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.

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The Drive Higher

The big story this week was that the Federal Open Market Committee’s (FOMC) minutes were released from its last meeting. In those minutes it becomes clear that the FOMC is looking to reduce its balance sheet. Long time readers know that we feel that it was the increase in that balance sheet that helped greatly influence the stock market rally and raise prices of virtually all asset classes in the post crisis period. Any reduction in that balance sheet would logically have the opposite effect at some point. If the FOMC were to roll off its balance sheet the valuations of equity markets, driven higher due to easy money policies, may not be able to maintain their currently elevated plateau. Earnings alone will not be able to expand market multiples.

The bottom line is that the Fed needs more weapons to fight the next recession. The Fed must reduce its balance sheet before they raise rates further. If they begin to roll off the balance sheet it becomes another weapon for them to use because they can stop and start the process or move it faster or slower. If they remain static it is a liability and not an asset.

We have been pointing towards a looming crisis in the municipal finance area. The latest on our radar is the state of Connecticut. Connecticut’s largest moneymakers have been leaving town and sticking the state with the bill. Big earners know tax law and are incentivized to leave the state for greener pastures of low tax states like Florida. Atlas is shrugging. Courtesy of zero hedge comes the following.

The latest figures showed that tax revenue from the state’s top 100 highest-paying taxpayers declined 45% from 2015 to 2016. The drop adds up to a $200 million revenue loss for Connecticut. Connecticut Tax Cut

Oil had a rough week but it did manage to crawl back and close higher on Friday. It failed to close above the critical $50 a barrel on West Texas Crude (WTI). Equities are breaking out of the range that they has been trapped in for the last 3 months. The range of 2330-2400 on the S&P 500 was broken this week as the market closed on Friday at the 2415 level. This breakout could extend to 2475 if it gets legs. For now, volume is low and the few big leaders are influencing the advance. Summer markets are more prone to sharp moves as investors head to the beach. Our main thesis still holds that the market heads higher post Donald Trump’s victory with a move much akin to 1987.

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.

 

Crackdown, Smackdown and Fever

Two areas of asset pricing that we always keep an eye on in an attempt to decipher the market’s next move are US Treasuries and the oil patch. Let’s take a look at the current oil market and the commodity sector. Falling oil prices indicate lessening demand and therefore a lagging economy. In a nasty selloff oil is now down 11% in the last 3 weeks. There are rumors of major oil focused hedge funds liquidating or taking all risk off of their books as the price of oil swiftly moves lower. All of this while copper takes a tumble too. A falling oil price (and copper for that matter) does not bode well for the economy, high yield stocks or the stock market. When we talk weak commodities our thoughts immediately turn to China. The recent selloff in the commodity sector is being linked to a tightening of monetary conditions in China. A crackdown by the Chinese government is leading to higher interest rates and a tightening of the money supply in an effort to deleverage the economy. That, in turn, leads to lower commodity prices as China is one of the world’s largest consumers of commodities. A slowdown in China needs to be on our radar.

We have also been seeing a drift lower in hard data on the US economy. This data has been dragging since the failure of Trump & Co. to repeal Obama Care the first time in March. It seems that the market is waiting on some good to come out of Washington DC. We should never count on anything to come out of Washington DC.

The market is stuck in consolidation mode. In spite of recent data on a slowing economy we still expect the market to break out of its recent range to the upside and in favor of the bulls. More often than not when a market consolidates a major move it breaks out of that pattern the same way that it came into it. It’s all about momentum and the animal spirits of the market. That would mean we break out to the upside. There are lots of negatives about like weak US data, a Chinese slowdown and massive insider selling by US Corporate executives but the market refuses to break down. Many astute investors are warning about valuations in the market and are taking down risk.  They could be forced to chase the market higher adding fuel to the fire of animal spirits.

There is currently a massive speculative fervor in the crypto currencies like Bit Coin and Ethereum. A speculative fever has broken out and it is suspected that a lot of that money is coming out of China as capital controls are implemented and from Japan where a tax on investing in crypto currencies is going to be waived soon. Please approach with caution! This market is moving fast.

