The Risk to the Rally

The Risk to the Rally is the Rally itself. We came across a note from a research firm that we will not name. We highly respect the firm but the comment struck us like a thunderbolt. “Nothing can seemingly stop this market in 2018”. That is a very bold statement with 11 months to go in the year. A great start that has us running with the bulls but investors may be getting just a bit ahead of ourselves.

“With a 6.1 percent year to date gain and just three down days in the fifteen trading days of 2018, nothing can seemingly stop this market in 2018,” the firm’s analysts wrote Wednesday.

So far in 2018 we have rising bond yields, full employment, a Federal Reserve that is raising rates, trade friction, a falling US Dollar, tax reform and a runaway stock market. The punch line is that we might as well be talking about 1987. We wrote last year that the Trump Administration’s policies may give the FOMC the cover that they need to raise rates. The problem now is that Trump Administration policies could force the Fed to raise rates faster than they would like. A seemingly lower US Dollar policy, tax reform, trade wars and deregulation all could help foster that inflation the FOMC has been wishing for and force them to be more hawkish when it comes to monetary policy. At some point those rising yields will put pressure on risk assets.

“Obviously a weaker dollar is good for us as it relates to trade and opportunities,” Mnuchin told reporters in Davos. Mnuchin said recent declines in the value of the dollar against other currencies were “not a concern of ours at all.” – Steven Mnuchin US Treasury Secretary

From our good friends over at the Global Macro Monitor blog here is their thoughts on the latest developments out of Washington DC.

We have voiced our concern as we have noticed over the past few weeks the dollar weakening as interest rates are rising. A red flag.

Bad Timing 

The U.S. economy is humming at full capacity with inflation already on the cusp of moving higher. A weaker dollar is, effectively, a monetary easing and makes the Fed’s job that much harder at a time when financial conditions are incredibly loose.

The Administration also just announced the implementation of tariffs on solar panels and washing machines. LG Electronics has already announced they plan to raise prices on some of its models.  Retaliation by our trading partners seems likely.  Ergo inflationary pressures increase on the margin

The measured pace of the Federal Reserve is much like the measured pace of the Greenspan Fed in the mid 2000’s. The paradox then was that as the Fed kept raising rates at a measured pace the market kept roaring higher. Effectively, financial conditions got easier the more the Fed raised rates. That is the same paradox we have today. Financial conditions indicate easier conditions as the market heads higher with rising yields.

We feel that looser financial conditions are being exacerbated by the Fed’s frog in the pot. If the Fed continues to slowly boil the water asset prices will continue to trend higher, however, the downturn in markets, when it comes, will be worse. The Fed, at some point, should shock markets and raise rates 50 BP. Unfortunately, we do not feel that they will have the political will to hit markets with a 50 BP rate rise. That would certainly get markets attention. Otherwise, it may be up to inflation or possibly a trade war to get the market’s attention.

Howard Marks is out with his latest memo this week and it is well worth the read. He has a new book coming out in October that we are looking forward to reading on cycles. Here are some of the highlights of what he had to say on his Latest Thinking this week. Go on to read the entire memo. It is worth the time.

The bottom line of the above is that some people are excited about the fundamentals, and others are wary of asset prices.  Both positions have merit, but as is often the case, the hard part is figuring out which one to weight more heavily.

 Closer to the bullish end of the spectrum or the bearish end?  Or balancing the two equally?  My answer today, as readers know, is that I would favor the defensive or cautious part of the spectrum.  In my view, the macro uncertainties, high valuations and risky investor behavior rule out aggressiveness and render defensiveness more sensible.

For one thing, I’m convinced the easy money has been made…., isn’t it appropriate to take less risk in equities than one took six years ago?

Prospective returns are well below normal for virtually every asset class.  Thus I don’t see a reason to be aggressive.

