Catch 22

Much like a cliffhanger episode of your favorite television show the market gave us a cliffhanger at the end of Q1. The rollercoaster, up and down ride of the S&P 500 in Q1 ended the quarter on the down beat and at key support levels. Would markets hold? Tune in next time.  Well, now we know that those levels held and Q2 produced a slow but steady walk higher in markets. The second quarter saw the S&P 500 Index up just shy of 3% which got the S&P 500 back on the positive side for 2018, albeit, just barely. While a decent quarter was had by equity holders it still appears that the market remains stuck in a consolidation range. The same range that we have predicted it would be stuck in for months and that it cannot quite break out. Why are markets stuck? The economy is doing so well. We have seen tax cuts and the repatriation of money from overseas. Shouldn’t that have markets rocketing higher?

Markets discount news in advance. Investors have anticipated peak profits. The tax cut, fiscal stimulus and repatriation of overseas funds were all widely anticipated. All of these maneuvers have helped profits tremendously but they are also all things that cannot be repeated over and over again as part of the business cycle.  These are one time turbo boosts to the economy. Great earnings were widely expected and were priced in months ago.

The second and most important reason that stocks are treading water is that the Federal Reserve has begun pulling back on liquidity and are now draining money from markets. This is done by the reduction of the holdings on the balance sheet of the Federal Reserve and steadily raising interest rates. While the Federal Reserve has only just begun their plan to withdraw liquidity from historical extremes markets have already begun to sputter.

It appears that markets are now waiting for the next catalyst. As you know we are proponents of the central bank thesis. This is the thesis that we, and others, subscribe to, that proffers that central banks are responsible for the rise in assets prices as a direct correlation to loose monetary policy and the existence of historically large balance sheets at central banks around the globe. Those large balance sheets and low interest rates have helped generate a fourfold rise in the S&P from the nadir of the financial crisis.

The Federal Reserve is just getting started removing excess stimulus and yet the ancillary effects of the removal of easy money are already rippling around the globe. Raising rates and draining the balance sheet have the effect of making dollars more scarce and more valuable. The draining of the balance sheet will lead to the draining of asset markets as there are fewer dollars to go around. This could quite possibly engineer a crisis in emerging markets.

Why emerging markets? Emerging countries have borrowed large amounts of money. Part of the broader problem is that they borrowed it in US Dollar denominated terms. Think about that for a second. Say you are Brazil. You borrow US Dollars and turn it into the Brazilian Real. Your currency drops in value by 14% due to rising US interest rates which make the Dollar more expensive. You now need to pay back your debt in US Dollars. That’s a problem. The country’s economy begins to grind to a halt. Then, authorities from around the world beg the US to stop raising interest rates. This is all happening while the Federal Reserve asset removal from their balance sheet has really been just a drop in the proverbial bucket. Almost akin to losing a deck chair off of the RMS Titanic and yet central bankers around the world are begging the Fed to stop raising rates. Central banks from Europe to Japan have indicated that October of 2018 could see further tightening from central banks around the globe. That could be the next catalyst.

The first half of 2018 has seen that there is a new game in town. The high wire act known as the Federal Reserve has made its impact on markets around the globe. The current tightening policies of the FOMC have led to a rise in the US dollar. That rise has had an impact on emerging markets. In just the past 90 days the Argentinean peso has fallen 30%. Other signs of distress have appeared in the Brazilian real, the Turkish Lira and the South African Rand which are all down over 14% this quarter. We have seen Asian emerging markets fall 3-5% while China leads the way to the downside with a double digit fall in its stock market for 2018. The change in policy by the Fed, by raising rates and shrinking its balance sheet has created a new dynamic. This new dynamic brings with it a flattening yield curve. A flattening yield curve makes it harder for banks to make money by lending and is seen as a harbinger of a slower economy.

In October central banks (US, ECB, BOJ) are poised to jointly deliver a net monthly shrinkage for the first time in 10 years and then the pace of that shrinkage is scheduled to increase as the ECB and BOJ both taper. Will markets respond in kind? We suspect they will. Eventually, if markets move low enough and economies slow enough,  it turns into a political issue. Will the Federal Reserve have the political will to continue shrinking policy as central bankers and politicians from around the world balk?

