Roller Coaster

Healthy markets don’t rally 2% in one day as they did on Tuesday. This week the market was faced with President Trump launching trade wars against Mexico and India while the US GDP is slowing, Europe’s de facto economic leader Germany’s manufacturing is collapsing, global trade bell weather South Korea saw its exports collapse further and global bond yields crashed. Copper is down 8 weeks in a row and oil is now in a bear market down 20%. So what changed? The Federal Reserve went fully into the dovish camp – again. Buy The Dip is back! Problem is the Fed won’t cut rates until the market plunges and that won’t happen because the market expects the Fed to cut if it plunges.

It seems as though everyone in the industry is prepared for a move lower in stocks. Algos and corporate buybacks have held equity prices above where they should be while investors got out and collected dry powder in the face of a slowing global economy. If the Fed cuts here it will look like 1998 all over again. When everyone expects something to happen – something else will.

I have been saying in my letters and blog posts for over a year now that I expected choppy sideways markets and it’s been my experience over the years that trying too hard in these types of markets only ends up costing you money. Markets go down and investors chase it lower and sell. The market reverses and investors chase it higher and buy. Like a roller coaster you go around and around – you get nowhere – and it only costs you money.

Where does this market go next? When markets find themselves in a sideways trend they tend to break out the same way that they came in. In this case markets are digesting the gains earned in the late 2016-17 time frame. The more time that passes the less likely the equity market is to head meaningfully lower. Markets rarely trade sideways for years and then suddenly crash (never say never). This market has taken everything thrown at it and stayed close to all time highs and investing professionals have taken down risk meaningfully. That means that pros are ready and have cash at their disposal to meet a strong sell off.

We talk of seasonal periods from time to time and find that the most helpful information is when something that performs well when it is in a seasonally weak period may be in for further strength. That asset right now is gold. Gold historically performs poorly in the summer months. The start to June has been quite different and precious metals may be having their day in the sun. While precious metals cannot be valued by their cash flow and pay no dividends they are subject to more technical market risk, having said that, a further allocation into the precious metals market may need to be thought of in a short term nature.

For the last 18 months our assessment has been correct as the path in the equity market has been sideways and it has been advantageous to sit and collect our dividends while we took down risk. We will sit until we see a clear direction to take advantage of but with each month ticking by we get closer to putting more risk back into the portfolio. Precious metals currently have our rapt attention.

lighthouse

 

 

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

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

 

 

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

 

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

Shrinkage

 

The S&P 500 lost 3.5% on the week. (So much for the bulls having the ball.) During shortened holiday weeks the bulls tend to have the upper hand. We pay attention to seasonality issues a bunch but the signals are strongest when the seasonality patterns do not hold. A nasty 3.5% drop when the bulls should be able to walk it over the goal line is a signal that there is something rotten in Denmark. We see the possibility of contagion on the horizon. What we have seen in 2018 is a rolling bear market. According to Deutsche Bank 90% of major world assets are down in value in 2018. Not exactly a banner year. The bear has rolled from one asset class to another with the S&P 500 being the last to fall.

We are starting to see pressure in the debt market which tells us that the fear is real and investors are de-risking – and fast. We have a close eye on the debt markets as US corporations have borrowed hand over fist to buy back stock and now those low interest rates are gone. 2019 is faced with a fading fiscal stimulus (from Trump tax cuts), slowing demand from abroad (trade wars), a declining Fed balance sheet and higher interest rates in the US along with the possibility of slowing corporate buy backs. We think, by far, the most dangerous threat to asset prices is the declining Fed balance sheet. All else is basically noise. Fed officials may try to walk back hawkish comments and markets may rally on those comments but as long as the flow is to decrease the balance sheet asset prices will struggle.

Stan Druckenmiller is a legend in the investing world. He is a multi billionaire and in over thirty years of managing money he never had a down year. He averaged 30% a year! Quite simply one of the best who ever played the game. He are two snippets from an interview he recently did with Real Vision.

Everything for me has never been about earnings, has never been about politics, it’s always about liquidity. 

They’re all (Japanese Central Bank, ECB, Fed) going in the same direction which is why I made the (short to market) bet in June and July…It is going to be the shrinkage of liquidity that triggers this thing.  And frankly it has already triggered this in emerging markets.  And that is kind of where it always starts.  What I haven’t seen yet, and where I think we should see it before we see it in the equity markets, and God knows, talk about a crazy priced market it’s the credit market… and it’s amazing… probably since the 1880s-1890s, this is the most disruptive economic market in history, there are hardly any bankruptcies.  So that Warren Buffett line about swimming naked when the tide goes out?  There are probably so many zombies (companies) swimming out there and there is going to be some level of liquidity that triggers it… who knows, it might start with Tesla. – Stanley Druckenmiller Real Vision interview 11/2018

We think it starts with GE. It’s all about liquidity. GE does not have the liquidity to get past its rough spots as they have gotten shut out of commercial paper markets. They are now drawing down their credit lines. Pacific Electric and Gas is drawing down its reserve lines with banks to pay for the wildfires in California. Illiquidity begets illiquidity. We have been awash in liquidity for ten years. Businesses have survived that should not have. Zombie companies. The walking dead. The central bankers are taking liquidity away. We will see stress in high yield and corporate debt market first. We will find some who are not prepared and corporate buybacks will be a swift victim.