At times when the economy does well, risk doesn’t rear its head, risk-takers prosper and the returns on low-risk alternatives are unattractive, investors tend to drop their prudence and conclude that high prices aren’t a problem in and of themselves.  This usually turns out to be a mistake, but it can take years. – Howard Marks

Now it seems that everywhere there is talk of melt up. We pointed to that possibility over a year ago. We tend to be early. Being early is a good thing. It allows for us to prepare. It is time to prepare. We are preparing for higher interest rates, higher than expected  inflation so that leads us to consider adding commodities and further shortening our duration in bonds while also cutting back on risk overall. The January Barometer tells us that with January up 7.5% in 2018 that should lead to a positive year. Great start but no time to rest. Keep in mind there may be some bumps along the way.

If you are not currently receiving our blog by email you can sign up for free at .

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  or check out our LinkedIn page at .


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.


Priceless Investing Advice

Being in the investment arena our job is mostly about gathering information. Reading. Lots and lots of reading. Corporate reports, sell side research, blogs, websites, financial journals, and the like. We have our favorite sources and investors.  If you have read our notes for any length of time you know that we read anything that we can get our hands on that Howard Marks has written. Mr. Marks’ latest note is out this week. Marks doesn’t write every week or even on a consistent basis but when he writes he has something to say and he envelopes everything he writes with priceless investing wisdom. If you are a serious investor you must read the whole piece. I am having trouble just boiling it down to a few well turned phrases or sound bites but here goes.

 As I explained on CNBC, there are two things I would never say when referring to the market: “get out” and “it’s time.”  I’m not that smart, and I’m never that sure. 

 “Investing is not black or white, in or out, risky or safe.”  The key word is “calibrate.”  The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive. 

 If it’s true, as I believe, that (a) the easy money in this cycle has been made, (b) the world is a risky place, and (c) securities are priced high, then people should probably be taking less risk today than they did three, five or seven years ago.  Not “out,” but “less risk” and “more caution.”

Marks mentions that he is not referring to this market as a “bubble”. He is probably right. There are no signs of euphoria (other than bit coin) but investors are begrudgingly going along with higher prices. It is more of a FOMO (Fear of Missing Out) mentality. Valuations are high and rising and “getting out” at the top is a pipe dream. Rather than jump in and jump out of the market we seek to re-calibrate our investment allocation in regards to the risk premium in the market. If prices are high then we wish to take some risk of the table. We can put our money into investments that have less risk or place them with outside managers with a history of performing well in riskier markets. We can also choose to place more of our assets in cash which is essentially a call option on risk. We, like Marks, continue to proceed but with caution. “Calling a top” and “getting out” are a Fool’s Errand but lessening our risk in light of historical valuations is a prudent thing to do.   

In regards to risky behavior we call your attention to something that we have seen for some time, over and over again and it costs investors huge sums of money. This time around it is the sale of “Cat Bonds” to the small investor. Once the province of big money center banks and off shore insurance companies “Cat Bonds” are catastrophe bonds sold by large reinsurance companies. The short story is you can make high yield returns by investing in bonds which insure against wind damage, hurricanes, earthquakes and other catastrophic events. Suffice to say that those investors after several years of decent returns will return to work on Monday with a lot less digits in those accounts. Those investors will be wiped out completely if Irma has her way with Florida this weekend. How do you spot these enemies to your portfolio the next time? It is easy. If someone promises you an above average yield in a product that is unlisted (it does not trade on an exchange) with high management fees – run, do not walk away from this investment advisor. I have seen too many of these investments in investor’s portfolios in my time. The advisor ends up with his management fees and the client ends up with the goose egg.

 When the pressure is on we like to have what we term “adults” in the room. The “adults” are not only the smartest people in the room but they are people who know how and when to make a decision. Stanley Fischer is one of those “adults”. Dr Fischer, former professor at MIT, vice chairman of CitiGroup, and chief economist of the World Bank, and former Governor of the Bank of Israel, resigned his position as vice chair of the Federal Reserve. Fischer played the role of intelligent hawk who we felt comfortable leaving in charge of the store. As this critical time approaches of the Fed removing stimulus his absence alone makes us less confident in the “adults” left in the room. In one of his last public speeches as part of the Federal Reserve Dr Fischer warned about historically high asset valuations.