The Catch 22 for the Fed is firmly in place. As inflation begins to take hold in the US and in Germany central bankers will be forced to tighten policy even more. Politicians will cry out in pain as economies slow or markets fall. If central bankers feel threatened by politicians they may end up behind the curve on inflation. They will be faced with a choice. A choice between inflation in developed markets and currency chaos in emerging markets. Ironically, the next crisis will probably be caused by the central banker’s actions (or inactions) as they try to pare down their balance sheets and normalize interest rates.

Valuations – 1999

We have begun to have that old déjà vu feeling again. When you have been investing long enough you see the same events over and over again. They just come in different forms and names. It’s human nature. We have that feeling that we are seeing the same movie again and perhaps we have seen the ending before. The movie is the late 1990’s.

Growth stocks again have taken a tremendous lead over value stocks and rumblings in emerging markets are growing steadily. Lately, what has piqued our interest is the tremendous disparity between large cap tech (i.e. Netflix) and consumer staples (i.e. Kraft Heinz). 1999 was when tech overtook all reasonable valuations and left good quality companies in the dust. We currently see Netflix valued at 275x earnings with no dividend versus Kraft Heinz at 7 x earnings and a 4.0% dividend. The change in sentiment may not be immediate but it is important as investors that we are not blinded by the bright lights of the pundits and the headline du jour. At some point value will become valuable again and growth will pay the dear price of not having any margin of safety in its valuation.

“Haven’t we seen this movie before? Technology takes over the stock market late in a recovery cycle, seemingly making the bull ageless, pushing portfolios toward a more concentrated new-era exposure, stimulating investor greed bolstered daily by watching a chosen few (FANGs) rise to new heights, and convincing many that tech is really a defensive investment against late-cycle pressures which trouble other investments.”- Leuthold Group’s Jim Paulsen

While the hoards are chasing growth at any price (Amazon, Netflix, Microsoft) we look to note what the smart money is doing. In our April 22 2018 blog we noted that Goldman Sachs made an announcement that went widely missed. Goldman decided to halt the corporate buyback of Goldman stock. That gave us the sneaking suspicion that Goldman’s leadership felt that their stock was not worth the price that it was currently trading. As we write financial stocks have just finished a losing streak of 13 consecutive trading days – a new record. In April, when the announcement was made, Goldman Sachs was priced north of $260 a share. The stock is now down over 15% from those levels. Smart money indeed.

What’s Next

If you are a regular reader you know that we follow certain investors as guides along this journey to try to parse out clues to the macro environment.  Recently, Bridgewater Associates, the largest hedge fund in the world, offered this very direct warning about what comes next.

2019 is setting up to be a dangerous year, as the fiscal stimulus rolls off while the impact of the Fed’s tightening will be peaking.

We are bearish on financial assets as the US economy progresses toward the late cycle, liquidity has been removed, and the markets are pricing in a continuation of recent conditions despite the changing backdrop. ­

Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive – reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half. – Bridgewater’s latest Daily Observations authored by co-CIO Greg Jensen

The Fed is pulling back on liquidity as it is the right thing to do for the United States. However, there are many outside the US that don’t share that view. In particular those include emerging markets that are beginning to submerge from Argentina to Turkey to Brazil. Those ripples across the pond from a rising US Dollar will form into waves that eventually hit our shores. This will put pressure on the Fed to slow its tightening cycle. As we always like to say, “There are no problems only opportunities”. We are loath to enter emerging markets as we see the Fed continuing to raise rates but there are places to hide. Currently, small caps and mid caps have been the out performers here in the US. The theory being that small and mid cap stocks will not suffer as much as their large caps brethren due to their lack of international sales.

Elsewhere, we see commodities as a place to generate return. We envision a scenario where the Fed will be handcuffed by political pressure.  The Fed will be forced to slow rate hikes by Congress and by external international pressure. That should allow inflation to run unchecked for some time until the pain delivered by inflation becomes worth the cure and the cure is painful – much higher interest rates. We are already starting to see inflationary wage pressures in trucking and the oil patch. Commodities should continue to flourish under this scenario.

