2018 What’s Next?

At the end of the year we begin to formulate ideas about how the next year in investing will transpire. We build scenarios and that helps us invest accordingly. In late 2016 this is what we had to say in our blog about 2017.

Seemingly, every single investing professional that we read or talk has the same expectations for 2017. Experts see a January dip being bought and Wall Street’s best and brightest see 2017 returning a rather staid 5% on average according to Barron’s. We have a funny feeling that isn’t quite how it’s going to work out. When everyone agrees – something else will happen. 

There was no dip to be bought in January and, obviously, the market returned far more than 5%. Since December 2016 in the post Trump election world we have been harping on the idea that we could see a 1987 type of market. While that year brings nightmares to investors you have to remember that before the October crash the market was up 35% on the year. Well, the Dow Jones is now up 35% since Trump was elected while the S&P 500 is up just over 26%.

Our attention in 2018 will be dominated by the draining of liquidity by the world’s central banks. Available research estimates that the G4 balance sheets will peak in Q1 of 2018 and begin to decline. An inflection point will be reached in or around the summer of 2018 when liquidity injections by all four major central banks will end and central banks will begin to drain that liquidity. Since the dawn of the crisis we have felt that any draining of liquidity by central banks would cause markets to shudder. We expect no less in 2018 if central banks should go forward with their plans.

The Fed put strike is falling with rising rates even if markets don’t realize it. As our Head of Global Economics, Ethan Harris, has pointed out, sitting at the lower bound in rates put the Fed in risk-management mode, meaning they had to be ultrasensitive to the risk of making a policy mistake as they had no traditional ammunition to fight a potential downturn. But as the Fed gradually increases rates, and with markets seemingly unconcerned, they will inherently become less sensitive to risk. In other words, the Fed put strike is falling both because the Fed is rebuilding ammunition, and because it recognizes that markets can better stand on their own. Of course surprise inflation remains the real killer as it would effectively handcuff the Fed from providing a high strike put, and will require much higher stress before they can step in. – Bank of America

Investors are seemingly whistling past the graveyard. The market continues to move higher with the underlying belief that any market turbulence will be met by the Federal Reserve’s (The Fed Put) efforts to calm markets. Are they right? As Bank of America is saying investors may be overestimating the extent to which the Federal Reserve can or will seek to contain any market damage.

We still see the possible tax reform passage as a “sell the news” event especially in light of end of the year regulatory funding issues. We are beginning to see some stresses in the system due to that end of the year regulatory funding. Not a major problem but it could cause some ripples. Investors may be looking to push sales and any subsequent gains into 2018. That could cause more selling at the beginning of 2018. This could be a negative unintended consequence of the tax bill passage.

We hope that you will not take us to task for not posting yesterday. We took the day to spend it with our children in the snow. It doesn’t snow that often here in Atlanta, never mind 5 inches of snow, so we take our opportunities when we can.

The market is showing signs of slowing its ascent. It needs a breather although the Santa Claus Rally is just around the corner. We are watching key levels on the charts that the computers might be pointing to. We are also formulating our end of the year letter which will be out in several weeks and we hope to point to more of what we see happening in 2018.

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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Want to Live Longer?

Andrew Scott is a Professor of Economics at the London Business School and is a co- author of The 100-Year Life: Living and Working in an Age of Longevity. I came across his work in an interview from the Council of Foreign Relations and I find his work helpful, not only in planning for client’s retirement but also in looking at the emotional side of retirement. We have had massive transformations in how we long we live our lives and in the quality of our lives since the dawn of the 20th century. Scott’s work shows that a 65 year old today is equivalent to being 51 in 1922! Something to accept going forward is that our lives will be longer and lived with a greater vitality and, in accepting that, working longer needs to be part of our retirement plan. Not necessarily in that same job some of you might dread going to everyday but working at something we love doing. Importantly, Scott’s research found that white collar workers that work longer – live longer. Something to consider.

65 is the equivalent to 51 in 1922, and today’s 78-year-old, in terms of mortality risk, is the equivalent of a 65-year-old. And you think about this longer life expectancy—you know, by some counts, children being born today can expect to live to high 90s, early 100s, if not more. It’s not clear that simply saving more will solve the problem, as we’ve been talking about here.

People never save enough anyway. People are fairly unresponsive to interest rates. So I think if we’re looking at how we finance longer lives, it’s going to have to be working longer.

And of course what is very striking with the data, too, is that effectively blue-collar workers, the earlier they retire the longer they live. White collar workers, the longer they work, the longer they live. I mean, it’s—old age has a very varied distribution across individuals, and some of that is strongly linked to income and particularly education. – Andrew Scott

https://www.cfr.org/event/retirement-challenges-individuals-global-comparison

Some pundits that stand out as perpetual bulls on the market are calling for a respite in 2018. We think that they might be right. The market has been on quite a ride this week and we used the rally this week to lighten up for some of our more aggressive clients. We still see the possible tax reform passage as a “sell the news” event especially in light of end of the year regulatory funding issues and a possible government shutdown dead ahead.