Let me conclude my assessment of current financial stability conditions with a discussion of asset valuation pressures… In equity markets, price-to-earnings ratios now stand in the top quintiles of their historical distributions, while corporate bond spreads are near their post-crisis lows. …

The general rise in valuation pressures may be partly explained by a generally brighter economic outlook, but there are signs that risk appetite increased as well…So far, the evidently high risk appetite has not lead to increased leverage across the financial system, but close monitoring is warranted.

West Texas Crude has had some wild moves post Hurricane Harvey but is still stuck between $45-50 a barrel. The safe havens benefited this week as gold has sufficiently punched through $1300 making that area now support.  The ten year Treasury which had been stuck between 2.15% and 2.40% since April finished the week at 2.05% which could augur a price movement down into the 1.75-1.85% area. The move is on into the safe havens while stocks mystically continue to hold their gains and their range between 2420-2480. While the caution signs are there the market is still firmly in an uptrend. A punch through 2480 on the S&P 500 could give the bulls room to run. The rally off of the lows has been anything but active. A low volume run up doesn’t bring with it much conviction but the animal spirits could take over regardless with a swift punch through 2480. The pressure is building.

 Harvey was the story last week. This week it’s IRMA. Best of luck to all our friends and family in Florida. Hold on tight.


If you are not currently receiving our blog by email you can sign up for free at .

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  or check out our LinkedIn page at .



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.




Stand Your Ground?

Howard Marks from Oaktree is out with another investor letter and as you know we read anything that comes across our desk from Howard Marks. Here is the money quote from his letter. Middle Ground.

If the economy continues to recover and the Fed’s bond buying eases off, interest rates are likely to go further on the upside. But given the modest level of confidence at play, the markets should not turn out to be perilous. Most assets are neither dangerously elevated (with the possible exception of long-term Treasury bonds and high grades) nor compellingly cheap. Its easier to know what to do at the extremes than it is in the middle ground, where I believe we are today. As I wrote in my book, when theres nothing clever to do, the mistake lies in trying to be clever. Today it seems the best we can do is invest prudently in the coming months, avoiding aggressiveness and remembering to apply caution.

Keep your eye on bond yields. While the stock market tends to gyrate wildly bonds have a steadier hand. The critical level is between 2.7% and 2.8% on the 10 year. The 2.7-2.8% level is important because stocks have started to struggle above those bond yields. Watch the 10 year. A soaring 10 year is a huge headwind for the housing market.

Fed officials were out and about and were pressing for a need to taper back on QE in September. Even Charles Evans from Chicago, a noted dove, is now seated in the hawk’s camp. There is some speculation afloat that Fed officials may be willing to have some bumps in the road for the stock market in order to engender some political support from Congress and make the next Fed chairperson’s job a bit easier. A new Fed Chairperson might be better off with the stock market a bit lower rather than trying to implement new policy (QE Taper) at all time highs. Will Bernanke do them the good favor? Remember new Fed Chairs tend to get tested in their resolve by markets.

July and August tend to be positive months for the stock market historically. Now that the first week of August has passed and new pension money has entered the market investors may be getting a bit more cautious ahead of September. September has a long history of volatility and the calendar holds a much anticipated FOMC meeting and a key German election. Japan has markets on edge this morning as the Nikkei is down 4% overnight. Geopolitics are also on the rise as Obama snubs Putin. Will the snub increase tension in the Middle East and Syria? It certainly won’t help.

Go left? Go right? Stand your ground? We think that Marks is right and now is not the time to get too clever. Opportunity may come soon enough.

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

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.

Blackthorn Quarterly Letter Q2 2013

The air goes out of the balloon much faster than it went in. 

