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.

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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.

Paradox

 The catch is, a boat this big doesn’t exactly stop on a dime.

Seaman Jones – Hunt for Red October

 Whenever you find yourself on the side of the majority, it is time to pause and reflect. ~ Mark Twain

Paradox

The word of the year just might be paradox. In a normal year the market is full of conflicting information and contradictory conclusions. 2018 and its historical asset valuations may set a new bar when it comes to investing paradox. A recent Bank of America Global Fund Manager survey shows a record high number of managers feel that stocks are overvalued yet cash levels continue to fall. The upshot is that even though managers feel that markets are overvalued they are forced to chase the market ever higher and deploy their cash holdings. An explanation for this data point is that managers act in this way in an effort to provide themselves with insurance against career risk. Chasing markets higher can be, in itself, just an effort to assuage investors who see the market returns and expect the same despite manager’s historical models telling them to act more cautiously.

One data point that simply jumps off of the page from the fund manager survey is that close to 70% of fund managers believe that tax reform will lead to higher stocks in 2018. If 70% of managers feel that tax reform will lead to higher stock prices, and the stock market is a discounting mechanism, then shouldn’t that idea already be factored into stock prices? In a world where for every buyer there is a seller 70% is practical unanimity.

Here is yet another paradox. Low rates are a commonly ascribed reason as to why equity valuations are so high. Doesn’t everyone expect rates to rise in 2018 including the Federal Open Market Committee (FOMC)? The FOMC itself has stated that they expect to raise rates three times in 2018.  If it is widely expected that rates will rise and low rates are the reason for expensive equity valuations then shouldn’t equities be falling? We are left with the idea that the current market is in melt up mode due to the twin engines of human psychology and market structure.

New Regime

Current market structure is built on self reinforcing algorithms engineered by computers. Computers run by market makers see buy orders and place other buy orders ahead of clients in order to implement more liquidity into the system. Market makers, by design, restrict themselves as to how much capital they put at risk. At a certain level, dictated by management, a market maker will cover their short or dispose of their long in order to manage risk. A high and rising market will lead to a market maker buying more and a lower market will lead to a market maker dumping their position into a falling market. That leads to self reinforcing loops. We now find ourselves in an era with lower volatility and grinding markets with self reinforcing feedback. While we believe that the lower volatility regime is partly a response to the lower human emotional component of investing the emotions are still present and impactful.  Investors currently find themselves chasing the market ever higher as their models have told them to reduce their allocations to stocks but yet stocks push ever higher and clients demand higher returns. Hence, another self reinforcing feedback loop.

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

We are currently seeing record low volatility with continued rising asset valuations, all while being in an era of experimental monetary policy attempted globally for the first time in history. After conducting their experiment of adding liquidity to ward off the greatest financial crisis since the Great Depression central bankers have now begun to drain liquidity and lift interest rates.

Prices of bonds and stocks continue to advance further away from median historical valuations. That tells us that there is too much money in the system and it needs to be drained. The Fed and BIS (Bank of International Settlements) see that too and are anxious to drain or, at the very least, stop adding liquidity. That tipping point of global central bank balance sheets draining liquidity instead of adding may happen sometime in the summer of 2018 if markets allow.

Central bankers have never attempted this before and will now, in the next six months, begin to attempt the most difficult part of their act. In the face of this never before attempted trick by central bankers we find investors are taking on even more risk.  Are investors waiting to see who runs for the door first in an elaborate game of chicken? “Prices are still rising. I can’t sell. I will miss out. I will get out before the other guy.” It will be a small door when the music stops. It’s like the boiled frog. A frog will jump out of a hot pot but put him in a cool pot that slowly boils he won’t perceive the danger until it’s too late. Investors are the frog as central banks slowly raise interest rates and drain liquidity. They won’t know what hit them. Note the following quotes (courtesy of ZeroHedge) from Jerome Powell, the newly appointed Chair of the FOMC, from the FOMC Minutes in October of 2012.