We see the Fed capitulating. The market just cannot handle the tightening and the drawdown of liquidity. The Fed will make a show of it to look like they are not bowing to Trump but they know the market is under stress. At the end of the day the Fed does not mind if the market goes down it just minds if the market goes down too fast. The Fed is going to blink. The question is at what level in the market? What happens next? Will we see inflation rise? Will stocks bounce? How high? Our guess is that the Fed will blink sooner rather than later but that may not stop the market from falling.

Be hyper vigilant. These markets can change on a dime. We expect Fed officials to be out and about this week trying to talk back the hawkish tone set from Powell on October 3rd. Traders handbook says we should start to see a Santa Claus Rally. Will Trump deliver one next Monday after the G20 summit? We would guess that he will try.

For a year now we have warned that the 2666 level on the S&P 500 would be a fulcrum and that it would take 18-24 months to surmount this area on the charts. It has been 12 months and counting. The market closed Friday at 2632 after rising as high as 2940 last month.

Signposts like this along the way are good spots for investors to take a respite and reflect on how far we have come and whether the trend should continue. 2018 may be a Year of Reflection.

We also noted that Bitcoin would be a canary in the coal mine for markets.

Keep an eye on Bitcoin. The crypto currency market seems to be shaping up as a temperature gauge for risk. Bitcoin just made a lower high and there seems to be pressure in the space. As goes bitcoin so goes the market? It is trading at about $8300 as we write. It is very important that the support at $6700 remain steady otherwise bitcoin could see a $2000 fall quite quickly.Blog May 2018 (Bitcoin closed last week at $4200)

Well, here we are. Bitcoin broke support and fell $2000- very quickly. Speculators are getting out. Liquidity is drying up. We have seen it across all asset classes. It’s just time for stocks. In our April Letter we warned that you should not have more than 50% in stocks.

We remind you of these to show you the pattern. Markets were very speculative and had gotten ahead of themselves. 2018 was a Year of Reflection – A time to pause and see if prices reflected reality. The market is very oversold short term but long term markets were VERY over bought and valuations had gotten unreasonable. Just look at bitcoin. 18-24 months seems about right to see if investors can digest this level in the market. We suspect they cannot if the Fed continues to drain liquidity. It’s always about liquidity.

We are due for a bounce but last week was not a real confidence builder. The 2525-2575 level on the S&P, if tested this week, needs to hold for the bulls. If the bulls fail the test a trapdoor could open. The end of the year gets tricky as investment managers will try to make things look good and come out with a positive year. There are also esoteric concerns about liquidity and bank reserves at the end of the year which could exacerbate things. The risk is asymmetric to the downside with a selloff being of less likelihood but of greater magnitude.

lighthouse

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

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

 

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

 

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

The Hot Hand

 

One thing about investing is knowing who to listen to. Howard Marks has a new note this week and we dropped everything to read it. Here are some of the pearls of wisdom he dropped this week. His new book is coming out and I, for one, can’t wait to get my hands on it – “Mastering the Market Cycle”.

Nothing in the investment world is a good idea or a bad idea per se.  It all depends on when it’s being done, and at what price and terms, and whether the person doing it has enough skill to take advantage of the mistakes of others, or so little skill that he or she is the one committing the mistakes.

On the current investing environment: Thus I’m not describing a credit bubble or predicting a resulting crash.  But I do think this is the kind of environment – marked by too much money chasing too few deals – in which investors should emphasize caution over aggressiveness.

As a reminder, here is a post from Charlie McElligott that we mentioned a month ago. Charlie has been spot on of late and seems to have a good handle on our current market environment. Charlie sees stocks headed higher for another two weeks and then we may need to pay the piper a bit.

WHY SEPTEMBER SETS-UP FOR A POTENTIAL MONSTER EQUITIES/LARGE ‘MOMENTUM’ RALLY – By Charlie McElligott, head of cross-asset strategy at Nomura 

All-in, this sets the table for what I believe could be a “grab” month in U.S. Equities through the month of September and into mid-to-late October; HOWEVER, this then leads to an “overshoot” potential once folks have taken net exposures back significantly higher, as my view has continued to be that by late-October, we should again see heightened cross-asset volatility off the back of negative impact of what will be a large “Quantitative Tightening” impulse via the Fed / ECB / BoJ in this window.