-Howard Marks

Last quarter we talked about the madness of crowds and the fantastic gains put in for the market to start the year. If one were to extrapolate those gains to an annualized basis one could see that the pace of those gains was unsustainable. If your guess was that the full gallop that the stock market had broken out of the gate with in 2013 would slow in the second quarter you would have been right. The stock market slowed down its frenetic pace to start the year but still managed to keep its head above water. The bond market however took on water. The key moment from this past quarter was the selloff in the bond market following Ben Bernanke’s remarks that the pullback from QE would begin in late 2013.

That brings the big question for the second half of 2013. Has the 30 year bond bull market just ended? The bond market was a bit of a bust last quarter as investors began to adjust to the assumed QE tapering that is expected at the September FOMC meeting. It is almost as if the Fed has kept a beach ball (the bond market) under the water and just released it. Investors were left searching for a beach towel as they got all wet. In our April letter we also quoted Stanley Druckenmiller, one of the great investors of our time, and his opine on the Federal Reserve’s policy on interest rates and the effect of QE.

 “It’s one thing to control short-term interest rates,” he said. “It’s another thing when you’re taking 75 to 80 percent of the bond supply and holding that price down. … This is a big, big gamble to be manipulating the most important price in free markets, [interest rates].”

We quoted Ray Dalio in our quarterly letter in April and his words now seem quite prescient. We would remind you that Dalio, the founder of the largest hedge fund in the world, felt that second half of 2013 would be a rough one for the bond market. The last few weeks of the first half certainly were as the air came out of that balloon rather quickly. It remains to be seen if there is more air to come out in the second half of the year.

We practice a defensive philosophy when it comes to investing. We find it prudent to never invest and come to find that you have painted yourself into a corner. Investing is not about predicting the future but about assessing probabilities and the diversification of our investments allows us to take advantage of that. We diversify investments so as to have some component of your portfolio making money at all times no matter what the outcome. The question inevitably comes “why don’t we just sell all of our bonds if rates are going to rise”? In a game of probabilities we would never abandon an asset class as large as Fixed Income as we cannot predict with 100% accuracy that rates will rise. What we can do is manage duration and bond holdings so that our stance would keep us in the game in fixed income if rates flatten or go down but if rates rise then our losses will be muted. That stance would allow us to capture further gains should the bond bull continue and income without exposing us to undue risk. That underweighting of bonds has generated a “safe” income that stood up well in last quarter’s downturn. Has the time come to underweight bonds even more? We think that it may be.

From another source last month comes a further review of Fed policies and the further course of the policies of Quantitative Easing (QE). The Bank of International Settlements (BIS) is known as the Central Bankers bank. The BIS was established to facilitate the transfer of war reparations from Germany in 1930 as per the Treaty of Versailles. The BIS’s main role today is to facilitate the transparency of monetary policy amongst its members thereby making monetary policy more predictable among its 58 member nations. Its current Board of Directors is a virtual Who’s Who of the Central Banking world and includes Federal Reserve Chairman Ben Bernanke. This is what the BIS had to say on QE and central bank policy last month.


Alas, central banks cannot do more without compounding the risks they have already created. Instead, they must re-emphasize their traditional focus – albeit expanded to include financial stability – and thereby encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever larger quantities of government securities. And they must urge authorities to speed up reforms in labour and product markets, reforms that will enhance productivity and encourage employment growth rather than provide the false comfort that it will be easier later. – Bank of International Settlements (BIS) June 2013


Read that first line again. Central banks cannot do more without compounding the risks they have already created. The Bank of International Settlements (BIS) as much states that QE has had unintended consequences and that bubbles may have formed. You have blown up the balloon. You can’t just let it go. Markets would not react well if central banks were to let out all of the air from the balloon at once. As Dallas Federal Reserve Governor Richard Fisher has said “we cannot go from Wild Turkey to Cold Turkey” overnight. The market needs time to adjust to a new regime of tapering of QE and that will create spasms of volatility in the marketplace much as we saw in the last weeks of Q2. Also withstanding a resolute Federal Reserve which has succinctly said that it stands prepared to ramp QE back up if it so chooses in light of weaker data. That data would be a rapidly falling stock market or rapidly rising rates on the 10 Year.