This may be a bit too inside baseball but the lack of volatility is important to watch. One of the most popular trades on the street over the last few years has been to sell volatility. Massive selling of volatility compresses the price of volatility, the numbers of players executing this strategy increases with the trade’s success and it brings in more and more investors to the trade. The word is that 95% of the float in VXX (Volatility ETN) is being used to short volatility. Ladies and gentlemen 30% would be large, but 95%!! The boat is listing to port as too many investors are in on this trade. This will explode violently in their faces. We don’t know when but it will. It always does. The risk parity trade and the selling of volatility combined with the reliance on passive investing ETF’s with High Frequency Trading market makers create a structural weakness in the market and will at some point create an opportunity for those with cash when the time comes. Forewarned is forearmed.

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.

WW III

We felt in recent months that there were too many people on the one side of the boat. That “side of the boat” was investors heavily shorting US Treasuries are they prepared for the Federal Reserve to raise rates three times this year. When everyone thinks something will happen you can almost guarantee that something else will. The 10 year closed Thursday at 2.23%. While a lot of because of geopolitical concerns and the long weekend we still think investors are too short Treasuries. This could be the last move lower in Treasuries as the short sellers’ force yields lower to cover their shorts and stop their pain. For now, we are still long duration but looking to sell into strength.

The last 30 minutes of trading have been abysmal. Four out of the last 5 trading sessions markets have moved lower in the last 30 minutes. We postulated in recent posts that the last 30 minutes are the “tell” in the market right now. Thursday was exacerbated by geopolitics and the long weekend so next week will help make that clue a bit more solid. Keep an eye on the last 30 minutes as that may be our best clue as to the near term direction of the market.

Strange week. Congress went out on Easter recess and so investors and the media began to focus (perhaps obsess) on geopolitics. The beneficiaries were the usual suspects of bonds and precious metals. Let’s see how things play out early next week if WW III doesn’t manage to break out this weekend.

Another week and another famous hedge fund manager is giving money back to clients. We take this as a sign that we could be at or near an inflection point. Jeff Ubben is a highly respected hedge fund manager and is giving 10% of his fund back to clients. He is finding it difficult to find value in this market. Valuations are stretched.

Active vs. Passive management has not been much of a fight over the last decade but we think that there are signs that perhaps we should be tilting more in the direction of adding some more active management. One of the headlines in Barron’s this weekend is “Can Humans Still Beat the Market”. This week Pennsylvania’s elected treasurer announced he is moving $1B from active to passive management to save $5M in fees. Treasurer Moving to Passive Investments

We know the argument all too well. Active is less predictable. It is more costly. It also pathetically tax inefficient. We think that investors have become too blind buying the whole market and there is room for active. The pendulum will swing back. We are diving back into researching for the active players who will outperform.

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.

Back to the Future – 1987 and Trump

The Trump Rally continues as we expected. Given our thesis in our January Letter the possibility of a policy error by the Federal Reserve and/or the Trump Administration looks to be increasing. We believe that a policy error could set the stage for a substantial rally and then fall ala 1987. 1987 should not be looked at in fear but in anticipation of an opportunity. The table looks like it is getting set. Combine the clamor and excitement over deregulation and tax reform with a slow moving Fed and you have room for the Animal Spirits to run as investor euphoria takes hold. A 30% run from the lows before Election Day would put us squarely in Bubble territory as the S&P 500 would approach the 2750 area. A subsequent 30% retreat would bring us back to the 2000 area. Currently at 2367 on the S&P 500 one can see the potential for misstep by exiting one’s holdings completely and trying to time reentry. One solution is to dial back risk as you see markets rising and adding when the risk premium is more in your favor. Always make sure that you have the ability to buy when discounts come.

United States 10 year yields peaked at 2.6% in mid December and have been steadily falling back to the 2.3% level. We still think that the lows are in for the 10 year but the steady drip lower in yields has us concerned. The bond market is the much wiser brother of the stock market. The actions in the bond market have us thinking that investors see risk on the horizon. 2 year bond yields in Germany have reached new lows of negative (0.90%). NEGATIVE!! You buy the bonds and pay the government!

The Fed is struggling to make the March meeting look Live. The Fed has proposed that they will raise rates three times in 2017 and that just might not be possible if they do not raise rates in March. We believe March is the first key to understanding where equity markets are headed. If the Federal Reserve drags their feet and does not raise rates at the March meeting equity markets could overheat. Fed officials will then be forced to overreact at later policy meetings as they get behind the curve. The time is ripe for a policy error and markets could react swiftly.

From our good friend and mentor Arthur Cashin’s Comments February 23, 2017.

