Catch 22

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

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

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

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

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

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

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

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

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

Valuations – 1999

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

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

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

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

What’s Next

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

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

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

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

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

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

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

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

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

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

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

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

Moreover, the years ahead will occasionally deliver major market declines – even panics – that will affect virtually all stocks…During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well.Warren Buffett 

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

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

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

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Rumblings

We hate when we are not clear. We get questions all the time about clarification. The problem is that the rules handcuff us so that we cannot get too specific as that would constitute advice as per the regulators and we always follow the rules. Suffice to say that there are rumblings in multiple areas underneath the market. One area clearly under attack are emerging markets. Emerging markets are submerging in Argentina, Turkey and Brazil to name a few. China has entered a bear market. We feel that central bank policy is the most influential driver of asset market returns. The current FOMC polices have the US Dollar soaring and capital fleeing emerging markets. We think this is as clear as we can be in writing what the great Benjamin Graham advised investors in 1972.

We can urge that in general the investor should not have more than one half in equities unless he has strong confidence in the soundness of his stock position and is sure that he could view a market decline…Thus, we would counsel against a greater than 50% apportionment to common stocks at this time. -Benjamin Graham The Intelligent Investor (1972)

We continue to see the S&P 500 stuck in a range pivoting around 2666. A trading range has been built. Trading ranges can serve to work off price elevation if they last long enough. One caveat is that trading ranges usually break out the way that they entered and in this case that would be lower. Small and Mid caps continue to power the market in the wake of trade tariffs from the White House but we are seeing negative divergence surrounding their latest new highs. Translated: that means that the excitement in those  areas of the market are less than when they hit their previous highs which suggests a weakening trend. At the end of June we will have seen month 7 of the trading range around 2666. The World Cup has the eyes of Europe and Asia and the tournament tends to keep a lid on things as will August beach vacations. Those would months 8 and 9.

If you have read us for some time you know that we subscribe to the thesis that it has been expansive monetary policy that has led to the rally in asset prices since 2009 and it is monetary tightening that will lead to the reduction in asset prices. Kevin Muir at Macro Tourist writes an insightful blog that I find very interesting. In his note last week he points to the actual days on which the Federal Reserve does the policy tightening and is finding a subsequent drop in the S&P 500. Makes sense to me. Here is a link to the piece. Kevin points to tomorrow to watch for another such drop.

http://www.themacrotourist.com/posts/2018/06/27/anotherqt/

We have been telling you to keep an eye on Bitcoin as an indicator of risk. As risk off has come to the land of Bitcoin it has also appeared to be risk off in other markets as well. Bitcoin fell just a bit to close Friday at of $5900 (Fri 4pm).It has since bounced this weekend but let’s wait until everyone comes back from the beach. We are not trading bitcoin nor have much interest in it beyond using it as a temperature gauge for risk sentiment and how that may apply to the stock and bond markets.

The S&P closed the week at 2718 down from 2754 or a 1.3% loss for the week. The loss would have been greater if not saved by a rally on the last two days of the quarter which is traditional. The S&P 500 is a touch oversold and due for a bounce but the moving averages are starting to turn lower ominously.  Gold has broken below support levels and is now very oversold and looking for a bounce.

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

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

 

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.

Alchemy – Bulls into Bears

So  much to say and so little space. I guess a chunk will have to wait for my quarterly letter next month.

Bulls into Bears

Some of the most visible market pundits that I term as permanent bulls have turned bearish of late. In fact, in my almost 30 years of doing this, these are people that I have never seen anywhere remotely close to bearish – so this is news. Perhaps it just has to do with how late we are in the cycle but I couldn’t help but notice. Prof. Jeremy Siegal, Abby Joseph Cohen, Leon Cooperman and now Ben Bernanke have all turned bearish in the last few weeks and they all seem to be pointing to how difficult 2019 is going to be. To us, that means, the trouble could start as early as July of 2018 in anticipation of a tough 2019. 

From Jeremy Siegal 

Caution is going to be the word here. 

This is a great year for earnings, no one argues with that. But the tax cut is front-loaded which means that the write-offs on capital equipment are going to accrue to 2018 and not nearly as much in 2019. 

The major threat of the market is higher interest rates going forward. Too many people read the FOMC minutes as being too dovish. –Prof. Jeremy Siegal

From Leon Cooperman

I would be a reducer on strength, not a buyer on strength. I think the market is adequately valued.