[W]hen it is time for us (the Federal Reserve)to sell, or even to stop buying, the response could be quite strong; there is every reason to expect a strong response. – Jerome Powell FOMC Committee Minutes October 2012

 

Moral Hazard

I think we are actually at a point of encouraging risk-taking, and that should give us pause. Investors really do understand now that we will be there to prevent serious losses. It is not that it is easy for them to make money but that they have every incentive to take more risk, and they are doing so. – Jerome Powell FOMC Chair FOMC Minutes Oct 2012

Since the election of Donald Trump in November of 2016 we have postulated that we were on the precipice of a melt up in stocks. Since that time we have seen the S&P 500 rally by over 28%. It was not the election of Trump that led to that thought process it was an amalgamation of set points that had come together at that instant to provide the fuel for the rally. The election released the Animal Spirits of the market. We felt that investors would be spurred by the idea that deregulation, tax reform and infrastructure spending would lead an economy, which was primed and ready, to go to greater heights. But most importantly, the groundwork for this rally was put into place prior to the election by the members of the FOMC. What the FOMC had put into place was similar to kindling and gasoline looking for a spark and that spark arrived in the form of tax reform and deregulation.

The above quote from Powell deserves to be read again. By engineering QE, the FOMC took steps to actually encourage risk taking and, with that, the FOMC had created a moral hazard. Moral hazard is the idea that investors could and should count on the Federal Reserve to effectively bail them out if things went wrong. Investors have been trained to think that if there is a significant selloff in the market then the Fed will add liquidity. Perhaps even begin a new round of QE if the selloff is bad enough. That leads investors to think Why Sell? No one sells. The market just heads higher. People have adjusted to the new paradigm. Whenever the market gets in trouble the Fed bails it out. 1987. 1998. 2001. 2007. 2011.2012. 2015. That has investors asking “Why EVER Sell”?

The moral hazard of the Fed gave rise to what became known as The Greenspan Put. The put was the level in the market, which if the market ever fell to, the Federal Reserve would ride to the rescue, add liquidity and save markets from themselves. The Federal Reserve gave no reason for investors NOT to take on risk and substantial risk at that.

Another factor in the rise of animal spirits has been the parabolic rise in the price of bitcoin and the mania surrounding it. It has helped drive investors to an extreme in bullishness anticipating future investing profits. Now, bullishness in itself is not bad and, in fact, an extreme level of bullishness can portend further gains but we do believe that it sets markets up for difficult comparisons. Most major tops and bottoms in the market in recent years have what is seen as a negative divergence in its level of Relative Strength (RSI). We are currently seeing extreme levels of RSI in the broader market. Having hit this level of extreme bullishness we should see some sort of selloff or just a breather in markets rise. Having had that breather when we approach these levels again comparisons become very difficult. If those levels of bullishness do not hit prior levels investors may see that as a negative divergence and begin to take off risk. Bitcoin’s parabolic rise is a sign of mania in markets and caution should be paid. The FOMO Fear of Missing Out has investors, perhaps, getting in a little over their heads.

Giddy Up and Getting Giddy

We learn far more when we listen than when we talk so when smart people talk we listen. David Swenson is the Chief Investment Officer of the Yale Endowment. He is seen as the Michael Jordan of endowment investing. We have rarely seen interviews of him but we came across this one in November of last year at the Council on Foreign Relations. He was interviewed by Robert Rubin the former US Treasury Secretary and CEO of Goldman Sachs. My take on “uncorrelated assets” is that a good portion of what he is talking about is cash or cash like instruments that do not move with the stock market.

RUBIN: Did I hear you say that you have 32 percent now in uncorrelated assets?

SWENSEN: That’s correct.

RUBIN: More than you had in ’08, when we were in recession?

SWENSEN: Slightly more, yeah.

RUBIN: Do you think we’re in recession, or what scares you that you really want to have a recession-level of cash?