Bonds never got those two consecutive closes above 3.25% on the 30 year. Bonds have pulled back from the brink for now. The incredibly large short position in Treasuries might have something to do with that and may continue hold off the march higher in bond yields. We continue to watch the US Dollar as it may hold the key here.

 

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

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

 

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

 

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

The Sun Also Rises

How did you go bankrupt? Two ways. Gradually and then suddenly. – Ernest Hemingway The Sun Also Rises

We have been pointing towards a looming crisis in the municipal finance area. No, this is not a repeat from last week when we talked about the fiscal problems in the great state of Connecticut. It was Illinois’ turn this week to make headlines. The two big ratings agencies, Moody’s and S&P lowered their rating on Illinois to one step above junk as its budget impasse dragged onward. Illinois will likely reach junk status by July of this year. It is now the lowest rated US state ever.

Big banks are complaining that their profit’s are drying up and this is mostly due to Federal Reserve polices. The yield curve is flattening which is stymieing bank’s ability to make money on loans while volatility in markets has dried up pinching trading profits. JP Morgan, Bank of America and Morgan Stanley all warned on profits this week as trading profits are blamed. We expect the Federal Reserve to heed their calls. The yield curve problem may take longer to solve but we should expect the Fed to allow for more volatility in markets. JP Morgan warned on trading in May of 2014. The market continued to march higher another 9% into December of that year.

The head of one of the largest asset managers on the planet, BlackRock’s’ Larry Fink, warned the equity market is not appreciating the message from the Treasury yield curve and we have to agree. The bond market continues to rally with the US 10 Year yielding a paltry 2.15% at week’s end. It is a caution sign that both the bond and stock markets are rallying while the yield curve flattens. Investors may be chasing the stock market a bit as there seems to be some evidence of FOMO. Fear of Missing Out as the market hits new highs. The laggards from 2017 YTD rallied this week and that tells us that money managers are chasing. This plays right into our animal spirits theory and the 1987 scenario. History doesn’t repeat but human beings are susceptible to making the same mistakes over and over again.

Oil had another rough week as it is still below the critical $50 a barrel on West Texas Crude (WTI). New pension and retirement money entered the market as the calendar flipped to the month of June. Equities have broken out of the range that they had been trapped in for the last 3 months. The range of 2330-2400 on the S&P 500 was broken last week and the market extended its move to just below 2440. We expect this breakout to extend to 2475.  For now, volume is low and the trend is your friend.

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/ .

 

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

 

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

 

Trump Troubles

A roller coaster runs up and down spins around and around while finishing where you started and it probably cost you money. – Arthur Cashin

We all rode the rollercoaster this week.  While there was plenty of noise and bluster the market fell less than one half of one percent this week. We feel that the volatility in the market was more about the massive positioning of trader’s being short volatility and not as much about Trump. Trump is just the excuse. Could this be a warning shot across the bow in the crowded volatility trade? Perhaps. Be careful. We are entering a slow period for the market seasonally. There just aren’t as many players around during the summer months and moves could become more pronounced. I, for one, would welcome back some volatility. It keeps investors onsides.

Financials are very important to the bullishness of the US stock market. The yield curve is flattening. That means that the bond market sees the economy slowing and the prospect of higher rates on the long end decreasing. The Fed will not be able to continue to raise rates if the economy is faltering. Financials are probably the most important sector of the stock market. Without financials it is hard to get the index to extend higher. The market is pricing in a June rate hike but chances are diminishing that the Fed will be able to raise rates a third time in 2017. Trump’s troubles make a fiscal bump less likely. If you have followed our blog you know that we made the case that a Trump bump from fiscal stimulus would give the Fed cover to raise rates. If that gets lost in the swamp then it makes the Fed’s job a lot more difficult. Our next point of interest is the Fed’s balance sheet. They are making noise that shrinking it is becoming a priority. That will be a huge factor in 2018.

West Texas crude was able to hold its recent lows and was able to close this week above the psychologically important $50 a barrel level. It could be just a bounce off of the OPEC meeting and Russian compliance or we could be seeing more growth worldwide. Oil has a top on it as if crude goes higher as more shale players will come online capping the price of oil but it is worth watching as an indicator of growth around the world.

