service possible while being as transparent as we can in order to give the client confidence in our managing of their assets. It is that confidence that is the basis of sound decision making during market extremes. We continue to be risk averse amid historical valuations that have proceeded less than stellar returns over the last 100 years whenever they presented themselves. Successful management of assets emphasizing risk adjusted returns over time requires patience and a thoughtful investor base which we have been fortunate to attract over the years.

Our risk adjusted returns show that we have chosen the right assets to rotate into while we continue to be on guard and show patience as this bull market evolves. Our experience has been that chasing returns over time does not work and paying strict attention to valuations in the marketplace and expecting some reversion to the mean is the correct approach. We manage risk. Right now investors are not getting paid an appropriate premium for taking risk, and so, we recalibrate. As Jesse Livermore once said, that it was never my trading that made me money, it was the waiting.

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 CEO of Goldman Sachs

 Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks…During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.Warren Buffett

 

One More Thing to Consider in Retirement

One of the next big crisis’ in the United States is pension funding. If you think that this will not affect you think again. It will hit you right in your wallet when you can least afford it – in your retirement. As a good portion of my readers and clients are approaching retirement this probable pension crisis should factor into where you retire.

I have been reading John Mauldin’s Thoughts From the Frontline for over twenty years on the recommendation of Arthur Cashin. If you haven’t read John’s work here is a link to his website. It is sent to over 1 million readers a week. It is well worth your time. Here are the highlights from John’s latest letter in regards to the looming pension crisis.

Total unfunded liabilities in state and local pensions have roughly quintupled in the last decade.

According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs.

The only way to bring it out of the spiral is with huge cuts to other needed services or with massive tax cuts to pension benefits.

But wait, it gets worse. The graph we showed earlier stated that unfunded pension liabilities for state and local governments was $2 trillion. But that assumes an average 7% compound return. What if we assume 4% compound returns? Now the admitted unfunded pension liability is $4 trillion. But what if we have a recession and the stock market goes down by the past average of more than 40%? Now you have an unfunded liability in the range of $7–8 trillion.

We throw the words a trillion dollars around, not realizing how much that actually is. Combined state and local revenues for the US total around $2.6 trillion.

This issue is going to set neighbor against neighbor and retirees against taxpayers. It will become one of the most heated battles of my lifetime. It will make the Trump-Clinton campaigns look like a school kids’ tiddlywinks smackdown.

http://www.mauldineconomics.com/frontlinethoughts/pension-storm-warning

The ten year Treasury hit 2.28% mid week and looks to be headed back to resistance at 2.5%. A decisive break through the 2.7-2.8% level could mean that rates are headed higher longer term breaking the 30 year down move.  The punch through 2480 on the S&P 500 still has the bulls in control. The next target on the S&P 500 is 2540. The market is still firmly in an uptrend but there are signs that bulls may not be all that strong. Gallup poll has 68% of investors optimistic about the stock market over the next year. That matches the record high for that poll set in January of 2000.  Investor sentiment is very high which is a contra indicator while valuations are in the 90th percentile historically. The animal spirits are unpredictable. Gotta be in it to win it but maybe just a little less in. Keep an eye on the 10 year and commodities.

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

 

 

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.

 

 

 

Diogenes and The Bond King

Jeffrey Gundlach from DoubleLine Funds gave another one of his webcasts this week. In a world of investing you have to know who is telling you their honest thoughts and who is just talking their book. We believe that Gundlach tells you his honest thoughts and his track record shows that he is well worth watching. The first thing that you need to know is that Gundlach is a bond fund manager who is not that high on the bond market right now. The “Bond King” doesn’t like bonds. How is that for honest? The Greek philosopher, Diogenes, would have never found what he was looking for on Wall Street, but then again, Gundlach is in LA.

Gundlach is constantly on the search for anomalies that may warn of an impending recession. In his “chart of the day” Gundlach presented a chart showing a ratio of the value of commodities to the S&P 500. The median value over the last 50 years stands at 4.1. That ratio is currently less than 1. That tells us that either commodities are very cheap or equities are expensive (or a combination of both). The last two times it got this low was just before the 1970’s Oil Crisis and during the Dot Com Bubble. Gundlach predicts that commodities will gain steam next year when the US 10 Year rate rises. Time to look at commodities.

One chart that Gundlach brought up was what we would term “The Chart of Next Year – 2018”. It shows the growth in the G4 Central Bank balance sheets since the beginning of the GFC until now and it overlays the rise in Global equity value. If you accept that the rise in equities was fueled by the rise in central bank balance sheets understand that the G4 balance sheet is projected to shrink beginning in 2018. Stalled growth in central bank balance sheets will equal stalled growth in equity prices and lower returns. A decline in central bank balance sheets will lead to a decline in equity prices around the globe.