SWENSEN: Yeah. So I’m not worried about the economy so much. I have no idea what economic performance is going to be over the next five or 10 years. What I’m concerned about is valuation. I think when you look at pretty much any asset class anywhere in the world, it feels expensive. And the handful of areas that I talked about where I thought there were opportunities are kind of niche-y—short-selling, Japan, I think there’s some opportunities in China and India, although it’s hard to call either of those markets screamingly cheap either. So it’s really a question of valuation, not a question of economic fundamentals.

For now we ride markets higher. We ride them higher with lower equity exposure and lower durations but ride them we must as our clients need a return on their assets to provide for current and future liabilities.  But we grow in caution as giddy investors confidence grows with their account balances. We are concerned because valuations are historically high because interest rates are historically low. If we believe that asset valuations are a derivative of the risk free interest rate then shouldn’t valuations be falling as interest rates are rising? Or, perhaps, valuations will just drop off a cliff when interest rates hit some theoretical number? Will it be 3% on the 10 year? 4%? 5%? No one knows this theoretical number so is it not prudent to scale back your risk allocation given that higher interest rates are on the way? The frog is in the pot. The water is getting warmer. You cannot plan to get out before everyone else. We recalibrate our risk perspective. The trick is that human nature has us chasing higher and higher equity prices because we have fear of missing out.

The market is a massive naval ship running full steam ahead. It doesn’t stop on a dime. The markets could continue to rage. We recalibrate and adjust our asset allocations because when turning points come they will come quickly and seemingly come out of the blue. The Fed cannot react to every market twitch and if they are truly dedicated to reducing their balance sheet then they will have to raise their pain threshold and that makes the Fed Put lower (and more painful) in terms of the level of the S&P 500. For now we recalibrate, accept slightly lower rates of return and brace for a shock with non correlated assets as our cushion.

We continue to believe that central bank purchases will dictate asset pricing and while we can try and predict when asset flows will turn negative we cannot predict when markets will react to that reversal in flow. For now buy the dip still reigns while volatility selling strategies are de rigueur. In a self reinforcing loop the current paradigm reflects an assumption of the continuance of the status quo and trades built upon that will grow ever higher in AUM. That will make the break all the more painful and swift.

 What’s Next?

In economics, things take longer to happen than you think they will, and then they happen faster than you thought they could.”– Rudiger Dornbusch

Since November of 2016 we have postulated that we were on the verge of an animal spirits led melt up and we projected that much like 1987 we would see a 30-35% rally in markets before a letdown in prices. We may have underestimated the animal spirits. A strong 2017 followed by a strong start to 2018 could lead to further gains. We may also have underestimated current market structure as it may be causing markets to have longer, less volatile regimes and that regime change may become less and less frequent.

We feel that while we are in the late stages of a bull market it is best to pull back on risk and while late stages of bull markets can see spectacular returns we nor anyone else knows when that comes to an end. So for now we are in it to win it but just a little less in.

2018 has come in like a lion. We think that a correction in 2018 is likely and how the Federal Reserve responds to that correction is likely to determine how long and how deep that correction is. Tax reform is priced in and economic news has been positive. While those positives are now baked in the cake disappointing actual results from tax reform could impact pricing. Also, impact could be felt from rising bond yields as investors seek safe haven in bonds over stocks. This week the rate on the 2 year bill rose above that of the S&P 500 yield for the first time since 2008. Investors may begin to see bonds as an alternative to equities. If a correction should come we would expect it to be sharp and scary but will set equities up for another leg higher in 2019 and beyond.  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.