We are more bullish on the US than Europe. We are currently seeing Europe’s economy slow down while the US speeds up. Why? The US and Europe both have QE and are buying assets in the real market. The difference is interest rates. The US is raising interest rates which is creating demand. Europe is not raising rates and therefore there is no impetus or motivation for people to spend. Jobs are getting more plentiful in the US. People can get raises, get better jobs, move, and spend money. Spending leads to more jobs with healthier pay which leads to people moving for better jobs which creates jobs and more spending. You get the picture.

QE is the kindling. Interest rates are the match. Europe just keeps pouring more gas on the fire without lighting the match. It took the US several tries before the market and economy gained confidence and believed that the Fed would continue to raise interest rates. Trump’s fiscal and tax polices helped give the Fed cover and made its story more believable. Europe needs the same. Light the match. Having said this, the fire will only burn so long. What comes next? Commodity prices will rise along with inflation here in the US. The Fed will try to continue to raise rates but the question remains will they end up behind the curve while feeding inflation? We think they will.

Markets are pricing in a goldilocks scenario that is ever elusive and fleeting. Change is the only constant. The market can continue to chug along to higher prices but that will become more difficult as we head into 2019 with less fiscal/tax stimulus and more QT around the world. 

We have been expecting and investing for a 9-18 month period of consolidation after which we should see a rise in volatility as the market breaks out of its consolidation range. Our thesis about the market consolidating its gains around the 2666 level on the S&P 500 for 9- 18 months continues to hold. At the end of June we will have seen month 7. Midterm election years in the United States have a poor record performance wise over history. We would expect more of the same in 2018. In fact, more specifically, July in midterm years has a particularly poor track record. That will have our focus as liquidity remains very light in the summer months and markets could be prone to shocks.

We continue to invest for low and rising inflation and anticipate stocks will continue to struggle within their current range. We have low duration with our bond portfolio and continue to add commodities to our asset allocation. Another focus is our cash and, for the first time in a decade, generating returns there. We continue to be the contingency planner. We are not predicting the direction of the market but developing scenarios and having a plan no matter the outcome. It’s not sexy. It’s Investing 101. Do the basics right and the rest will take care of itself.

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 

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Disclosure: According to SEC Custody Rule 206(4)-(a)(2), Blackthorn urges you to compare statements/reports initiated by your Blackthorn with the Account Statement from the custodian of your account for data consistency. To that end, if you find any discrepancy between these reports and the statement(s) that you received from your account’s custodian, please contact your Advisor or custodian. Also, please notify your Advisor promptly if you do not receive a statement(s) from your custodian on at least a quarterly basis.

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

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

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NetFlix Partying Like it’s 1999

Trade wars and tariffs continue to grab the headlines as small and mid cap stocks in the United States outperform. The theory is that small and mid cap stocks will not suffer as much as their large caps brethren due to their lack of international sales. Lately, what has piqued our interest is the tremendous disparity between large cap tech (i.e. Netflix) and consumer staples (i.e. Kraft Heinz). Not advice folks, just examples. We are getting that 1999 feeling again. 1999 was when tech overtook all reasonable valuations and left good quality companies in the dust. We currently see Netflix valued at 275x earnings with no dividend versus Kraft Heinz at 7 x earnings and a 4.0% dividend. This is Not advice. We are just bringing attention to disparate valuations.

Our thesis about the market consolidating its gains around the 2666 level on the S&P 500 for 9- 18 months continues to hold. At the end of June we will have seen month 7. The World Cup has the eyes of Europe and Asia as the tournament tends to keep a lid on things and so will August beach vacations. Those would months 8 and 9.

We have been telling you to keep an eye on Bitcoin as an indicator of risk. It was another tough week for bitcoin as it fell 6% from where we last marked it to a current level of $6061 (Fri 4pm).We felt that the $6777 level was a key level of support. We would now look to the $4000 area as support. Let’s see if any continued selling has an effect on speculators in equities. We are not trading bitcoin nor have much interest in it beyond using it as a temperature gauge for risk sentiment and how that may apply to the stock and bond markets. Bitcoin will begin to interest us when it falls 90% from its high of $19,200.