Given all that happened this week the market is still stuck in consolidation mode. Emerging markets and Europe have been the place to be but Brazil took a hard shot this week. Keep an eye on Brazil. Impeachment is a strong word. Given the very small sample of US Presidents that have been on the impeachment trail stock markets have not reacted negatively in the longer term based on the impeachment process. Having said that, impeachment is also not likely given that Republicans control the House, that is until the midterm elections in 2018.  It is hard to argue against the bull thesis as the market continues to hold its recent range of 2330-2400 on the S&P 500. Until we break decidedly below 2330 we hold on to the bullish thesis.

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/ .

 

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

 

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

Published in: on May 20, 2017 at 8:24 am  Leave a Comment  
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Buckle Up

In the 1st Quarter of 2017 it will mark 8 years of the bull. Valuations are elevated to say the least but new policies from the White House and Republicans may give another boost to the market. A new resident at 1600 Pennsylvania Avenue can introduce risk to the market. A new leader in the Executive Office may prefer to take a recession or market rout early on in their term in order to blame the other guy. But this new leader seems to be unlike any other we have ever seen. In the short term moving into Q1 we think that there may be some buyer’s remorse on the Trump win. Not in relation to Trump (we are agnostic politically in terms of making investment returns) but in relation to getting those policies of decreased regulation, lower taxes and the repatriation of funds actually passed. The Supreme Court may have to come first.

January could find some bumps in the road but once a bull market gets this far we expect it to end in spectacular fashion. Two years come to mind that took place in a rising interest rate environment – 1981 and 1987. In 1981 Ronald Reagan came into the Oval Office with great expectations and saw stock prices up 5% in the first quarter of his Presidency.The market then fell over 19% in Reagan’s first nine months in office. While this does rhyme somewhat with the Trump Rally the landscape was very different in 1981. Although 1981 was a period of rising interest rates we saw a nation that was struggling with a 14 year bear market and an economy that was treading water with Fed Fund rates in the early teens and rising. 1981 was an environment of low valuations and high interest rates which is just the opposite of what we have today.

A year that might have more significance would be 1987. At the dawn of 1987 share prices had appreciated more than 100% from the lows put in 5 years earlier and the year began with a bang. The Dow Jones would be up 35% by August of that year. While the Federal Reserve was raising rates euphoria ran wild on Wall Street with seemingly daily mergers creating wealth for shareholders. “Animal Spirits” of a rising stock market took hold and shares ran higher with investors fearing that they were being left behind and easy money was being made on Wall Street. 2017 could bring something very similar. Investors are anxious as valuations are historically elevated and, while not wanting to take on added risk, there is a fear of being left behind. According to Sir John Templeton bull markets die in euphoria. We are at the point where we think this market is close to euphoria and it being more likely that this bull move ends with a bang and not with a whimper. While valuations have us cautious and protecting against negative shocks to the system what we could see is a shocking move higher.  

In Jeremy Grantham’s work on bubbles he postulated in June of last year that the market could run up to close to 3000 on the S&P 500 before breaking under the weight of excessive bubble – like valuations. That would be about 30% from here.

This week it became evident that Trump’s win could give rise to policies that would provide the Fed the cover that it needs to be more aggressive in raising rates. In their first post election meeting Janet Yellen and the Federal Reserve are predicted 3 interest rates hikes in 2017 rather than the 2 expected previously. While we all know the Fed is notoriously inept at predicting anything its current projections show a more aggressive hawkishness from its previous stance. This could help normalize interest rates into the range of 2-5% that the Fed prefers. This would be healthy from a longer term perspective and give the Federal Reserve ammunition should another crisis arise but it may produce some bumps in the road near term. We think that this normalization would be a net positive by giving business owners more confidence and more impetus to invest in their organizations which in the long term would be supportive to jobs and the economy.  

US Treasury rates on the 10 year are hovering around 2.6% as they seemingly stabilized this week. As far as equities go investors kept their wallet on their hip this week and did not drive the market into further overbought territory. There is some angst over the end of the year and the memory of the last several January’s which saw equities move lower. We expect investors are ready and willing to buy the next dip. That dip will probably not be pronounced and may provide kindling for the animal spirits to drive the market higher in 2017.   

Chinese may be struggling as they saw had debt and currency issues this week. Their currency is falling rapidly as they try to maintain control. China’s economy and their relationship with the US is shaping up to be THE story of 2017.The Saudi’s still wish to see a higher oil price at least until the Aramco IPO gets floated in 2017. They will try and keep oil stable and rising until then. Watch the Aramco IPO for clues as to oil’s direction. Markets are still overbought and Santa has not even arrived yet. Market pundits are seemingly all calling for a low return year. What you expect is not usually what you get when it comes to the stock market. When everyone is leaning one way we lean the other. We see volatility coming back and some wide swings up and down. Buckle up.   