I’m sympathetic to the idea that sometime in the next 12 to 24 months, there will be events that will catch the market. In other words, … I think that inflation and interest rates will catch up to the market as we normalize. –Leon Cooperman  Omega Advisors

From the Did He Really Say That Dept?

The stimulus “is going to hit the economy in a big way this year and next year, and then in 2020 Wile E. Coyote is going to go off the cliff,”
– Ben Bernanke,  former Fed Chairman, June 7

 While not a perma-bull the most direct and information laden warning came from the largest hedge fund in the world – Bridgewater Associates.

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

We are bearish on financial assets as the US economy progresses toward the late cycle, liquidity has been removed, and the markets are pricing in a continuation of recent conditions despite the changing backdrop. ­- Daily Observations  co-CIO Greg Jensen Bridgewater Associates

The Fed is pulling back on liquidity as it is the right thing to do, however, there are many that don’t share that view. In particular, emerging markets that are beginning to submerge from Argentina to Turkey to Brazil and the ripples across the pond are becoming waves. Those waves will eventually hit these shores and the Fed will have to slow its tightening cycle. There are no problems only opportunities. We are loath to enter emerging markets but see commodities as a place to hide as inflation rears its ugly head as a handcuffed Fed is forced to slow rate hikes by Congress and external international pressure. We are already starting to see wage pressures in trucking and the oil patch. Markets are pricing in a goldilocks scenario that is ever elusive and fleeting. Change is the only constant.

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

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

The market can continue to chug along to higher prices but that will become more difficult as we head into 2019 with less fiscal/tax stimulus and more QT around the world. To be sure, Cooperman cautioned that while trouble could be ahead for late next year, he isn’t ready to head to the exits just yet, saying “the conditions normally associated with a big decline are not yet present.” We agree.

Small caps continue to lead while the trade wars stay on the front burner. Keep an eye on the banks. Markets won’t get far without them. You’ll find us in the commodity space. You won’t find us in emerging markets. That’s where the trouble will surface.

We have been telling you to keep an eye on Bitcoin. It bounced slightly this week to close on Friday at $7660.66. It still has our attention. $6777 is important support for bitcoin.

The S&P closed the week at 2779 or up about 1.6% but still near our fulcrum of 2666. 2800 is resistance. Small caps and the Russell are holding their recent new highs but look a bit overbought and could use a rest. We are headed to NY/NJ to see clients and had considered taking the whole week out of the office. We think that is sufficient to confuse the trading gods and expect next week to be an active one. Whenever we are out of the office the trading gods seem to knock the hell out of the market. Next week is a busy one with summits and central bankers galore. Keep your helmets on. The bulls are still in charge and looking for a knockout punch.

pexels-photo-722664.jpeg

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.

Housing On Fire – Again

The housing market is absolutely on fire of late. We are hearing tales of bidding wars again. What short memories we have. We had an interesting conversation with some in the core housing supply chains. Their tales are more of woes surrounding supply rationing and trucker shortages. Inflation here we come. The real story is about interest rates and their effect on markets at home and abroad. We have long surmised that it was absurdly low interest rates that were holding back the economy. Our thought process is that with 0% interest rates there is no rush to go out and buy that house, that car or build that factory. Rates are low and will be for some time. Well, now the rush is on to make moves before interest rates run even higher and inflation is entering from stage left. The ironic part is that if the Federal Reserve raises rates further it may push the economy further into overdrive.

If one oversteps the bounds of moderation, the greatest pleasures cease to please. – Epictetus

For a more in depth analysis of where rates may be headed check out this blog post from our friends over at Global Macro Monitor.

As I said, it is all about interest rates. Here is what David Tepper, hedge fund legend and now owner of the Carolina Panthers (who bought the team for a mere $2.2 billion) had to say on about interest rates and the stock market earlier this month.