The S&P closed the week at 2754 or smaller than 1% loss for the week. The S&P 500 has consolidated its run from the last few weeks and that is healthy. The 200 DMA is sitting right about 2666. Small and mid caps continue to lead but are a bit over bought and signaling that they may need to take a breather. Gold has broken below support levels and is a bit oversold and looking to bounce.

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 .

lighthouse

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.

Full Swing

One of the most positively anticipated earnings seasons in years is in full swing and most of the news has gone according to plan. As earnings seasons go this has been very good Corporate America. Here is the problem. Markets haven’t budged. That in essence shows how the market is a discount mechanism. Great earnings were widely expected and were priced in months ago. Inflation is the new worry and the statistics that we get next week will most likely show inflation rising above the 2% goal of the Federal Reserve. Next week could signal more rate hikes on the way and a higher 10 Yr Treasury. That could prove negative for stocks.

It seems that we are not the only ones signaling caution as we are seeing that in the positioning of public investors/institutions and sentiment numbers. The key takeaway here is that as investors become more cautious in their positioning it makes it more likely that when we break out of our current range the upside will be exaggerated and the downside could be more limited. Conservative positioning will leave us all with more dry powder and buying power as a group. We are not saying which way it will break but we are trying to decipher which way to lean.

We continue to invest for inflation and anticipate stocks will continue to struggle with their current range. We have low duration with our bond portfolio and continue to add commodities to our asset allocation. The commodity sector is one of the best performing asset classes in 2018. Another focus is our cash and generating for the first time in a decade returns there. Not sexy. Just smart. The market continues to struggle and is stuck in the range between 2550-2700 on the S&P 500. The longer it stays in the range the better it is for the bulls and the harder the breakout will be when it comes. We see the market breaking to 2850 and new highs or a trapdoor opening with a swift move to 2400 or lower. The market still struggles with 2666 as we closed the week at 2669. We are stuck, for now, in a range between the 100 Day Moving Average (DMA) and the 200 DMA and that range is growing tighter each week. Something will have to give. Keep an eye on the door. When these ranges break things will change rapidly – but for now we wait.

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 .

lighthouse

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.

Back to the Future

It has been our central operating thesis since the Great Financial Crisis that low interest rates+ low volatility+ larger central bank balance sheets would = higher asset prices. We are now entering an environment where we are seeing higher interest rates+ higher volatility+ smaller central bank balance sheets. We surmise that will = lower asset prices. It’s just math.

The big news this week was probably Trump’s trade policies and tariffs on steel. On that subject we do not believe that those tariffs will see the light of day. He will lose when he goes to the WTO and will be forced to retract them but, then again, we think that his threatened imposition of tariffs is probably only a negotiation tactic. We had several discussions this week on tariffs with people we respect. They made several interesting points about trade and steel and tariffs. My contention is that none of that matters. Wall Street and investors see tariffs and they think trade war. They think trade war then they think about the Great Depression and Smoot Hawley with a shooting war to follow. When it comes to trade wars investors will shoot first and ask questions later. A trade war = lower asset prices.

This week we saw the new Fed Chair go in front of Congress and act hawkish on inflation. Markets reacted negatively. The very next day he seemed to walk back his earlier comments. This is precisely why, as investors, that we need to prepare for inflation. No one wants to fight it. It is not politically acceptable until it is too late. No Fed chair will have the political will to fight inflation until it is raging and it begins to hurt Main Street. The biggest beneficiaries of inflation are the largest debt holders. Who are the largest debt holders? Governments. They need to inflate away their debt. They want inflation because it allows the very existence of bigger government. The political will to fight inflation will not be there until it hurts and hurts Main Street badly.

CONFIDENCE ON INFLATION GETTING STRONGER” – “Hawkish” Fed Chair Powell

NO STRONG EVIDENCE OF DECISIVE MOVE UP IN WAGES, MORE LABOR MARKET GAINS CAN OCCUR WITHOUT CAUSING INFLATION” – “Dovish “ Powell

By far, the most interesting part of the week for us was an interview from Goldman Sachs of Paul Tudor Jones, a legendary hedge fund manager who called the 1987 crash. He has run a Global Macro hedge fund for over 30 years investing in stocks, currencies and commodities. Check out the whole interview if you can. Here are some of the highlights (emphasis ours.)