QE has been highly correlated with risk assets (specifically the S&P 500) “levitating,” Gundlach said. That has been true since 2009 and on a global basis, he said. The actions by other central banks have lifted the prices of non-U.S. equity markets.

Gundlach said that when earnings are revised down, equity prices fall and vice versa. Except that wasn’t true when QE was going on. Now that central banks are tapering globally (“quantitative tightening”), it is a bad sign for equities, according to Gundlach.

“Maybe we will start getting into trouble in mid-2018, as QE goes away and the German 10-year yield goes up,” Gundlach said.

West Texas Crude is still below $50 a barrel but is challenging that critical level of resistance. The Saudi Arabian government is rumored to be looking at delaying its very important IPO of Saudi Aramaco.  Saudi Aramco is their state owned oil company and the biggest oil company in the world. It is valued in the Trillions of dollars!! Could it be because they are seeing higher oil prices on the horizon? $60 a barrel in crude would bring in substantially more money in the IPO than $50. It’s a big bet by a big and knowledgeable player.

Just to review. This week we experienced Hurricane IRMA, North Korea test fired a missile across Japan, terrorism in France and England while hard economic data continued to deteriorate in China and the US. So, logically, we should have new all time highs in the stock market and the best week of the year for the Dow Jones Industrials. By the way, if you needed any more evidence that the computers are in charge the S&P 500 closed Friday at exactly 2500. While we are on the subject of crazy Jeffrey Gundlach pointed out in his webcast that European junk bonds have the same yield as a U.S. Treasury basket (the Merrill Lynch U.S. Treasury Index). He said that spread is typically 700 basis points or more.

Gold was able to hold $1300 this week.  The ten year Treasury rocketed off its lows of 2.05% to close the week at 2.20% it what looks to be a failed breakdown. The S&P 500 broke through 2480 to close the week at 2500. That makes the next target on the S&P 500 2540. The caution signs are still there but the market is still firmly in an uptrend. The punch through 2480 on the S&P 500 could instigate the animal spirits and give the bulls room to run. Friday was a Quadruple Witching meaning that 4 sets of options expired on the same day. It happens four times a year. Things can change suddenly after expiration as all hands were more concerned with the options market than the stock market itself. Early next week is going to give us better clues as to if this breakout in the S&P will get legs. Gotta be in it to win it but maybe just a little less in. Keep an eye on the 10 year and commodities.

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

 

 

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.

Priceless Investing Advice

Being in the investment arena our job is mostly about gathering information. Reading. Lots and lots of reading. Corporate reports, sell side research, blogs, websites, financial journals, and the like. We have our favorite sources and investors.  If you have read our notes for any length of time you know that we read anything that we can get our hands on that Howard Marks has written. Mr. Marks’ latest note is out this week. Marks doesn’t write every week or even on a consistent basis but when he writes he has something to say and he envelopes everything he writes with priceless investing wisdom. If you are a serious investor you must read the whole piece. I am having trouble just boiling it down to a few well turned phrases or sound bites but here goes.

 As I explained on CNBC, there are two things I would never say when referring to the market: “get out” and “it’s time.”  I’m not that smart, and I’m never that sure. 

 “Investing is not black or white, in or out, risky or safe.”  The key word is “calibrate.”  The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive. 

 If it’s true, as I believe, that (a) the easy money in this cycle has been made, (b) the world is a risky place, and (c) securities are priced high, then people should probably be taking less risk today than they did three, five or seven years ago.  Not “out,” but “less risk” and “more caution.”

Marks mentions that he is not referring to this market as a “bubble”. He is probably right. There are no signs of euphoria (other than bit coin) but investors are begrudgingly going along with higher prices. It is more of a FOMO (Fear of Missing Out) mentality. Valuations are high and rising and “getting out” at the top is a pipe dream. Rather than jump in and jump out of the market we seek to re-calibrate our investment allocation in regards to the risk premium in the market. If prices are high then we wish to take some risk of the table. We can put our money into investments that have less risk or place them with outside managers with a history of performing well in riskier markets. We can also choose to place more of our assets in cash which is essentially a call option on risk. We, like Marks, continue to proceed but with caution. “Calling a top” and “getting out” are a Fool’s Errand but lessening our risk in light of historical valuations is a prudent thing to do.   