… a lot of it has to do with interest rates. We’re right on the cusp of breaking out on interest rates at this level around 3%. (the 10 Year closed the week at 3.06%)…But a lot of people don’t think they’re going to break higher – most people are only saying they’re only going to 3.25%. And I think if they only go to 3.25% for the rest of the year then stocks might be up. But too many people are saying that. And when too many people are saying one thing that’s when I start to get worried. So if we break above that, then stocks might have a problem.- David Tepper Appaloosa Management

Now we must deal with the unintended consequences of zero percent interest rates and the unwinding of QE. Because interest rates are headed higher so is the US Dollar. That is having a chilling effect on emerging markets. The iShares Emerging Market ETF is now trading below its 200 DMA and looks like it may be headed for a fall. I remember 1997 and the Asian Crisis very clearly. It was and still is the only time that US stock markets closed early due to trading curbs and the Dow Jones’ 550 point loss that day. We were on the floor that day and it was particularly eerie. The Asian Financial Crisis began in Thailand with the collapse of the Thai Baht and its effects were felt around the globe. Keep an eye on emerging markets like Argentina, Brazil, Turkey and South Africa. Turkey may merit extra attention as inflation in that country just hit 11% and its dictatorial leader is demanding rate cuts!? The economic textbooks would tell you to do the opposite.

Keep an eye on Bitcoin. The crypto currency market seems to be shaping up as a temperature gauge for risk. Bitcoin just made a lower high and there seems to be pressure in the space. As goes bitcoin so goes the market? It is trading at about $8300 as we write. It is very important that the support at $6700 remain steady otherwise bitcoin could see a $2000 fall quite quickly. The S&P closed the week at 2713 or about 50 points above our fulcrum of 2666. It has been 5 full months since we first hit 2666. Remember, we thought that we could spend 9-18 months here. The S&P keeps swinging back and forth between the 100 day moving average and the 200 day. Those lines are sloping upward and so is the market. The bulls have some work to do.

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

lighthouse

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.

666 Redux

Rollarcoaster markets. Around and around, up and down and we are back where we started. Hopefully, it didn’t cost you money. Another week and month and we are stuck at 2(666). You can read our thesis on the number 666 in our postings Bitcoin and Warning Shot. The short version is that the market has struggled at 2 times, 3 times and now 4 times the low on the S&P 500 of 666. It’s not magic. Its algorithms. The computers are in charge and for now the trading houses love the volatility but it’s all just churning. We have expected this churning to last 9- 18 months but we are getting closer to taking the under on that bet.

While the pundits are obsessed with Elon Musk’s seeming breakdown we will continue to obsess over the recent ranges of gold, stocks and bonds. It could be a long summer as the doldrums kick in but given our track record it will happen when we are furthest from the office. We have a knack for taking vacations at exactly the right time. For an inside tip look at your August calendar.

We continue to be invested because we do not know which way the market will head and time is money. It’s boring and it’s not sexy but look at where you cash, your dry powder, is invested. The differences are staggering and it is well worth your time to pick up 200 basis points. The market continues to struggle and is stuck in the range between 2550-2700 on the S&P 500. The longer it stays in the range the better it is for the bulls and the harder the breakout will be when it comes. We see the market breaking to 2850 and new highs or a trapdoor opening with a swift move to 2400 or lower. The market still struggles with 2666 as we closed the week at 2664 (which is the actual 4 x 666). We are stuck, for now, in a range between the 100 Day Moving Average (DMA) and the 200 DMA and that range is growing tighter each week as the 200 day is trending higher. Something will have to give. Keep an eye on the door. When these ranges break things will change rapidly – but for now we wait.

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

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

 

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.

Monday’s Blueprint for Markets

Here is our Blueprint for Monday and beyond. Since the election of Donald Trump we have been building an investing scenario that looked much like 1987. We were calling for a 1987 style melt up and then, a smack down.

A 30% run from the lows before Election Day, much like 1987, …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. (The S&P 500 was at 2360 as we wrote.) Witches’ Brew Blackthorn Quarterly Letter April 2017

We may have missed the top by 100 points on the S&P 500. Last month we backed off of the 1987 style melt down part of this scenario in light of everyone jumping on the 1987 bandwagon. We have begun to expect a more drawn out solution but you must be prepared for either in this environment.

This is what we had to say in our blog post Warning Shot Across the Bow published 2/4/18.