As investors, our job is NOT making the case for why markets will go up. Making the case for why markets will rise is a pointless endeavor because we are already invested. If the markets rise, terrific. We all made money, and we are the better for it. However, that is not our job. Our job, is to analyze, understand, measure, and prepare for what will reduce the value of our invested capital. –Lance Roberts

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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My Name is Mario and…

We have talked about the rise in central bank balance sheets and how those balance sheets may be THE most important metric when investing in this era. The European Central Bank (ECB) made an announcement this week and it seems that central bankers while promising to cut back and reduce balance sheets are already hedging their bets. The ECB, while slated to end their form of QE in December, announced that they will continue to use until September of 2018. But they are promising to cut back their monthly usage in half. Like an addict that says that they will quit just not right now. This form of monetary heroin is responsible for the rise in asset prices and it is causing distortions like European High Yield yielding less than the US 10 year. This is the height of lunacy. We are not happy being right. It is our job to make money so while central bankers print and buy assets we stay at the party. The bigger question is will central bankers ever stop printing?  While we see that the G-4 central bank balance sheets are slated to stop growing in 2018 we question the will of central banks to stop the monetary heroin.

We are stuck in our thesis on the concept of the “Fed Put” and how that is going to evolve and effect asset prices. One of the drivers of this relentless march higher is the idea to BTFD. Buy the Dip. Every dip in stock prices is bought because you don’t’ have to worry because if there is a real crisis the central banks will come in and back stop the market. So you find yourself asking, will prices ever go down? That alone has us nervous. If something cannot continue forever it won’t. The market will go down at some point. It always does and it is never different this time.

Tech stocks had a phenomenal week as we saw Amazon up 13% and Intel up 7% on Friday alone. It is starting to feel like a mania as the animal spirits have taken over. The broader market did show some technical signs of weakness. A warning shot across the bow perhaps? We still think that a tax plan passage is a sell the news event.

This is a one way market and investors need to recognize this and take steps to manage risk. Recalibrate. Market structure is responsible. 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.

The ten year Treasury broke through 2.4% and closed the week at 2.416%. We are looking for a new range between 2.4% and 2.6%. Above 2.6% and the warning lights will come on. The bulls are still firmly in control. 2600 on the S&P 500 is the next logical stop. Much as 666 loomed large in early 2009 the number 2666 now looms large for the S&P 500 and is less than 4% away from current levels. Wall Street and investors are a superstitious lot. The animal spirits are unpredictable and in control. Gotta be in it to win it but, maybe just a little less in.

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

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

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

Very Superstitious

There is no getting around the 30th Anniversary of the Crash of 1987 and all of the attendant media coverage this week. We ourselves have been writing about it all year. While history doesn’t repeat it does rhyme and we fancy ourselves not as divine prognosticators but as contingency planners for your wealth. That is why we are slaves to history and attempt to continually create plausible scenarios and investing thesis.

When we look back on the Crash of ’87 we can learn several things. The overarching lesson is that it is never different this time. You can read more on that in our recent quarterly letter here. Here is a quote from Howard Marks and his experience on that October day in 1987. Marks was the Head of the High Yield Department at The Trust Company of the West at the time.

 Portfolio insurance convinced people that they could somehow own more stocks without increased risk, which is fanciful. And like all silver bullets, it didn’t work.

-Marks

 It is never different this time. Risk is still risk and the widely accepted reason for the excessive price action that day was portfolio insurance. The selling of volatility and risk parity are today’s version of portfolio insurance. Investors are selling volatility with abandon. That creates a lower implied risk environment. Those figures go into automated strategies that take on more and more risk as stocks rise and volatility falls. More stocks with less risk- Great idea! 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.

 One of the drivers of this relentless march higher in stock prices is that there seems to be a consensus that there is no reason to fear the Federal Reserve. After all if stock prices do come crashing down the Fed will be there to support markets. Right?! So why ever sell? You just buy more if prices fall because the Fed has your back. What could possibly go wrong?

Trump’s tax plan is looking to be moving along. A passage of that tax plan in an economy which is already at full employment could tip the Fed into aggressive tightening mode. A passage of this tax package may be “ill timed” to quote NY Federal Reserve’s Bill Dudley. Dudley is considered the second most powerful person at the Federal Reserve. His remarks mesh very well with Michael Hartnett’s recent comments over at Bank of America. Hartnett has been calling for a melt up this year as we have. Hartnett is looking for that end with a spike in wages and inflation. If Trump’s tax package is passed that may be just what we get. Higher wages and inflation may force the Fed’s hand to tighten more aggressively than planned and investors may again be shocked into “fearing the Fed”. Hartnett’s call is for a 10% correction and not a 1987 style crash. For the record, we also do not think that markets will crash because of the fervent belief in the “Fed Put” but a correction is well overdue.