In regards to risky behavior we call your attention to something that we have seen for some time, over and over again and it costs investors huge sums of money. This time around it is the sale of “Cat Bonds” to the small investor. Once the province of big money center banks and off shore insurance companies “Cat Bonds” are catastrophe bonds sold by large reinsurance companies. The short story is you can make high yield returns by investing in bonds which insure against wind damage, hurricanes, earthquakes and other catastrophic events. Suffice to say that those investors after several years of decent returns will return to work on Monday with a lot less digits in those accounts. Those investors will be wiped out completely if Irma has her way with Florida this weekend. How do you spot these enemies to your portfolio the next time? It is easy. If someone promises you an above average yield in a product that is unlisted (it does not trade on an exchange) with high management fees – run, do not walk away from this investment advisor. I have seen too many of these investments in investor’s portfolios in my time. The advisor ends up with his management fees and the client ends up with the goose egg.

 When the pressure is on we like to have what we term “adults” in the room. The “adults” are not only the smartest people in the room but they are people who know how and when to make a decision. Stanley Fischer is one of those “adults”. Dr Fischer, former professor at MIT, vice chairman of CitiGroup, and chief economist of the World Bank, and former Governor of the Bank of Israel, resigned his position as vice chair of the Federal Reserve. Fischer played the role of intelligent hawk who we felt comfortable leaving in charge of the store. As this critical time approaches of the Fed removing stimulus his absence alone makes us less confident in the “adults” left in the room. In one of his last public speeches as part of the Federal Reserve Dr Fischer warned about historically high asset valuations.


Let me conclude my assessment of current financial stability conditions with a discussion of asset valuation pressures… In equity markets, price-to-earnings ratios now stand in the top quintiles of their historical distributions, while corporate bond spreads are near their post-crisis lows. …

The general rise in valuation pressures may be partly explained by a generally brighter economic outlook, but there are signs that risk appetite increased as well…So far, the evidently high risk appetite has not lead to increased leverage across the financial system, but close monitoring is warranted.

https://www.federalreserve.gov/newsevents/speech/fischer20170627a.htm

West Texas Crude has had some wild moves post Hurricane Harvey but is still stuck between $45-50 a barrel. The safe havens benefited this week as gold has sufficiently punched through $1300 making that area now support.  The ten year Treasury which had been stuck between 2.15% and 2.40% since April finished the week at 2.05% which could augur a price movement down into the 1.75-1.85% area. The move is on into the safe havens while stocks mystically continue to hold their gains and their range between 2420-2480. While the caution signs are there the market is still firmly in an uptrend. A punch through 2480 on the S&P 500 could give the bulls room to run. The rally off of the lows has been anything but active. A low volume run up doesn’t bring with it much conviction but the animal spirits could take over regardless with a swift punch through 2480. The pressure is building.

 Harvey was the story last week. This week it’s IRMA. Best of luck to all our friends and family in Florida. Hold on tight.

 

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

 

 

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.

 

 

 

Pressure is Building and Hurricane Relief Homework

The markets perceived safe havens of gold and the US Treasuries continue to rally. The yield on the 10 year is back to flirting with the 2% level. Gold is trying to break through $1300 an ounce and was outperforming the S&P 500 for 2017. Those are not exactly confidence builders for stock investors. Those are flight to safety trades.

 While lower interest rates have been a hallmark of this bull market, used to justify virtually any valuation, the lens through which investors view them is nuanced. Too low and they start to suggest economic stress.

After rallying in sync for much of 2017, bonds and stocks have become disjointed as economic data misses expectations for the third straight month. The one-month correlation between the S&P 500 and the Bloomberg Barclays Global Aggregate Bond Index is at the lowest since April, with the S&P 500 flat lining since its Aug. 7 high, as 10-year yields dropped 11 basis points.

We grown concerned when the bond market looks anxious and the stock market ignores it but this is not your father’s stock market. This market has shrugged off thermonuclear war fears with North Korea, Presidential special prosecutors, the firing of a sitting FBI Director, a potential debt ceiling debate/default, rising interest rates and the expected shrinking of the Federal Reserve balance sheet.

The S&P 500 rallied off of its lows of 2430 to close the week at 2476. That brings us back to the resistance levels that we have been talking about since mid July. The market has rebounded quite quickly. What is interesting is that investors have been seemingly unanimous in calling for a market setback in the August – October timeframe. If that selloff does not come we may that melt up we have been talking about (ala 1987). Fund managers are under invested and do not wish to disappoint clients come year end. Time is money. A punch through 2480 on the S&P 500 could give the bulls room to run. The rally off of the lows of last week has been anything but active. A low volume run up doesn’t bring with it much conviction but the animal spirits could take over regardless with a swift punch through 2480.

Hurricane Harvey may be helping the stock market by taking a debt ceiling fight off of the table but you wouldn’t know it by looking at the short term bond market. The calendar around when we suspect the government will run out of money has grown quite active and its pricing is indicating that the bond market doesn’t have that much faith in Washington.