Interview with Paul Tudor Jones

Allison Nathan: Is the market underestimating commodity-related inflation today? 

Paul Tudor Jones: Absolutely. The S&P GSCI index is up more than 65% from its trough two years ago. In fact, relative to financial assets, the GSCI is at one of its lowest points in history. That has historically been resolved by commodities putting on a stunner of a show, stoking inflation. I wouldn’t be surprised if that happened again.

 Allison Nathan: Does all of this just boil down to the Fed being behind the curve?

Paul Tudor Jones: … The mood is euphoricBut it is unsustainable and comes with costs such as bubbles in stocks and credit. Navigating these bubbles will be one of the most difficult jobs any Fed chair has ever faced.

 Allison Nathan: In this context, what do you want to own?

Paul Tudor Jones:  I want to own commodities, hard assets, and cash. When would I want to buy stocks? When the deficit is 2%, not 5%, and when real short-term rates are 100bp, not negative. With rates so low, you can’t trust asset prices today.

 Allison Nathan: You are well-known for calling Black Monday. Is the recent surge in volatility behind us?

Paul Tudor Jones: In my view, higher volatility is inevitable. Volatility collapsed after the crisis because of central bank manipulation. That game’s over. With inflation pressures now building, we will look back on this low-volatility period as a five standard- deviation event that won’t be repeated.

If you are a regular reader you know that one of our biggest concerns is rising bond yields. By way of our friend, Arthur Cashin, comes some insight on those rising bond yields. Barry Habib is quoted from time to time in Arthur’s Daily Letter and his track record is nothing short of amazing.

 We are going to see 3.04% on the 10-year within the next couple of weeks. That will be the moment of truth. The level of 3.04% matches the top of the 30-year downtrend in yields, as well as the 0% retracement from the highs 4 years ago. In other words…it’s a big deal if this is convincingly broken to the upside, and strongly suggests that the 10-year will hit 3.80% before summer.

Interestingly, Paul Tudor Jones spoke of rising bond yields in his interview. His thought is that the 10 year goes to 3.75% by year end and that was a conservative target. We thought that the S&P 500 would make a run to the old highs but it seems that talk of trade wars has aborted that attempt. The struggle between the bulls and bears is a push right now. Either could take over. Markets are a bit oversold here which gives the edge to the bulls but the failure to trade to old highs and trade war talk tilts things in favor of the bears. So much to say in such a small space. We are looking forward to our quarterly letter where we will get more in depth in some of these issues.

From the Back to 1987 Department:

Gluskin Sheff’s David Rosenberg summed it all up nicely“Hmmm. Let’s see. Tariffs. Sharp bond selloff. Weak dollar policy. Massive twin deficits. New Fed Chairman. Cyclical inflationary pressures. Overvalued stock markets. Heightened volatility. Sounds eerily familiar (from someone who started his career on October 19th, 1987!).”

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.

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.

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

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com  or check out our LinkedIn page at https://www.linkedin.com/in/terencereilly/ .

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

Caution Flags

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

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

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

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

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

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

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

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

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

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

 

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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.

Fall Is In The Air

As much consternation was shown this week the S&P 500 was only down 1.4%. While markets have slowly marched ever skyward since 2015, lulling investors into complacency, market internals seem to be breaking down of late and just in time for the traditionally weak fall season. Our friends over at Lucena Research are at the forefront of applying Artificial Intelligence and Machine Learning to investment decision making. Their note to us on Monday researched some market internals as they dug up some dirt on the recent divergence of the S&P 500 and the Dow Jones Industrials. Their research came up with 39 instances of this type of divergence in the last 17 years. According to their research, over the next year the S&P 500’s average drawdown was 8.5% with the bottom of the expected bearish move coming within 7 months on average.  Here is the link to their note. Brilliant stuff.

http://lucenaresearch.com/wp-content/themes/lucena-theme/predictions/8-7-17.html

Also showing the internal weakness of the market is that the market has grown increasingly narrow in its ascent. An article from CNBC this week shows that 20% of the S&P 500 is in correction territory. A “correction” is generally accepted to be when a stock has retreated more than 10% from its high. 200 of the 500 stocks in the S&P 500 are in correction territory including Amazon, General Electric and Exxon. The S&P 500 is up over 9% in 2017. It shows how narrow the rally in stocks has become. The article goes on to note that less than 60% of the Russell 3000 is trading above its 200 day moving average (DMA). The 200 DMA is the dividing line between being long term bullish on a stock and long term bearish. The market’s strength is slipping.