Is The Past Prologue? Maybe We Should Hope Not – The ever vigilant Jason Goepfert at SentimenTrader combed his prodigious files to see how many times the Dow closed at record highs for nine straight days. Here’s what he discovered: The Dow climbed to its 9th straight record. Going back to 1897, the index has accomplished such a feat only 5 other times. The momentum persisted in the months ahead every time, with impressive returns. But when it ended, it led to 2 crashes, 1 bear market and 1 stretch of choppiness. The five instances were 1927; 1929; 1955; 1964 and 1987. Here’s how Jason summed up his review: Like many instances of massive momentum, however, when it stopped, it stopped hard. Two of them led up to the crash in 1929, one to the crash in 1987, one to the extended bear markets of the 1960- 1970s and the other a period of extended choppy price action. So a little something for everyone there.

Momentum is towards higher prices. Stocks are extremely overbought. The S&P 500 has not seen a close of up or down more than 1% in over 50 sessions. Complacency is high. Machines seem to be running the market. Right now we are wary of market structure and overreliance on ETF’s. Know what you own. Keep an eye on bonds both here and in Europe. Europe is bubbling again. What if Germany left the euro? Discuss.

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.

Trump Train or Bulldozer?

All eyes are on Trump and Washington DC as the Trump Train rolls through our capital. Trump has been even more aggressive in using Executive Orders and in speaking to foreign leaders than most suspected and that has the Street on edge. Maybe we need to rename the Trump Train to the Trump Bulldozer. While most eyes are on Trump we are increasingly focused on the Fed. The Fed must attempt to act in concert with the President and his fiscal policy to avoid overheating or stalling the economy but good luck to them anticipating his next move. The Fed has made noise in recent weeks that perhaps it could shrink the size of its portfolio. The Fed has been consistent, in that, there was an inherent belief at the Eccles Building that the Fed did not need to shrink its balance sheet and that doing so would be the last maneuver in its process of normalizing rates. Ben Bernanke, former Fed Chairman, took the time out to explain in his blog why that is simply not a good idea. Could it be that politics are playing a role at the Fed?

…best approach is to allow a passive runoff of maturing assets, without attempting to vary the pace of rundown for policy purposes. However, even with such a cautious approach, the effects of initiating a reduction in the Fed’s balance sheet are uncertain. Accordingly, it would be prudent not to initiate that process until the short-term interest rate is safely away from the effective lower bound. 

…the FOMC may still ultimately agree that the optimal balance sheet need not be radically smaller than its current level. If so, then the process of shrinking the balance sheet need not be rapid or urgently begun.  Ben Bernanke

 Why is the Fed now talking about shrinking its balance sheet and not raising rates? We would like to see more consistency from the Fed. They have insinuated that three rates hikes are due this year. After taking a pass on raising rates this week and not setting the table for one in March the market is now pricing in just two rate hikes. The first rate hike is due in June and the second in December. If you have not read our Quarterly Letter you can take a peak for a further discussion on the topic. The short version is, if the Fed raises rates too slowly Trump’s policies may overheat the stock market which is at already historical valuations.

 If Fed Speak can’t jawbone a March rate hike back onto the table, policymakers will have precious little room for error to make good on their promised three rate increases for the remainder of the year. Danielle DiMartino Booth

February is the worst performing month in the October – May period but investors are heavily loaded up on equities regardless.  By way of Arthur Cashin , here are the widely followed Jason Goepfert’s notes on the market’s latest gyrations or lack thereof.

 After spurting to a new all-time high in late January, the S&P 500 has had a daily change of less than 0.1% for five of the six sessions since then. That’s almost unprecedented, but there have been times when it has contracted into an extremely tight range after a breakout. Several of those have occurred in just the past few years, and all of them preceded a tough slog for stocks over the medium-term. Hedge funds are betting that the rally continues. Exposure to stocks among macro hedge funds is estimated to be the highest since July 2015 and the 4th-highest in the past decade. The three other times it got this high, stocks struggled as the funds reduced exposure and eventually went short.

Stocks have stalled. Investors are heavily exposed to equities. February is not the best month for equities so investors aren’t expecting much. The market has a way of surprising you. Could the market finally be ready to make a move? Investors seem to be heavily tilted to the rally side of the boat.

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.