Since 1950, August and September are the worst performing months for the S&P 500. However, in the last ten years it is January and June that have taken the mantle of worst performing months. While the caution signs are there the market is still firmly in an uptrend. Support on the S&P 500 is very strong at its 100 Day Moving Average (DMA) and the 2420-2400 area is support for now. Trading desks have been understaffed since Memorial Day and markets have gone nowhere. Oil is stuck between $45-50 a barrel while gold struggles with $1300. The S&P 500 is range bound for now between 2420-2480. The ten year Treasury has been stuck between 2.1% and 2.40% since April. The pressure is building. With staff back in town things may get very interesting very quickly.

Harvey may bring some shortages up and down the east coast. Fill up before you leave the house. Have a great Holiday weekend!

Our old friends at Charity Navigator have done the homework for you and listed a few highly rated organizations for Hurricane Harvey relief. You can see more at their link below.

If you’re looking for a local charity to support in the wake of Hurricane Harvey please consider Houston SPCAHouston Humane SocietyHouston Food BankFood Bank of Corpus Christi, or San Antonio Humane Society. These highly-rated organizations are located in the most-affected areas and are providing support to individuals and animals.

– Charity Navigator

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

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.

Caution Flags

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

“…algorithmic traders and institutional investors are a larger presence in various markets than previously, and the willingness of these institutions to support liquidity in stressful conditions is uncertain.”- Janet Yellen Jackson Hole 8/25/17

In Janet Yellen’s speech this week at Jackson Hole she brokers the subject of market structure and her anxieties surrounding the structural integrity of the market given additional stress.  Will current market structure provide the liquidity needed given a stressful event? We think that it will not and a temporary condition will be created consisting of a lack of liquidity will happen for a time. The pessimist sees what would be a very scary moment if market structure lets us down in the next stressful period. What we see on the horizon is a market structure that we think will fail and will create a big opportunity. Market structure. We see the risk as real and evidently we are not the only one.

Dow Theory is the long running thesis that if Dow Jones Industrials are hitting new highs then its brethren in the Dow Jones Transports should be hitting highs as well. The Industrials make the goods and the Transports ship the goods. So if the one is doing well shouldn’t the other? We are not the only one concerned. By way of Arthur Cashin, comes Jason Goepfert recent notes on the topic.

Jason Goepfert, the resident sage at SentimenTrader noted the recent wide divergence between the Dow Industrial and Dow Transports. He recalls that prior similar divergences have rarely been resolved in a bullish fashion. Here’s a bit of what he wrote: The Dow indexes are out of gear. The Dow Transportation Average continues to badly lag its brother index, the Dow Industrial Average. The Transports are not only below their 200-day average, they just dropped to a fresh multi-month low. Yet the Industrials are more than 5% above their own 200-day average, a divergence which has tended to resolve to the downside for both indexes, especially in the shorter-term.

While we have the caution flag up we are intrigued by how many analysts and investors are calling for a downturn. When everyone expects something to happen something else usually does. From Bloomberg this week comes notes from Morgan Stanley, HSBC and Citigroup that markets long term relationships are breaking down and signaling that a correction is in store.

Analysts at the Wall Street behemoths cite signals including the breakdown of long-standing relationships between stocks, bonds and commodities as well as investors ignoring valuation fundamentals and data. It all means stock and credit markets are at risk of a painful drop.

“Equities have become less correlated with FX, FX has become less correlated with rates, and everything has become less sensitive to oil,” Andrew Sheets, Morgan Stanley’s chief cross-asset strategist, wrote in a note published Tuesday.

https://www.bloomberg.com/news/articles/2017-08-22/wall-street-banks-warn-winter-is-coming-as-business-cycle-peaks

At the beginning of this week stocks were very oversold and due for a bounce. Equities were so oversold, in fact, that we did buy some equities for underinvested and new clients. The S&P is now approaching very important resistance levels at 2450 and again at 2475. 2475 is THE resistance level that the market has been struggling with since mid July. The market looks tired here and the seasonality is not in its favor with September and the October debt ceiling approaching. A failure at 2475 could give the bears confidence. The S&P 500 saw support at its 100 Day Moving Average (DMA) and the 2420-2400 area is support for now. The next support is the 200 DMA at 2350 which is down about 3.7% from here. If markets fell to that level that would be a 5.5% drop from the all time highs, certainly, not a major crisis. However, the bulls would need to hold the 2350 level or then the bears are in charge. We are still concerned that while the S&P 500 has held in there the Russell 2000 is struggling. That coupled with high valuations and a negative Dow Theory signal has us sending up caution flags.

 

If you are not currently receiving our blog by email you can sign up for free at https://terencereilly.wordpress.com/ .

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  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

 

 

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.