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

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

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

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

The Market’s Violent Transition

“There are decades where nothing happens; and there are weeks where decades happen.” 
― 
Vladimir Ilyich Lenin

This was another busy week for the markets in the aftermath of the Trump victory. There has been a sea change in the outlook for markets going forward which is much more predicated on the House, Senate and White House being controlled by Republicans than it is solely about Trump. A stranglehold on DC by the Republicans will enable them to pass legislation to help stimulate the economy and perhaps stoke the fan of inflation. We had some bright minds check in with their thoughts this week. Ray Dalio proffered his thoughts on LinkedIn this week on the Trump win and where that takes the investing landscape. Dalio feels that we are at a major reversal point that may last a decade.

As a result, whereas the previous period was characterized by 1) increasing globalization, free trade, and global connectedness, 2) relatively innocuous fiscal policies, and 3) sluggish domestic growth, low inflation, and falling bond yields, the new period is more likely to be characterized by 1) decreasing globalization, free trade, and global connectedness, 2) aggressively stimulative fiscal policies, and 3) increased US growth, higher inflation, and rising bond yields. 

As for the effects of this particular ideological/environmental shift, we think that there’s a significant likelihood that we have made the 30-year top in bond prices. We probably have made both the secular low in inflation and the secular low in bond yields relative to inflation. 

 The question will be when will this move short-circuit itself—i.e., when will the rise in nominal (and, more importantly, real) bond yields and risk premiums start hurting other asset prices. 

https://www.linkedin.com/pulse/reflections-trump-presidency-one-week-after-election-ray-dalio?trk=hp-feed-article-title-publish

The key to success here will asset allocation. The early winning sectors out of the gate are financials, materials and industrials. The losers are bonds, utilities and REIT’s. We will be looking towards oil as we have been writing about for several weeks. The bottom may be in for oil as $60 a barrel looks far likelier than a revisit to the lows of $20 a barrel. US Treasuries have been absolutely hammered since the election and we suspect while the 30 bond bull market in bonds is dead but a trade-able low in bonds may be at hand as bonds are oversold.

We have been prepared for this upward move in bond yields as we sought cover by lowering our duration for our investors. We believe the 30 Year could move to 5% over the next five years. We were shocked to hear Jeffrey Gundlach, whose prescient calls we follow in the bond market, is predicting a move in the 10 Year to over 6% in the next five years. A move of that magnitude is what Dalio is speaking of when he relates that at some point bond yields will move too high for stocks. At some level investors will prefer bond yields to stocks and stocks will falter. At what level that occurs is the current $1 Trillion dollar question.

 Future inflation expectations are soaring. We believe in the sea change that Dalio and Gundlach are espousing with regards to inflation and higher bond yields. In the short term it appears as if everything is currently either overbought or oversold as we have entered this violent rotation out of bonds and bond like instruments into equities. The markets going forward may soon turn their attention to an exit from the EU by Italy as their referendum is fast approaching. For now, 2190-2200 on the S&P 500 is resistance while support is anywhere lower as the buy the dip crowd is back, although, investors will be buying financials rather than utilities. Things may have moved too far too fast. We think that bond yields will soon revert lower if only to relieve their oversold condition but it appears the 30 year trend has changed.

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

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

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

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

The Greatest Game

 

“Golf is deceptively simple and endlessly complicated; it satisfies the soul and frustrates the intellect. It is at the same time rewarding and maddening – and it is without a doubt the greatest game mankind has ever invented.” – Arnold Palmer

 

My great passions, besides my family, are golf and investing. They are very similar in their nature. As Mr. Palmer so eloquently stated both games are maddening but perhaps that is why they are so rewarding and satisfying. We enjoy that both games seem simple but are frustratingly complex and it is in conquering their complexity that we find such satisfaction.

The 3rd Quarter of 2016 was maddening as the entire quarter was spent watching and waiting for some sort of resolution to market direction. While investors and hedge fund managers went off to the beach, the market, with the exception of the first two weeks in July, looked like it went off to the beach as well. The S&P 500 was up 3.5% in the first two weeks of July and that is where it closed for the quarter.  Much like a duck it was about what was going on under the surface that counted.

The pressure in the market continues to build as the market stays range bound between 18,000 and 18,500 on the Dow Jones Industrials. The pressure, if you listen to the media, is increasingly blamed on the election but it is the course of central banker policy that should hold your attention. The election is merely a sideshow. Central bankers, while publicly stating that negative interest rates are working, are finding that negative interest rates in Japan and Europe are having serious consequences. The pressure is mounting on central bankers to claw back higher interest rates without disturbing the animal spirits of the market place which would knock down asset prices while hindering confidence in the recovery.