Things are starting to get interesting. The market rejected 2475 on the S&P 500 as that area still holds as resistance. The bulls need to get back in gear. We closed the most eventful week in months in the middle of our range. We still see support at 2400. The likelihood of an actual shooting war in the Korean Peninsula is very low but we have never seen diplomacy by Twitter. The bulls need to hold 2400. As a side note we do find it refreshing that the market is actually taking geopolitics into account. The biggest contributor to the downside move this week may have been the short volatility trade. Shorting volatility has worked for years but we have been noting that it is a crowded trade and traders were due to get burned. Those traders looking for cover may have made an outsized contribution to the swings in the market this week. Might be time to take some chips off of the table if you haven’t already.

 

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.

Tops and Bottoms

 

More signs of top and bottoms. Andy Hall, legendary oil trader, otherwise known as “God” in the oil pits has finally thrown in the towel. According to Bloomberg, the long time oil bull was forced to liquidate his main hedge fund this week. The slump in oil has worn his investor’s patience thin as his main fund was down 30% in the first half of 2017. His latest letter stated that OPEC had lost control of the market and oil is stuck at $50 a barrel.

Tesla has had a similar effect on short sellers. According to S3 Partners Research short sellers have lost over $3.5 billion in the last 18 months trying to pick the top in Elon Musk’s Tesla. The massively overvalued stock has short sellers running for cover after its latest earnings release. A short squeeze has helped Tesla’s shares reach new heights. Short sellers are investors looking to profit from the fall of a security. They borrow stock and sell it hoping to see the stock fall in price when they can then buy it back at a lower level and profit from its fall. Tesla’s release of its latest earnings has short sellers competing with each other to cover their short and cut their losses.

Each of the above is noteworthy, in that, they show that moves have become extreme. The closing of funds show market bottoms. The closing of short positions show market tops. Keep an eye on oil and high valuation stocks.

We received word from different sources this week that cash allocations for investors are at historically low levels. The American Association of Individual Investors (AAII) reported in its latest survey that individuals are holding their lowest cash levels since 2000 and the end of the Internet Bubble. Bank of America reported in a survey of its High Net Worth clients that they too are at all time low levels of cash not seen since 2007. 2007 is another year that conjures up rather poor images for investors. We have high cash allocations in our clients’ accounts due to high valuation levels but from a statistical point of view we are stashing more of it into MM funds and short term bond funds as yields rise and cash savings rates come off of zero interest rates. This could be an indicator of a frothy market or just a statistical anomaly.

Based on Thursday night’s close the S&P 500 11 day closing range is the lowest in its 90 year history. 90 years! That’s a long time. Even with the news of North Korean missile launches and a Grand jury investigation of the sitting US President’s campaign the stock market has grown stagnant. The market has grown increasingly narrow in its ascent. The Dow Jones Industrials are up 2000 points so far in 2017. Over half of those gains have been provided by just 3 stocks – Bowing, McDonalds and Apple. While another Dow component, GE, is down 20% from its highs and entering its own bear market.

You may start to hear more about Dow Theory in the coming days. Dow Theory says that the Industrials and Transports need to move in concert. Transports are down 5% from their highs and trying to hold its 200 Day Moving Average while Industrials are hitting new all time highs. There is also a divergence between the Dow and the broader market as exemplified by the Russell 2000’s struggle to hold its 50 DMA while the Dow hits new highs. The signs of a top are showing but the trading algorithms will not let the market down. Algos flaw is that they promote virtuous and vicious cycles.  The higher the market goes the more algos buy. The more the market goes down the more they need to sell and the fewer bids there are.