When Everyone Agrees

Here is a short blog today as we are currently writing our end of the year letter and formulating our investment thesis for 2017. Bob Farrell was an absolute legend during his 5 decades on Wall Street and finished his career on the Street as the Chief Strategist at Merrill Lynch. Farrell encapsulated his 45 years of experience in his widely distributed 10 Rules for Investing.  As our thoughts turn to what is going to happen in 2017 we find ourselves turning to his sage like wisdom. While they are all of equal importance we find ourselves drawn to #9 as 2017 dawns.

  1. Markets tend to return to the mean over time.
  2. Excesses in one direction will lead to an opposite excess in the other direction.
  3. There are no new eras — excesses are never permanent.
  4. Exponential rising and falling markets usually go further than you think.
  5. The public buys the most at the top and the least at the bottom.
  6. Fear and greed are stronger than long-term resolve.
  7. Markets are strongest when they are broad and weakest when they narrow.
  8. Bear markets have three stages.
  9. When all the experts and forecasts agree, something else is going to happen.
  10. Bull markets are more fun than bear markets.

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

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.

 

Buckle Up

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

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

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

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

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

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

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

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

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

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

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

Controlled Burn

I believe risk is most when we feel it least and the risk is least when we feel it most. -Steve Blumenthal CMG

I read Steve Blumenthal’s weekly blog On My Radar every week. I don’t always agree with Steve but he always makes me think. His take on risk really struck a chord with me. I read it over several times. When the wine if flowing and markets are rising we don’t notice that risk is rising. Market moves lower create sheer panic. That gets our attention. It is then that risk is lower. Tops may or may not be forming but the signs are there. Investor complacency. Mega deals. High valuations. Be on guard.

http://www.cmgwealth.com/ri/radar-youve-got-remember-two-things/

Oil has taken a beating over the last week. The negotiations between the OPEC nations have seen more posturing and negotiating and that has oil backing away from $50 a barrel. We think that they are closer to the end of the negotiations than the beginning. Things for the Saudi’s at home are running a little tight and they need higher oil prices. The Saudi’s are looking for cooperation and we think they will make a deal. Right now oil is in a bit of a panic selloff and may seek to retest the lows. Goldman Sachs has piled on by calling for lower oil prices. Doing the opposite of what Goldman says publicly has been a great strategy for years.

http://www.zerohedge.com/news/2016-11-01/goldman-warns-oil-headed-low-40-declining-probability-opec-deal

Arthur Cashin pointed out on Friday morning that the market is on an extended losing streak and it has been picking up steam since breaking through the 2130 level we warned about.

The negative close made it eight down sessions in a row something the S&P hasn’t done since October of 2008 in the days following the Lehman collapse. The severity of the selling was far sharper in 2008. That eight session sell off dinged the S&P for 23% while this move has only sliced 3% from the S&P. 11/4/2016

Friday’s close made it 9 down sessions in a row. That makes for the longest losing streak in 36 years. The market is down only 4.9% from its all time high so this is acting as a very controlled burn. A Trump win could make for more downside but another 5% would be a very healthy 10% correction which we haven’t seen in a while. The big question is will the Federal Reserve still raise rates if Trump wins? That could help propel the selloff. We have our doubts that the Fed will have the stomach for it. If they do we could see cheaper prices. We have had heavy cash positions for some time. One year returns have gone negative on the S&P. Valuations have been high and that justified our cash position. History tells us that markets have struggled to rise from these valuation levels. The market has been stuck in a rut. We would love to see cheaper prices.

Market closed at 2085 which is just above our support level of 2080. Even a blind squirrel finds a nut from time to time. A break of 2080 brings 2040 into play but markets are very oversold and looking for a bounce. 2080 is support for now. We would not be surprised if we do not have a winner on Tuesday night. Gore v Bush. Hold all tickets!

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.

 

 

 

 

 

Published in: on November 5, 2016 at 8:20 am  Leave a Comment  
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Roller Coaster Markets

Be fearful when others are greedy and greedy when others are fearful. – Warren Buffett

Well, that was some beginning to 2016! We knew that volatility was coming our way but we did not foresee what happened in Q1. The Dow Jones managed to complete a round trip ticket as we fell 13% and subsequently rose back up 13% in one quarter. That is the biggest intra quarter comeback since the middle of the Great Depression in 1933. Our portfolio strategy coming into 2016 was to tactically manage our asset allocations given that we expected higher volatility and lower returns. Although we didn’t see a round trip in the offing for Q1 of 2016 our strategy worked out quite well. We believe that the rest of 2016 has much the same in store as the market reacts to every nuance emanating from the Eccles Building in Washington DC which is the home of the Federal Reserve Bank of the United States.