Deutsche Bank and Interest Rates

Of late, central bankers in Europe have also come face to face with another dilemma and that is the market is attacking the stock price of Germany’s largest bank, Deutsche Bank (DB). The market has begun speculating that Germany’s largest bank and perhaps the world’s most systemically important bank could be in trouble. While we don’ think Deutsche Bank is on the brink of failure attention must be paid. When Wall Street senses weakness they feed upon it. The market has a way of cleaving the weak antelope from the herd. Financial firms’ biggest asset is confidence in the institution itself. A bank is only as good as its promise that it will deliver on its obligations. If there is no confidence in the institution then it is no longer viable and money will flow away from it. A bank run is not always logical.

Markets are going to push Deutsche Bank, possibly to their limit. Markets have a way of fleshing out the weak players. Traders will get into to a position where they will profit from a fall in Deutsche Bank’s stock. It has been this way since the dawn of Wall Street. You could call them parasites but as speculators they perform a function. They keep the system honest and flesh out the weak hands. That is what capitalism is. We have seen it over and over again. This can be seen in the failure of Lehman Brothers, Bear Stearns and probably most clearly in the failure of Long Term Capital Management.

(In 1998, Long Term Capital Management was THE hot hedge fund full of famous Wall Street traders and Nobel Prize winners. They made increasingly larger bets that put them in hot water.  Traders around the Street got wind of their problems and garnered insights into Long Term’s worsening positions and bet against them until Long Term had to capitulate and be bailed out by the big banks.)

One of the biggest issues surrounding Deutsche Bank and the European banking system is the unintended consequences of negative interest rate policy. The current negative interest rate environment is curtailing bank profitability. By trying to save the European economy European Central Bank (ECB) officials are putting the solvency of their banking/insurance sectors and pension funds at risk.

From a macro perspective we see that not only can central banks no longer lower interest rates they must raise them to enable banks to make profits and heal their balance sheets. Danielle DiMartino Booth is a former advisor to Federal Reserve of Dallas President Richard Fisher and is now President of Money Strong and serves as a consultant on worldwide central banking. Here is what Danielle had to say on the current interest rate environment.

In a reversal of economic fortunes, today’s economy is in desperate need of higher rather than lower interest rates, of a normalization of policy to put a floor under the bloodletting in pensions, insurance companies and among retirees worldwide. – Danielle Martino Booth Fed http://dimartinobooth.com/the-overlords-of-finance/

Central banks are currently trying to keep zombie companies and banks from failing. They are not allowing capitalism and its creative destruction component to function. The capitalist system is designed and needs to allow weaker hands to fail and the system to heal and become stronger. That has been what is missing since the dawn of this crisis – The allowance of failure. The politics of it are not palatable. The system is weakened because of it. At some point authorities must allow creative destruction or we will end up in an endless series of crises and become like Japan with low growth and stagnation for decades. The piper must be paid. Pain must be felt. Could we be at the beginning of that realization? Rates must be allowed to rise so banks can make money and repair their balance sheets. Central banks may be forced to raise rates.

Do we think that Deutsche Bank is going to fail? No. The legal settlements will not be as high as the headline grabbing amounts suggested so far. The bank does have sufficient liquidity at the moment but bank runs are bank runs and if one begins for Deutsche Bank there is never enough capital. Bank runs are panics and cannot be reasoned with.  We look at the macro risks and opportunities. We believe that there has to be a Plan B in effect and the German government will step in if Deutsche Bank begins to fail. A lack of confidence in Deutsche Bank and a lower stock price will deny them the ability to raise more capital. Either the governments will have to back off and allow them to operate under less stringent capital measures or Germany may have to step in and take a large stake in the world’s largest derivative dealer. The contagion risks are too high worldwide. What we see from a macro perspective is that the ECB will have to back off its pledge of negative interest rates as the unintended negative consequences are too high. Banks need positive rates and a steeper yield curve to make money. You cannot have your banks fail. They are the plumbing of the economic system. If Deutsche Bank fails then Credit Suisse is next and so on. The dominoes fall. Central bank leaders need to make it easier for banks to generate profits and negative rates are killing banks.

http://www.zerohedge.com/news/2016-09-29/run-begins-deutsche-bank-hedge-fund-clients-cut-collateral-exposure

 Saudi Issues – Oil

 

The other issue that has had our attention all summer is the lingering dissension among OPEC members and talks to tighten oil supply. Saudi Arabia is the 800 lb gorilla in the oil markets and without a definitive commitment on Saudi Arabia’s part no supply cut will have any effect.  A younger generation has taken control in Saudi Arabia and has been attempting a different tack in managing its foreign policy and economy. This has led them to attempt a change in their oil policy. The Saudi’s have been trying to drive prices lower in order to maintain market share and perhaps drive Russian and United States policy in their favor. The continued oversupply of oil markets has had the effect of dragging down oil prices but the outcome may have been too painful for the Saudi’s to handle. Things in the Kingdom have gotten much worse for the rulers as social issues mount. The Saudi Arabian government was forced to tap the international bond market for the first time in decades in order to fund a large budget deficit approaching 16% of GDP.  Currently their stock market is tumbling and the default risk of Saudi Arabia is rising in world markets.