Yet Two More Cautions – Jason Goepfert of SentimenTrader noted yet two more cautionary precedents. Wednesday marked the 7th straight daily gain for the Dow, and of course, a multi-year high. Remarkably, this is the 4th time in the past 200 days that the Dow has managed a streak like this, the most in its history. The last time it managed even three such streaks was in the summer of 1987, which led to a bit of trouble a couple of months later

8/3/17 Cashin’s Comments

Hat tip to Arthur Cashin for the above research from the very insightful Jason Goepfert. We couldn’t resist mentioning 1987 again. Sorry for the length of the blog this week. Things are starting to get interesting. We are dropping our oldest off at college this weekend. Wish us luck. Time flies. For now, the market refuses to break through resistance at 2475 on the S&P 500. We still see support at 2400. If they break through resistance then we are off to a new range of 2475-2550. The path of least resistance is higher for now but September/October loom.

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.

One Classic Mistake

 We were fortunate enough to find the time to read Howard Marks’ latest letter. As a refresher Howard Marks is the person that Warren Buffett once said that anything that Howard writes goes straight to the top of his reading list. While Marks’ letter is probably his longest in years it may also be one of his best. It is FULL of investing gems that should be made required reading at any graduate program. Here are some highlights but do yourself a favor and give it a read. The link is below. It is long but a very easy read and well worth the time. Marks opines that this time seems very similar to 2000 and 2007. It is hard to disagree.

Latest memo from Howard Marks: There They Go Again… Again

 Here’s how I summed up on this topic in “There They Go Again” (May 2005):

You want to take risk when others are fleeing from it, not when they’re competing with you to do so.

This combination of elements presents today’s investors with a highly challenging environment. The result is a world in which assets have appreciated significantly, risk aversion is low, and propositions are accepted that would be questioned if investors were more wary.

 Not a nonsensical bubble – just high and therefore risky.

 The usual consequences of the conditions I describe – like an eventual increase in risk aversion – should happen, but they don’t have to happen.

And they certainly don’t have to happen soon.

I’m never sure of my market observations.

As a natural worrier, I tend to be early with warnings

the easy money in this cycle has been made

 Oaktree will continue to follow its 2012 mantra: “move forward, but with caution” – and, given today’s conditions, with even more caution than in the recent past.  If one is going to invest at times like this, investment professionalism – knowing how to bear risk intelligently, striving for return while keeping an eagle-eye on the potential adverse consequences – is the absolute sine qua non.

But there is one course of action – one classic mistake – that I most strongly feel is wrong: reaching for return.

 The basic proposition is simple: Investors make the most and the safest money when they do things other people don’t want to do. 

 By way of Arthur Cashin comes research from Keene Little of Option Investor. Little emphasizes that while earnings for US companies have increased 265% since 2009, which is in line with the 271% spike in the S&P 500, sales for those companies have increased only 32%!!! How is that possible? Corporate buybacks. Buybacks reduce the number of shares outstanding which pumps up Earnings Per Share (and corporate executives pockets). Our blog last week pointed out one of the unintended consequences of QE and too low interest rates has been the fear of investing in plant and equipment. Why build the factory when the economy is in the doldrums and interest rates are going nowhere? There was no impetus to take a chance and build. Corporations were incentivized to borrow at all time low rates and take the low risk approach of buying back their own stock. Little goes on to ask who will do the buying when corporations stop?

Here is a quote from our blog last week.

The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. 

Dr. Ben Hunt Epsilon Theory

There were more research notes out this week from some of the quants on Wall Street and the subject is, again, volatility. This is a crowded trade. It feels as though this trade is building and building. This trade has the potential to crush markets as it will feed a vicious spiral. If volatility were to increase quickly then funds will be forced to sell and de-lever. That selling and deleveraging will force more into the market to be sellers as buyers step aside. It was compared to portfolio insurance this week by Marko Kolanovic at JP Morgan. Just a reminder, it was portfolio insurance that was blamed for the 1987 stock market crash that took the market down 20% in one day. 1987. There is that year again.