We believe that risks are rising after our second 12% rally in months. We have elevated valuations and falling earnings estimates for US companies. It is going to be difficult for the stock market to move higher from here but we cannot bet against continued central bank largesse. The stock market, having rallied 13% off of its recent lows in early February reminds us of a blog post from back in October of 2015. This is what we had to say back in October.

October 2015 will go down as the best performing month for the S&P 500 in four years.  I think that we all enjoyed the ride back up in October. The S&P 500 rallied 8.3% and followed through with more gains today to get the S&P 500 into the plus column for 2015. Those gains would be nice gains for an entire year – never mind a month! Whenever we get to thinking how much we have gained we cannot help but to contemplate the downside. We must always be on guard to temper our greed/ego just as much as we would concentrate on opportunity when fear strikes.

As a reminder, the volatility continued then as well. The S&P 500 closed October of 2015 at 2080. It would be 10% lower by January of 2016.

The key to making money in your portfolio lies in Investor Psychology. Understanding investor psychology and our own personal relationship with money is the key to successful investing.  Having just ridden the roller coaster of emotions that was Q1 we are in a good position to replay how the highs and lows of the market made us feel and how we reacted to it. The two following charts can help you be more successful in understanding how emotions play a role in your investing process.  The first shows two 12% rallies in the last 7 months. The second is a chart of investor psychology. After our second 12% rally in 7 months we should revisit how that roller coaster made us feel. Were you despondent at the lows? Did it make you want to sell and get out or buy more? Are you now relieved? Optimistic? Are you aching to buy more as prices rise?

dow chart 2 12pct rallies 2016

 

psy-cycle

 

In order to be on the right side of the market it is important to sell risk when prices are rising and buy risk when prices are falling. Or in emotional terms, when prices are falling and you are scared ask yourself “What should I be buying”? When prices are rising, ask, what are we selling? Understanding and keeping your emotions in check is the key to making money in markets like these. Ride the roller coaster.

 Valuations

For long time readers and clients you know that one of our favorite metrics of stock market valuation is the US Stock Market Capitalization to GDP. It also happens to be Warren Buffett’s favorite metric in case you wonder why we follow it as well. As you can see from the following chart courtesy of Ned Davis Research the last time that the Stock Market Capitalization as a percentage of GDP was in an undervalued position was in July of 1982.

Ned Davis March 2016 Mkt Cap GDP

What changed since the early ’80’s? Central banks gained enormous influence over markets when President Richard Nixon took the United States off of the Gold Standard. This allowed central banks to help manage booms and busts in the economy without being hamstrung by the amount of gold in Fort Knox. Theoretically, they now had an unlimited supply of gold with printed fiat money taking the place of gold. This was the dawn of the Golden Age of Central Banking. The Prime Interest rate from the Federal Reserve reached its high of 21.5% in June of 1982. We have had a steady trend of lower interest rates for the last 30+ years.

Since 1995 (with the exception of February 2009) we have been in the overvalued area of the chart. This chart is evidence of the inexorable influence of central banks on asset prices. Some questions remain. Are we in a permanent state of overvaluation due to the influence of central bankers? If that state of overvaluation is not permanent at what point does central bank influence wane and valuations retreat to historical levels. Also, if central bankers remain in control of markets how low will central bankers allow markets to descend? Given our current inflated valuations we know that based on history we can expect lower returns over the next 10 year time frame.

Another natural question is posed if we feel that returns are to be muted or that prices should retreat. Why not sell out of all our assets and wait things out in cash? I think that the chart also answers that question. We have been in a perpetual state of overvaluation since 1995 – over twenty years!  In order to meet our investing goals we cannot afford to sit out markets until they become more rationally priced. There is also the distinct possibility that markets become even more overpriced. If inflation were to take hold here in the United States investors would want tangible assets that rise in value with inflation. Equity prices could become wildly overpriced.  John Maynard Keynes, the legendary economist once said, “markets can stay irrational longer than one can remain insolvent” betting against them.

We know that it has been a goal of central banks since the dawn of the crisis in 2008 to raise asset prices and therefore raise confidence in the economy but they are now distorting price discovery with monetary policy. This extreme action taken by central banks takes away some of our normal techniques for evaluating markets as markets are warped by policy.