Efforts to manage the fallout from cheap oil gathered steam over the past two weeks. Policy makers have suspended bonuses and trimmed allowances for government employees. Ministers’ salaries were cut by 20 percent. The central bank also said it’s injecting about 20 billion riyals ($5.3 billion) into the banking system to ease a cash crunch.

Austerity will help Saudis reduce a budget deficit that reached 16 percent of gross domestic product last year

 

The benchmark Tadawul All Share Index is down 18.5 percent this year, the third-worst performer among more than 90 global indexes tracked by Bloomberg. The MSCI Emerging Markets Index has climbed 15.4 percent.

http://www.bloomberg.com/news/articles/2016-10-05/saudi-arabia-s-post-oil-plan-off-to-a-rough-start-in-year-one

Current Saudi policy of over production is not working and the latest negotiations among OPEC nations may be the royal family admitting defeat and enabling a fundamental change in policy. The Saudi’s’ must constrict production in order to raise prices which will entail them taking the brunt of production cuts.  By agreeing to those terms perhaps they can elevate the price of oil. Higher oil prices will bring greater supply especially above $55 a barrel here in the United States but the capitulation of the Saudi’s could indicate a broader policy reform that over time will help support oil prices.

Bubble in Central Bank Policy

High interest rates are going to encourage savings, and I think we desperately need savings. Take a widow: they don’t know what to do with the money. There is no way they can do anything with it unless they go into stocks. I think forced equity investing creates the bubble.”

When asked who do you blame for this mess, the legendary hedge fund investor had one name: Janet Yellen, who Robertson says “is unwilling to see the American public taking pain at all and because of that I think she is creating a serious bubble where serious pain is going to come.”- Julian Robertson Bloomberg 9/28/2016

 

We could be on the cusp of real change in how investors are maneuvering especially in reaction to higher interest rates. Because of low interest rates investors, and in particular retirees, have been forced into buying ever higher priced income producers. Those income producers, such as real estate and utilities, have become overpriced in historical terms. We are looking to pull back from those areas of the market. In addition, low volatility strategies are seeing increased downside risk due to leverage, risk parity strategies and the current correlation of stocks and bonds.

The Saudi’s are indicating a change of heart on production numbers as things in the kingdom are getting rough. Whether or not they will be able to get production numbers down is another story. We think that the major gains for the 30 year bond market are behind us but we do not see interest rates heading much higher in the near future. The Fed is too afraid to rattle markets and they will raise rates even slower than most think.

 

While we can make the case for markets to fall the fact remains that we are in a binary environment and stocks could sharply rise as well. Although we think that risks continue to be tilted to the downside. In making the case for higher stock prices we note that professional investors are under invested and under performing. According to Goldman Sachs only 16% of Large Cap money managers are beating their benchmarks. There are some very high levels of cash at mutual funds and under performing managers will be looking to protect their jobs. Also, central bank policy may be forced into buying riskier assets to continue to forestall another crisis. That means they may be forced to buy equities as the Swiss and Japanese have already begun to do. If under invested under performing mutual funds begin to chase the market and inflation begins to move higher central banks will be reluctant to take away the punch bowl.

The election could roil markets but we think that a rate rise from the Federal Reserve in December is the more likely suspect to press markets. If that is the case we could be in for a replay of late 2015 and early 2016.

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

 

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Terry@BlackthornAsset.com

Fed Up

The S&P 500 had its best week since mid July as central bank largess was increased yet again. On the menu this week was a buffet served up by not only the Bank of Japan (BOJ) but by the United States own, Federal Reserve. The BOJ refuses to give up on its intention to foster inflation north of 2% and in doing so announced that it will now attempt to control (manipulate?) the yield curve in Japan. Analysts that we follow are polar opposite on their views of where the new Japanese policy has us headed. We value both analysts’ opinions. We are facing a binary environment and either outcome is possible. Japanese central bank policy will only succeed in driving a vicious cycle. If price pressure does begin to mount this new central bank policy will only drive more inflation. If deflation begins to rise central bank policy will only bring more deflation. Here is more from George Saravelos from Deutsche Bank. One thing that we are fully confident in is that we are at the precipice of a decline in confidence in central bank policy.