We are in the midst of our first extended period since the financial crisis began that the market is rallying while the Fed’s balance sheet is holding steady. You can see in the chart below courtesy of BAC that in the 2014-16 period the market treaded water while the Fed’s balance sheet did the same. Now the market is leaving the central bank balance sheet in the dust. Right when the Fed’s are talking about decreasing the balance sheet.

September looms large as the tapering of the Fed’s balance sheet looks to be still on schedule to start after the FOMC meeting on September 20th. The next ECB meeting is September 7th with the Bank of Japan stepping to the plate on September 21st. Shale companies like Anadarko are slashing CAPEX. The growth in rigs seems to have stabilized. Could that be an oil bottom? West Texas Crude up 8.5% for the week to close just below $50 a barrel. Biggest week of 2017.

The debt ceiling is scheduled to be hit in mid October. For now we see support at 2400 on the S&P 500 with 2475 providing resistance. If they break through resistance then we are off to a new range of 2475-2550. The path of least resistance is higher for now but September/October loom.

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.

Anyone Have a Match?

The debt ceiling is coming! The debt ceiling is coming! Not quite Paul Revere but the Treasury market is showing signs that investors are getting concerned about the debt ceiling being reached in mid October as the CBO has warned. If Republicans can’t get a bill through that they have been working on for seven years how will they get the debt ceiling passed through the most polarized congress in history? Months ago we were looking at sweeping changes with the Republicans controlling both houses. Now, instead of tax reform, we are looking at a government shutdown. For once, gridlock in DC may not be so good.

We have been postulating for years that the reason that the economy is not doing well is that interest rates are too low and that there was no threat that interest rates would go higher. Think about it. There has been no incentive to borrow and buy a car, a home or invest in plant and factory. We can “put it off until next year” because we aren’t sure about the economy and rates aren’t going anywhere. We came across this blog post from Epsilon Theory and Dr. Ben Hunt. It is not the common thinking but that is usually where the answer lies.

The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback?

(As the Fed slowly raises rates) It will force companies to take on more risk. It will force companies to invest more in plant and equipment and technology. It will force companies to pay up for the skilled workers they need.

In exactly the same way that QE was deflationary in practice when it was inflationary in theory, so will the end of QE be inflationary in practice when it is deflationary in theory.

My view: as the tide of QE goes out, the tide of inflation comes in. And the more that the QE tide recedes, the more inflation comes in.

Dr. Ben Hunt Epsilon Theory 

I agree with Dr Hunt that at some point central bankers may be asking – Why is inflation accelerating as we raise rates? How come we cannot contain inflation? In talking to business leaders over the last several years we have not seen many talking up their industry as “hitting on all cylinders”. Last month we spent some time with a leader in the medical device field which he says is booming. Industry players are borrowing for plant and equipment for the first time in years. Combine some tax reform with higher rates and BINGO! That joint is jumping. Central bankers have been pouring gasoline on the pyre for years with no effect. Pushing on a string. Higher rates may be the match and with too much gasoline on the fire inflation may be the result.

Markets have been quiet. A little too quiet. We have read story after story about the volatility trade and how volatility has to spike higher to flaunt this overcrowded trade. We agree but this year has been very quiet. How quiet? This year has seen its largest drawdown of only 2.8% on the S&P 500. That is a far cry from the 14% average. According to LPL, the S&P 500 has not had a drawdown of 5% or more in a calendar year only 5 times in the last 60 years and it has not happened in 30 years. NASDAQ was up 11 straight days until Friday. According to LPL’s Ryan Detrick this has happened 21 times since 1980. The next month on average for the NASDAQ is up 2.6% with 16 of those 21 being positive months.

The tapering of the Fed’s balance sheet looks to be still on schedule to start in September. The debt ceiling is scheduled to be hit in mid October. Short interest is back down to levels last seen in the second quarter of 2007 at the market peak. Equities are at the top of their new range on the S&P 500. For now we see support at 2400 on the S&P 500 with 2475 providing resistance. If they break through resistance then we are off to a new range of 2475-2550. The path of least resistance is higher for now but September looms large. The animal spirits are still in charge as long as the flow of the Fed’s balance sheet is neutral to positive.

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.