The S&P 500 is now up 13 months in a row and seems to have hit a speed bump. As the technology stocks hit their old highs from 2007 the computer algorithms hit the sell button and began to buy value stocks. Changes in investment positioning may be in store as value may begin to outperform growth. Growth has been the winner for perhaps a bit too long as returns try to revert back to the mean.  The yield curve here in the US is the flattest it has been since 2007 and we worry that it is about to invert and signal a recession. We warned two weeks ago that volatility would return and that it was only a matter of when. Well, it seems like this was the week. We expect more volatility to come as funding pressures increase with the turn of the calendar.

We have talked about the animal spirits being in control and now perhaps it is the computers turn. Keep an eye on key levels. We are watching 2666 on the S&P 500 very closely. The market bottomed at 666 in March of 2008. 4 times 666 is 2664. Close enough for government work. Programmers are humans after all and some numbers jump off the page. Call us crazy but we feel that it is an important hurdle and, make no mistake, the computers are in charge. We are still in it to win it but just a little less and 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.

Less In

One of our favorite bulls is changing his tone this week as Jim Paulsen of the Leuthold Group seems to be pouring a little cold water on this rally. In his piece titled “No More Juice” Paulsen, a long time bull, says investors should be prepared as central bankers try to wean markets off of the juice (QE). Paulsen has been spot on for years with the market rally since 2008 and when he speaks we listen. We agree with Paulsen and we do not see a market collapse but there is a need to constantly reevaluate and recalibrate where our investment money needs to be in this market.

“As financial markets are weaned off the juice they have been drinking for almost a decade, investors should prepare for a very different bull market in the balance of this recovery,” he said. “Without a chronic injection of financial liquidity, the stock market may struggle more frequently, overall returns are likely to be far lower, and bond yields may customarily rise.”

To be sure, Paulsen is not predicting a market collapse. Instead, he suggests investors will need to shift strategy away from the cyclical U.S.-centric approach that has worked for most of the past 8½ years, due to the likely contraction of money supply compared to nominal GDP growth.

That means value over growth stocks, international over domestic, and inflationary sectors, like energy, materials and industrials, over disinflationary groups like telecom and utilities.

It is our job not to predict but to contingency plan. In order to do that we look to the horizon for what could trip up our investing plans or to find what investments may benefit from changes in the environment. One of biggest worries is China. The yield curve continues to invert in China. For those of you that are new to our blog an inverted yield curve is a sign that a recession may be approaching. A recession in China would have reverberations worldwide. According to FT, Chinese debt has grown from $6T at the beginning of the crisis in 2007 to over $29T today. The government there continues to want reform but needs to proceed with caution to avoid creating a crisis. The Chinese central bank added more reserves to their system this week in one of its biggest injections of 2017 and that helped soothe markets – for now.

In another sign of the imbalances created by central banks and QE it still boggles our minds that European High Yield has less of a yield attached to it than 10 Year US Treasuries. If we have a bubble then it is certainly there. In yet another great piece by John Mauldin, in his Thoughts from the Frontline, he notes the preponderance of negative yielding government bonds. Can you believe that Italy and Spain have short term negative yielding debt? Who would want to own debt from Italy and Spain at negative yields?!  Mauldin also points to Louis Gave and their research suggesting a currency peg could cause a waterfall of problems and they are pointing to Lebanon. It is a very interesting piece. If you don’t get John’s Thoughts From the Frontline, then sign up, it is free.

Market internals continue to deteriorate and that is especially important in light of historically high valuations. The market has entered what seems to be a new pattern of opening lower and rallying back throughout the day. The S&P 500 is up 12 months in a row and has only experienced pullbacks of less than 3% in 2017. The daily range in stocks is the lowest it has been since the 1960’s. The yield curve here in the US is the flattest it has been since 2007 and the curve in China is inverted. Trees cannot grow to the sky and what cannot continue – won’t.  Volatility will return it is only a matter of when. We see the relative strength on the S&P 500 reaching historically overbought levels. When the S&P reaches this level it makes the comparisons very tough. A pullback is warranted in the S&P and when it does the next rally will not be able to surpass these overbought levels. At that time investors will see it as a negative divergence. That is when the market may begin to struggle.

We continue to fret about risk parity and volatility selling. When stocks go down we will look at bond prices. At some point they will both go down in tandem and selling will beget selling. If there is a meltdown, we believe that is where it where we will see it start.

The Warren Buffet of endowment investing is David Swenson from Yale. We were able to watch an hour long interview with the investing legend and have included a link. The interview of Mr. Swenson is from a meeting of the Council on Foreign Relations conducted by former Treasury Secretary Robert Rubin. Here is the money quote.

But when you start out, you were talking about fundamental risks in this world. And when you compare the fundamental risks that we see all around the globe with the lack of volatility in our securities markets, it’s profoundly troubling, and makes me wonder if we’re not setting ourselves up for an ’87 or a ’98, or a 2008-2009. David Swenson Chief Investment Officer Yale University

So much to say and so little space this week. Obviously, we are a bit concerned that the rally is a little long in the tooth and investors may have lost respect for the power of markets amid market’s seeming invincibility. The animal spirits are unpredictable and still in control. Gotta be in it to win it but, maybe just a little less and a little less in. Tax reform passage could be a sell on the news event and we are, warily, watching the turn of the calendar.  Happy Thanksgiving everyone!! No blog next week as we will be still filling up on leftovers.

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.

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.

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.