Less Gas in the Tank

Unfortunately, the Federal Reserve has recently discovered with its latest interest rate hike that they are now the WORLD’s central bank and its moves have outsized effects on the rest of the world.  Central banks can pull future returns forward and stall for time so that legislators can enact fiscal policy with which to mend an ailing economy. However, due to reluctance or ineptitude legislators have done nothing and left central banks, and in particular, the US Federal Reserve as the only game in town. If the Federal Reserve raises rates it then weakens other currencies and encourages capital flight. Capital goes where it is treated best. Higher rates of interest in the US and a stronger US Dollar force money to quickly flood out of emerging nations and into the United States. Central banks are stalling for time and currency wars are de rigueur. We have entered a “Twilight Zone” of monetary policy with negative interest rates in Europe and Japan. Central bank officials are also faced with the fact that monetary policy is not immune to the effects of the Law of Diminishing Returns as we enter Year 8 of a bull market in stocks.

Most likely, as risk premiums increase, central banks will increasingly ease via more negative interest rates and more QE, and these moves will have a beneficial effect. However, I also believe that QE will be less and less effective because there is less “gas in the tank.” – Ray Dalio Bridgewater Associates  2/18/16

What’s Next?

And while QE will push asset prices somewhat higher, investors/savers will still want to save, lenders will still be cautious lenders, and cautious borrowers will remain cautious, so we will still have “pushing on a string.” As a result, Monetary Policy 3 will have to be directed at spenders more than at investors/savers. In other words, it will provide money to spenders and incentives for them to spend it.  Ray Dalio Bridgewater Associates

This latest rally saw investors chasing safe haven and dividend paying stocks like consumer staples and utilities. Investors are moving ahead but with caution. Other safe haven assets performed well in Q1 such as US Treasuries, Municipal bonds and Gold. We are also seeing investors maintain cash positions to levels not seen in years. We think that those are good signs. The fact that investors have sought and are seeking shelter will provide some cushion to any market tumble. Investors are preparing for another 2008 style crash. That, in essence, is why 2016 is NOT 2008.

Clients have been asking what metrics we are looking at as far as taking more equity risk. The 200 Day Moving Average (DMA) is the Maginot Line when it comes to seeing markets as bull markets or bear markets. Obviously, we would take more equity risk if we felt that we are in a bull market. Currently with the S&P 500 in a battle to take flight above its 200 DMA we are inclined to believe that we are still in a bear market and continue to hedge risk. If the bulls can get above and stay above the 200 DMA in the S&P 500 we would be more inclined to changing our mindset.

Oil’s bounce is alleviating pressure on borrowers and drillers but prices need to get back above $50 a barrel to really stop the pain. Currently, as we write West Texas Crude is below $40 a barrel. The selling of oil and oil related debt may be easing for now but the pain may only be delayed. High yield debt has seen money pour into that sector in the last month. Investors may be catching a falling knife there with more pain to come if oil cannot continue its recent rally.

We will continue to tactically change our asset allocation as the S&P 500 stays range bound between 1800-2100 and volatility continues its resurgence in 2016. We continue to hold bonds as it has been the most unloved of asset classes for the last several years as short sellers have been betting on rising interest rates and falling bond prices. In Q1 of 2016 bond returns have been in excess of 2% which is a very nice quarter for bonds. We see bonds as having value while the US 10 year yield is still north of 1.8% as we write while Japanese 10 year rates are less than zero. We feel that there is still adequate return to entice capital from around the world into US government bonds at 180 basis point spreads.

We cannot predict with 100% accuracy every move in the market but what we can do is try and profit by tactically allocating and hedging our portfolio in times of market stress to take advantage of market volatility. Investing is not a game of perfection but of managing the risk inside one’s portfolio. We do not jump in and jump out of the market wholesale. By divesting ourselves of overpriced assets and availing ourselves of opportunities when prices are low allows us to take advantage of the long term benefits that the math of compounding brings.

We still foresee 2016 as being a tactically driven year. We feel that changing our positions tactically with the ebb and flow of the market, decreasing the volatility of our portfolios by increasing positions in bonds and bond like instruments while also paying attention to companies that have pricing power like technology and health care will be the key to performance. Cash is also an important part of asset allocation because although it returns zero when risk premiums rise its value will be seen in its inherent call optionality and the opportunity set that it provides given lower asset prices.

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