Our new scenario calls for a more drawn out selloff. First, we may see a drawdown in the magnitude of 5-15% followed by a retracement back to the old highs. From there (You Are Now Here) we should see a selloff of a larger magnitude leading to a bear market over the next 18-24 months. It’s not voodoo. Valuations show that historically we will see limited upside from these levels. Markets are high. Rates are rising. The yield curve is flattening. Markets tend to struggle in the second year of a Presidency as midterm elections approach. It’s not rocket science. It’s the study of psychology and history. We have seen the warning shot across the bow.  Buckle up. It’s going to be a bumpy ride. Watch the central bank balance sheets. If they stop tightening all bets are off.

As far back as October of 2017 we were warning about the 2666 level on the S&P 500 and a struggling market for 18-24 months.

We felt that the market would struggle for 18-24 months when it hit 2666 on the S&P 500. The market has spent time at each multiple of the 666 low in the S&P. 2664 is 4x the 666 level. You must remember we are dealing with algorithms written by humans. Levels like 666 and 2x, 3x and 4x are just levels in a computer program. Be careful of computers. They only do what they are told. As computer use has created a wondrous cycle of upward movement so we can have the vicious spiral downwards.

Market structure could exacerbate may any selloff. We have warned about market structure in the past and here is where you can do further reading from our blog posts – My Name is MarioParadox and Caution Flags.

The market is flawed in its design as its automated structure puts the momentum players, the market makers and algorithms in control. While it is pleasurable to see it go up every day it will be much quicker and painful when the market goes down in a one way fashion. For every action there is an equal and opposite reaction. Blog Post “My Name is Mario” 10/28/2017

We mentioned on Twitter on Thursday morning that gaps at 2850 and 2700 would lead technicians to project a measured move lower to 2550. That was 4% lower as we wrote. We realized that a move of that magnitude would take the S&P down to test the lows from February’s vol quake. What we didn’t realize was how quickly we would get to that number. For next week the old school playbook is for a rough Monday and a chance for the bulls to turn things around Tuesday afternoon. We have a feeling that Wall Street didn’t study for this test. Market is very oversold and due for a bounce. How it reacts to the prior low (2550) will tell us a lot.

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

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

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.

Where Are We? – Emotional Capital City

Where are we? Markets are about cycles. We see them repeat over time. The question now is where are we in the cycle? One important reason why we need to be aware of cycles is because investing is an emotional roller coaster.  If we jump out of the market too soon we risk under performance and client angst. If we are too late clients may feel over invested and lack the courage to buy when others are selling. It is then that we run the risk of permanent capital loss. Our job as financial advisors is really about contingency planning, trying to anticipate what happens next and how to respond. An underappreciated part of investment management is how we, as advisors, react to our client’s emotional response. Our ability to respond to market cycles is directly influenced by where our clients are emotionally – their emotional capital.

We have spent a good deal of time lately talking to clients about emotional capital. When cycles reach a more mature stage it is prudent to sell some winners and build a cash (and emotional) cushion with which to buy future bargains. That way when market losses come you are keenly aware that you prepared for this moment and this money was set aside to buy assets at bargain prices. If you are holding too much in the way of assets when they begin to fall you will be tempted to start selling. It is then that you will be managing your money from an emotional point of view. We all know that losses hurt far more than gains feel good. Much as Joseph stored the grain in Egypt during the 7 years of plenty it is time to store some cash to prepare emotionally for when the lean times arrive. Leaving some gains on the table will make you a better investor over the long haul.

Now let Pharaoh look for a man discerning and wise, and set him over the land of Egypt. 34“Let Pharaoh take action to appoint overseers in charge of the land, and let him exact a fifth of the produce of the land of Egypt in the seven years of abundance. 35“Then let them gather all the food of these good years that are coming, and store up the grain for food in the cities under Pharaoh’s authority, and let them guard it. 36“Let the food become as a reserve for the land for the seven years of famine which will occur in the land of Egypt, so that the land will not perish during the famine.” -Genesis 41:34

We caution that we are not seeing anything imminent. We just know that trees don’t grow to the sky and bull markets end. We know that we are in the midst of one of the longest bull markets on record influenced by historical central bank largesse. We don’t know when but we are due for leaner years. We need to store some cash and build emotional capital. The people in the industry whose opinions we respect are advocating caution. Hopefully, it will only be a minor disruption but it is imperative that one is not “all in” when it arrives and we are emotionally prepared to purchase bargains. A recession is the big worry and that still seems some time away. 

