Red Flag Warning

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

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

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

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

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

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

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

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

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

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

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

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

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

Advertisements

Caution Flags

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

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

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

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

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

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

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

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

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

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

 

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

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

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

 

 

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

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.

The Great Escape

It is a 10 year anniversary for us this week. This week marks 10 years since our move to Georgia. It also marks the 10th anniversary of the dawn of the financial crisis. Not a coincidence I assure you. Having traded through the Internet Bubble and watched Lucent Technologies, which was that bubbles’ “Darling” stock, trade from $79 to 79 cents we knew the real estate market would have also have to get as bad as it was good. And in 2006 -07 it was very good. We foresaw the real estate crisis and sold our house in New Jersey for an exorbitant price which according to Zillow it still has not climbed back to. As a side note, Lucent never got back to $79 either. We say this not to brag but as an investment lesson learned well. Trees do not grow to the sky. Know when to cut back on your risk.

Not much is being made of the 10th Anniversary of the Great Financial Crisis (GFC) but there has been a lot of consternation surrounding the Federal Reserve’s most recent decision and path going forward. If we have established that the growth in central bank balance sheets around the world has been responsible for the run up in asset prices it stands to reason that any shrinking of those balance sheets would diminish asset prices. Here is another timeless lesson of investing. Never fight the Fed. While the Fed has spent the last 10 years injecting liquidity into the system to pump up asset prices it is now talking about taking liquidity out – Quantitative Tightening (QT). Ironically, during our time on Wall Street the phrase QT was a questionable trade, an error that needed to be resolved and it usually cost you money. The question facing us now is the Federal Reserve making a questionable trade and will it cost you money?

The economy is growing, albeit slowing. That is due to the immense amount of debt on the United States balance sheet. This slow growth is now being met by a central bank that seeks to raise rates and shrink its own balance sheet. Now instead of a tailwind, the economy and markets are looking at a headwind. As we have written in prior posts, the Federal Reserve could have been acting since December with the impulse that more stimulative fiscal policy was going to come out of Washington, in the post election period. The new administration Trumpeted the advent of a new era with tax reform and deregulation at its forefront. The Fed sought to get ahead of the curve by applying tighter money policy. Well, Washington is at a standstill and has provided none of the above.

Is the Federal Reserve making the ultimate central banker mistake? Are they tightening into a slowdown? The bond market seems to think so. The yield curve is flattening which indicates that bond investors do not see inflation on the horizon and see subpar growth in the economy. Yet the stock market keeps chugging along. Who is right? Generally, we always go with the bond market.  We believe that the Fed is tightening due to financial conditions and not economic conditions. That is what the stock market is missing. As long as the market expects the Fed to stop tightening because of slowing economic conditions then the market will continue to rally and the Fed will continue raising rates. Someone is going to blink first.

We think that the animal spirits playbook is still alive. Markets have not broken down and still seem to be headed higher. Higher markets may force investors to chase it even higher.

The Federal Reserve’s thinking has two main problems. One is that the Fed believes in stock and not flow which means that the Fed believes a big balance sheet helps the market. We believe it is the flow that determines the direction of markets. Flow is the direction in which the Fed and policy are headed. The Fed also believes that the market will discount their talking points as they move towards QT. We believe that the market will change when the flow changes.

Oil continues to get pounded as it is down 20% from March highs even though things in the Middle East heat up. Oil may try to find a bottom here as oil production will slow below $40 a barrel, at least here in the US. Biotech has had a great week as investors rotate there as the pressure from Washington on that sector seems to have ebbed. Equities are still in the middle of what we anticipate to be the new range on the S&P 500. For now we see support at 2400 on the S&P 500 with 2475 providing resistance. Interest rates may have seen their interim low for awhile.

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

Cross Your Fingers

The parade of famous money managers coming out to proclaim that asset valuations are too high continues. This week’s contestants included Paul Singer of Elliott Management and Bill Gross from Janus funds. Speaking at the Bloomberg Invest summit in New York, Bill Gross proclaimed that in regard to US markets as an investor you are “buying high and crossing your fingers”. Bloomberg

Singer had the following to say:

“I don’t think that the fixes that have been put into place have actually created a sound financial system. I don’t believe that confidence is justified in policy makers and central bankers.”

If and when confidence is lost, it could be lost in a very abrupt fashion causing conceivably a ruckus in bond markets, stock markets and in financial institutions.” – Paul Singer

While we agree with the parade of money managers that markets are overvalued, overly complacent and apathetic to growing risks, until markets recognize those risks, assets prices will continue to rise. Here is our next level of thinking on the subject. Singer has just raised $5 billion in ready cash and he is anxious to deploy it. He, like other underinvested money managers, needs lower prices. We think that the animal spirits playbook is still alive. Markets have not broken down and still seem to be headed higher. Higher markets may force investors to chase it even higher.

While there was plenty of potential for fireworks as we came into the week it went out with a real thud. Most eyes were on Thursday and the Comey congressional testimony but it was Friday that provided the only action of the week. In a week that saw the world’s largest natural gas supplier, Qatar, being cut off from supplies and creating food shortages in one of the richest nations on earth, markets didn’t even blink. While the much hyped James Comey testimony and a hung parliament in the United Kingdom election didn’t move markets it was a reevaluation of tech stock prices on Friday that gave the week any life at all. The fireworks were provided by Face book, Amazon and Apple. The street has been making noise that the high flying tech stocks needed a breather and they got that breather on Friday. The key is will we see a real rotation out of tech and growth and into value stocks and the 2017 YTD laggards. We will see next week if that is what we have in store for the summer of 2017.

Equities are still in the middle of what we anticipate to be the new range on the S&P 500. For now we see support at 2400 on the S&P 500 with 2475 providing resistance. Interest rates may have seen their interim low for awhile. Financials and energy were the standout performers on Friday with small and mid cap stocks getting a day in the sun. Small and mid cap stocks have lagged so far in 2017.Perhaps they have further to run if this rotation continues.

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.

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.