The ten year Treasury is still stuck between 2.1 and 2.4%. If it breaks through 2.4% then 2.6% is the new area of resistance and that should be a tough area to get through. Why are we harping on the 10 year lately? It should be our canary in the coalmine for equities. Higher interest rates could break the back of this equity market. The question is what is the magic number? A decisive break through the 2.7-2.8% level could mean that rates are headed higher longer term breaking the 30 year down move.

The punch through 2500 on the S&P 500 still has the bulls in control. Like a running back that has open field in front of them the S&P is taking off. There are no real resistance points as it is all theoretical now. 2600 is the next logical stop. Much as 666 loomed large in early 2009 the number 2666 now looms large for the S&P 500. Wall Street and investors are a superstitious lot. The animal spirits are unpredictable and in control. All is still going according to our thesis of a 1987 type melt up. The tax agenda from the White House could be a “sell on the news” event. Gotta be in it to win it but, maybe just a little less in.

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

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

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

 

 

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

One More Thing to Consider in Retirement

One of the next big crisis’ in the United States is pension funding. If you think that this will not affect you think again. It will hit you right in your wallet when you can least afford it – in your retirement. As a good portion of my readers and clients are approaching retirement this probable pension crisis should factor into where you retire.

I have been reading John Mauldin’s Thoughts From the Frontline for over twenty years on the recommendation of Arthur Cashin. If you haven’t read John’s work here is a link to his website. It is sent to over 1 million readers a week. It is well worth your time. Here are the highlights from John’s latest letter in regards to the looming pension crisis.

Total unfunded liabilities in state and local pensions have roughly quintupled in the last decade.

According to a 2014 Pew study, only 15 states follow policies that have funded at least 100% of their pension needs.

The only way to bring it out of the spiral is with huge cuts to other needed services or with massive tax cuts to pension benefits.

But wait, it gets worse. The graph we showed earlier stated that unfunded pension liabilities for state and local governments was $2 trillion. But that assumes an average 7% compound return. What if we assume 4% compound returns? Now the admitted unfunded pension liability is $4 trillion. But what if we have a recession and the stock market goes down by the past average of more than 40%? Now you have an unfunded liability in the range of $7–8 trillion.

We throw the words a trillion dollars around, not realizing how much that actually is. Combined state and local revenues for the US total around $2.6 trillion.

This issue is going to set neighbor against neighbor and retirees against taxpayers. It will become one of the most heated battles of my lifetime. It will make the Trump-Clinton campaigns look like a school kids’ tiddlywinks smackdown.

http://www.mauldineconomics.com/frontlinethoughts/pension-storm-warning

The ten year Treasury hit 2.28% mid week and looks to be headed back to resistance at 2.5%. A decisive break through the 2.7-2.8% level could mean that rates are headed higher longer term breaking the 30 year down move.  The punch through 2480 on the S&P 500 still has the bulls in control. The next target on the S&P 500 is 2540. The market is still firmly in an uptrend but there are signs that bulls may not be all that strong. Gallup poll has 68% of investors optimistic about the stock market over the next year. That matches the record high for that poll set in January of 2000.  Investor sentiment is very high which is a contra indicator while valuations are in the 90th percentile historically. The animal spirits are unpredictable. Gotta be in it to win it but maybe just a little less in. Keep an eye on the 10 year and commodities.

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.

 

 

 

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.

https://www.federalreserve.gov/newsevents/speech/fischer20170627a.htm

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 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.

 

 

 

Tops and Bottoms

 

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

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

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

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

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

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

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

8/3/17 Cashin’s Comments

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

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

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

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

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

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

The Great Escape

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

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

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

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

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

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

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

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

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

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

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