The market is still struggling to supplant 2800 on the S&P 500. Bond yields are struggling with rising above 3% on the 10 year. Gold cannot seem to break out and hold above $1350.  The yield curve is flattening. The key takeaway here is that the pressure is building. We are at a crossroads. Bonds. Commodities and equities. We are all waiting.

The bears pushed back this week but we give a slight edge here to the bulls. Stocks are slightly oversold and bonds slightly overbought. The big option expiration came and went without incident. Next week, hopefully, will tell us more but we could just see the tension build. The bulls still need to get over the 2850 gap to really convince us but if they do things will progress quickly. Be on your toes.

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

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

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 Stepping on The Gas

As Warren Buffett famously said, “When the tide goes out you find out who has been swimming naked”. That tide may be rising interest rates. The tide has only begun to recede and yet it appears we may have found some to be swimming naked. In recent weeks we have seen unexpected announcements from the likes of Met Life and GE in regards to accounting irregularities and large conglomerates in China and the Netherlands with liquidity issues. HNA Group which owns Hilton Hotels is desperately searching for liquidity. The tide hasn’t even gone out yet. This could be the tip of the iceberg as zombie companies which have been left alive due to central bank zero interest rates may now fight to stay afloat. The rising tide of interest rates should bring us more instances of who has been swimming naked.

Coming off one of the worst weeks in years for equities we now have one of the best weeks in years. Don’t be lulled into complacency. This was to be expected as investors have now reversed half of the sell off after retesting the lows at the key 200 day moving average. We do not think that the all clear can be given yet. The selloff was violent from extremely elevated levels and that should give us caution. The true test, as we have been warning, is the retest of the old highs. The old highs were hit with such fervor that we do not think that the amplitude will be the same when we get there again. The swift and violent move off of the extreme highs has brought doubt into the equation for the first time in awhile. Let’s see if equities can pass this exam.

It appears that the expected outcomes by market participants may have changed the moment the tax bill was passed. Fiscal stimulus this late in the business cycle with a performing economy could force the central bank to tighten quicker than it had planned. That only increases the level of difficulty of the high wire act that the central bank is already attempting. The odds of a central bank policy mistake are rising and that contributed to the selloff along with rising inflation and the prospect of higher interest rates. Another contributing factor of the sell off was that Wall Street can smell weakness. Much had been made about the overzealousness of the volatility selling crowd. Those sellers were ripe for a lesson and Wall Street gave it to them. Wall Street, when sensing weakness, will press the case against the weak. Much like culling the slow and weak from a herd Wall Street feeds on the same. We have no doubt that the case was pressed against vol sellers until they capitulated. That gave rise to further de leveraging which spurred the computers into an all out rout. The key question here is, has the tide turned? We will see soon enough when the highs on the S&P 500 are tested once again.

Point here being that the uber-ambiguous “something has changed in the market” meme that’s been going-around is based-upon the underlying change in perception with regard to a bond market that is waking from its slumber due to a new-found Central Bank willingness to normalize policy on account of actual signs of “growth” and “inflation”—ESPECIALLY after being “put over the top” by US fiscal stimulus.  The above observations are simply the manifestations of this mentality-shift in the market….qualitative observation into quantitative phenomenon.- From Charlie Mcelligott, head of Nomura’s Cross-Asset Strategy

We have been writing that the Trump policies would give the FOMC cover to raise interest rates but those same policies may be too much of a good thing. Fiscal stimulus, tax reform, deregulation and infrastructure spending may force the Fed to raise rates faster than they would like. As the Fed is hitting the brakes Trump is stepping on the gas.

We continue to hold short duration bonds coupled with a slight underweight in equities. However, we did cautiously add to equities during the selloff. We continue to add to new positions that prepare for a further rise in inflation. We believe that we are in the late stage of the business cycle where commodities tend to prosper. Current central bank positioning combined with fiscal stimulus could lead to a quicker than expected rise in inflation. We are positioning for a surprise to the upside.

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

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

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.

It’s Just Math

So much to say and so little space. Let’s jump right in.

What Happened?

Investors are convinced that Interest rates have begun to move higher and may have broken their 30 year + downtrend. The US 10 year has gone from 2% to 2.85% in just 5 months. The 10 year is in every risk calculation. The risk free rate is a base from which just about every valuation springs from. Has the 30 year bond bull market ended? It seems more and more are in that camp.

It can’t be just Bonds. Can it?