The Fed seems to be implying through its latest statements that they will take Goldilocks approach to using continued QE. If the economy is running hot then less QE is in order. If the economy is running too cold then more QE is on the menu. Could that Goldilocks approach take the form of a rate peg? This would be a rate range at which the Federal Reserve would buy bonds if rates went above a certain level and sell them if rates fell below a prescribed level. A central bank biggest weapon may be its mouthpiece.  If the FOMC told markets the range at which it was essentially satisfied it would probably have to do less purchasing then talking.

The concept of pegging the 10 Year Us Treasury to a rate range is one that was noted by Federal Reserve Chairmen Ben Bernanke in his infamous Helicopter Speech in 2002. Pegging rates by the Fed is not unprecedented. The Federal Reserve implemented a rate peg in the post WW II period very successfully and without much balance sheet expansion. If that were the case then the next question is at what rate on the 10 Year will they peg? 2.5%? 3%? 4%? The answer to that question goes a long way in determining at what level we wish to be involved in bonds. If that change were to induce a volatile spasm where investors drove prices to bargain levels we would consider entering the buy side of the equation. Our job as investors is to sell when prices are high and investors are eager to take on risk. We also seek to buy when others are fear filled and reticent to take on that same risk as we seek to buy assets for less than they are worth. Our margin of safety.

It is not our role to predict the future but it is our role to extrapolate the probability of an investing outcome. Having said that let’s revisit the Recession of 1937. The classic schools of economics differ on the cause of the 1937 Recession that prolonged the depths of the Great Depression. Keynesian economists would have you believe that the recession was caused by a cut in Federal spending and the raising of taxes. We have higher taxes in 2013 and a sequester and still no recession. The Austrian School assigns blame to the large expansion of monetary supply from 1933-1937. Well, we have had a massive expansion of the Fed’s balance sheet and still no recession. There is only one school left so stay with me. I know your eyes are glazing over. Monetarists, such as Milton Friedman, blame the tightening of money supply in late 1936.  Given this knowledge how does the Federal Reserve normalize policy? Given the changes in the Federal Reserve’s policies and a de facto tightening in policy by the Fed and a reduction in QE how will the stock market respond? The stock market response in 1937 was to go down 50%.

We do not think that the stock market’s response will be the same in 2013-14 as it was in 1937 but we are not going to count on that outcome. The way to invest successfully is to try and plan for any outcome.

We feel with continued Fed easing the market may continue higher and perhaps even much higher although a tapering of QE could lessen the chance of a market melt up. We would however continue to have cash on the sidelines in order to be prepared for a selloff. No one wants home insurance until lightening strikes. Insurance costs money but that cost has to be weighed against the opportunity premium that will present itself given lower equity pricing. Cash has an implicit call option attached to it.  The true value of cash is its ability to buy assets during selloffs in the market. Where most investors go wrong is that they buy when they see others making money and sell when they lose their own. It takes steady nerves and great patience.

Given the highly indeterminate nature of outcomes and the unpredictability of worldwide economies and global markets it makes sense to practice defensive investing. It is far more important to ensure survival in light of the possibility of a highly negative outcome than it is important to maximize returns when times are good.Howard Marks

We try to be prepared and invested for all outcomes so that we are making money in at least a portion of our portfolio. We don’t know the future we can only make a probabilistic distribution and invest accordingly. We feel that for now our next move is to continue to back away from duration and fixed income while we take on incrementally more risk in high quality equities as opportunities present themselves at prices that we feel would give us a margin of safety.  Remember we need to look for 3 foot bars to step over and not 7 foot high bars to jump over. We will continue to monitor bond yields and our fixed income portfolio. The management of which may be a large part of what determines our returns going forward in 2013 and 2014. Remember, markets go down far faster than they go up.

A healthy respect for uncertainty and focus on probability drives you never to be satisfied with your conclusions. It keeps you moving forward to seek out more information, to question conventional thinking and to continually refine your judgments and understanding that difference between certainty and likelihood can make all the difference. – Robert Rubin