In a note titled “It may be over for the BOJ”, DB’s George Saravelos writes that “by targeting nominal rates the BoJ is relinquishing control of real rates. This creates a policy asymmetry that becomes highly pro-cyclical. Consider a negative demand shock that raises demand for JGBs and depresses inflation expectations. The BoJ will end up reducing the amount of JGBs it buys and raising real rates.Consider the opposite: a huge fiscal stimulus from the government that puts upward pressure on yields: the BoJ would effectively monetize the debt raising inflation expectations even further. We worry that a self-fulfilling tightening is more likely than an easing in coming months.”

However, once the curve starts shifting substantially, either parallel-shifting or steepening the central bank would quickly lose control as its intervention would only exacerbate the underlying move 

We are in a very binary atmosphere. We could tip towards recession without the necessary tools to fight it in central banker’s hands or inflation could rise with central bankers without the political will to fight it. Central banks are losing credibility and that could spiral out of control very quickly. 

Donald Trump, while trying to bait Fed Chair Yellen into raising rates, proved that the Federal Reserve does make political decisions as a decision to do nothing is still a decision. Confused? Think about how Janet Yellen feels. Get the Tylenol ready for Monday night’s debate. While Yellen was damned if she did and damned if she didn’t she managed to come out looking political anyway. Maybe this is Trump’s true genius. He accused Yellen of running a political body in the Federal Reserve and she by not raising rates looked political. We never thought that the Fed would raise rates in front of the election but that is because we know they are a political body. Let’s be fair. They have to play politics. Congress is their boss. That, in the end, is the problem and why they will never meaningfully raise rates. They are boxed in. I think though you can now bet on rate rise in December if Trump pulls off a victory.

Professional investors are under invested and under performing. According to Goldman Sachs 16% of Large Cap money managers are beating their benchmarks. There are some very high levels of cash at mutual funds and under performing managers looking to protect their jobs. While we think that a tightening and a downward move in assets prices is more likely we could start to move out control to the up side as well. If under invested under performing mutual funds begin to chase the market and inflation begins to move higher central banks will be reluctant to take away the punch bowl. Ironically, a Trump win could be the cover they are looking for to take it away.

Vicious and virtuous spirals could be headed our way. While we think the line on this game is for a tightening and markets to head lower we think that move down might have to wait until after the election. In a repeat of last year we could see assets move higher until December while 2017 could have some early bumps.

Squeezing the Lemon – Dalio and Gundlach

Ray Dalio spoke at the Delivering Alpha Conference with CNBC. He made interesting note that interest rates cannot be made materially lower and may in fact “go the other way”. As bond yields go down it has the effect of making stocks more valuable. The bond bull market that has seen interest rates on the US 10 Year sink from 15% in the early 1980’s to 1.5% today may be over and that tailwind that it has given us to invest may becoming a headwind. Interestingly, Jeffrey Gundlach of Double Line Funds presented his latest webcast focused on the same idea. The lemon has been squeezed. It is time to look at bonds a bit differently. Those of you have followed us for the last several years know that we have been bullish on bonds longer than most and that has served us well. It may be time to change that thinking.

http://www.cnbc.com/2016/09/13/bridgewaters-dalio-theres-a-dangerous-situation-in-the-debt-market-now.html

Deutsche Bank got word that the Department of Justice (DOJ) was looking for $14 billion to settle a probe tied to activity in mortgage backed securities. That is with a B. Why are we concerned about Deutsche Bank? DB is one of the world’s largest derivative dealers. They are a key linchpin in the financial ecosystem. The settlement will be much lower than $14B but any number above $4billion could bring into question Deutsche Bank’s capital position. European banks are already under extreme pressure with negative interest rates severely impairing their ability to make money. DB and Italian banks are on our watch list.

Explosive devices in NYC lend help to Trump. Markets may not react positively to a Trump victory and may be leaning a bit too heavily towards factoring in a Clinton victory. Not making a statement here. The deal is Wall Street doesn’t like uncertainty. Trump has no political track record and the Street has no way of knowing where to place bets on a Trump victory except that he just might shake things up. Clinton is the status quo. The Street doesn’t like uncertainty.

Federal Reserve and Bank of Japan opine this week. Things may be quiet until then. We don’t expect much. The Fed is going to be wary of raising rates in front of an election that is running very close. It is also a great excuse to hold steady as they are terrified that the market might go down on a rate hike. The Fed may never raise rates again until there is a change in leadership at the Fed. Their current policy of waiting until the perfect time will never work. There is always something to be afraid of.

Stocks and bonds have been uncomfortably correlated. That means stocks and bonds have been going in the same direction. An asset allocation between them relies on them going in opposite directions. Risk Parity funds have been taking a hit of late. They could be forced to de-lever and raise cash. Market is sitting right on its 100 day moving average and that has Momentum traders on edge.  Market could swing sharply in either direction. Watch how stocks and bonds relate. Stay on your toes.