No. The severity of the move was exacerbated by the short volatility trade (see our warnings Very Superstitious, Less In and Fall is In the Air) and market structure which we warned about My Name is Mario, Paradox and Caution Flags.

Short Volatility Trade

In the next sharp market move volatility will be the driver as investors scramble to cover their shorts wiping out many involved in that trade. Blog Post 10/21/2017 “Very Superstitious

Bonds, the Vol Trade and Risk Parity

We continue to fret about risk parity and volatility selling. When stocks go down we will look at bond prices. At some point they will both go down in tandem and selling will beget selling. If there is a meltdown, we believe that is where we will see it start. Blog PostLess In” 11/18/2017

Market Structure – Or Why the Market Fell So Fast

The market is flawed in its design as its automated structure puts the momentum players, the market makers and algorithms in control. While it is pleasurable to see it go up every day it will be much quicker and painful when the market goes down in a one way fashion. For every action there is an equal and opposite reaction. Blog Post “My Name is Mario” 10/28/2017

You may have pundits who say that it cannot be bond yields. They will say, “Four years ago the 10 year was at 3%. 3% 10-year yields didn’t stop the bull market then”.  Yes, but 3 years ago the S&P 500 was at 2000. It is now closer to 3000 with a high of 2872 put in a month ago. The S&P 500 at 2000 with a 3% ten year yield is a lot more palatable than when the S&P 500 is at 3000. Stocks are more expensive and have a lower dividend yield in 2018. Remember, stocks are valued in light of the risk free rate – the 10 year yield.

We are now in the late part of the short-term debt/business cycle when demand is increasing faster than the capacity to produce, so interest rates rise to put the breaks on and that hurts investment asset prices before it hurts the economy. -Ray Dalio Bridgewater Associates LinkedIn 2/8/18

The three legged stool of a higher stock market since the GFC has been stronger economic growth, low inflation and central bank stimulus. Those components of a stronger stock market may become a headwind in 2018. Currently, the Atlanta Fed is predicting 4% GDP in Q1 of 2018. That tells us that if growth gets much stronger central banks will have to take away stimulus at a more rapid pace. Inflation is rising with higher wages and central banks are already scheduled to take away stimulus in 2018. Don’t fall for the stronger economy = stronger stock market argument. A stronger economy and higher inflation will only lead to the Fed tightening faster. Trump’s policies may force the Fed to take away stimulus.

The combination of experimental central bank monetary policy and the Trump administration’s stated goals, if not enacted in concert, raise the risks that something is going to break. Those stated policy goals, while giving the Federal Reserve cover to raise rates, also make the Federal Reserve’s exit from their easy money polices of the last 8 years particularly tricky. To be frank their exit was never going to be easy. Blog Post Witches’ Brew 4/8/2017

Governments want inflation – just not too much inflation. Great investing minds such as Jeff Gundlach and Paul Tudor Jones are telling us that inflation is coming and commodities should play out well this late in the cycle. Central banks still have negative rates in parts of the world and in the US we have a President trying to stimulate the economy and having success. Right policies, wrong timing. Central banks are now behind the curve and markets may not like faster tightening. Another issue is the Fed Put. The Fed Put has given investors enormous confidence to buy ever rising stocks. Where will the Fed step in if markets get in trouble? We think that as inflation rises the Fed Put moves lower. The Fed cannot repeat the mistakes of the Weimar Republic and let inflation rage out of control. They will need to stop inflation and the acceptance of more volatility and a lower stock market may be the price.

The fundamentals have changed. Good news has become bad news. Any positive developments on the economy may be translated to a need for more tightening from the Fed. As Main Street benefits in higher wages Wall Street may suffer. Inflation will create the regime change from global economic recovery to global stimulus withdrawal. Governments want some inflation. Some inflation is good. From a government’s perspective deflation is always bad. That is why the Fed will support the market in a deflationary environment but not support it as quickly when it comes to too much inflation. Their support of the market is much, much slower to arrive in an inflationary environment especially when it sees a White House that is already stimulating the economy fiscally.

We have grown weary of hearing one pundit after another tell us that “The fundamentals have not changed; that the economy is strong and that stocks will go higher once this correction has run its course.” It is precisely because the fundamentals have not changed that stocks are weak, for the history of equities is to discount the future and the equity markets are looking beyond today’s economic fundamentals… which are, again, very strong… and are looking to the future when those fundamentals will eventually change for the worse. That is the job of the capital markets: to discount the future by looking into the future and not looking at the present. Dennis Gartman – The Gartman Letter

Bull market tops are a process and are usually not an event. We believe that we are at the beginning of that process. Fixed income is becoming more attractive as rates rise and central bankers will now attempt to step away from their support of assets. We do not think that they will have any luck but we think that the next 12-18 months in markets will be difficult with a strong increase in volatility.

This is what we had to say last month.

We believe it is prudent to be a bit more conservatively positioned this late in the cycle and expect lower returns in order to be prepared to profit from others panic and flawed market structure. Paradox 1/8/18

 

We were prepared for this selloff and continue to position our clients for success in this environment. We have been underweight equities and have shortened bond duration as far we can stand. We continue to expect volatility and market shocks while being prepared for the return of inflation and to profit from both.

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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.

S&P To Triple in 2018

If you read our Quarterly Letter you know that the overriding question is at what level will bond yields begin to hurt stocks? Well, courtesy of “Bond King” Jeffrey Gundlach we have a number. Gundlach held his yearly January conference call this week which is always fascinating and filled with thought provoking ideas. In his conference call Gundlach stated that the 2.63% level on the 10 year is going to be a very important level and at which stocks may begin to suffer. The 10 year closed the week at 2.55% but touched a high of 2.597%.

I have spent the better part of the weekend in the office reading interviews with investing mavens and re-listening to conference calls, much to the chagrin of my wife. This week we heard from Jeffrey Gundlach, Bill Gross and Jeremy Grantham, all of whom we value highly in their opinions. If you have time check out Grantham’s latest missive titled “Bracing Yourself for A Melt Up”.  We, of course, agree with Grantham as we have been calling for a melt up in the markets since November 2017 and its subsequent 30% mark up. He makes what we believe are salient points in regards to his concept of bubbles and his feeling that one critical component is the acceleration of prices. Turning points in markets happen very quickly. That is why we stay invested. This melt up could run much further, higher and faster than any of us can predict. That is why we stay invested and simply recalibrate our allocations.

Another reason we have spent so much time in the office this weekend is that we believe that we are on the cusp of a regime change in markets. That regime change could spell the end of the bond bull market of the last 30 odd years and see a reemergence of inflation. Jim Paulsen, Chief Investment Strategist from the Leuthold Group had this to say back in November on the regime change.

“As financial markets are weaned off the juice they have been drinking for almost a decade, investors should prepare for a very different bull market in the balance of this recovery,” he said. “Without a chronic injection of financial liquidity, the stock market may struggle more frequently, overall returns are likely to be far lower, and bond yields may customarily rise.”

To be sure, Paulsen is not predicting a market collapse. Instead, he suggests investors will need to shift strategy away from the cyclical U.S.-centric approach that has worked for most of the past 8½ years, due to the likely contraction of money supply compared to nominal GDP growth.

That means value over growth stocks, international over domestic, and inflationary sectors, like energy, materials and industrials, over disinflationary groups like telecom and utilities.

Here is what Dr. Ben Hunt at Epsilon Theory had to say on inflation and QE back in July of last year.

(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

The timing on Trump’s tax reform is a bit late in the cycle and may end up exacerbating inflationary pressures. Central bankers have been pouring gasoline on the pyre for years with no effect. Pushing on a string. Higher rates (and tax reform) may be the match and with too much gasoline on the fire inflation may be the result.

(the economy) “will be getting an extra boost in 2018 and 2019 from the recently enacted tax legislation” which could lead to overheating. In which case, it would be necessary for the Fed to “press harder on the brakes”  –

NY Federal Reserve President William Dudley

The combination of higher rates, the end of QE and tax reform may push the market and economy into overheating. Late stages of bull markets tend to be very kind to commodity plays and we are beginning to see movement in the typical commodity plays. Transports are off to their best start since 1983. The S&P is off to its best start since 1987 while the Dow is off to its best start since 1997.At its current rate so far in 2018 the S&P 500 will triple by the end of the year. Not entirely likely. According to one of the many sentiment indicators that we follow the bulls are partying like it is 1987. It is starting to feel more like 1998-99. Watch for price acceleration.

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.