Summer Heat?

The end of Q1 always brings out interesting insights from around the investing landscape. Quarterly Letters and the Milken Institutes’ Conference give the best and the brightest platforms from which to speak their collective investing minds.

From the Milken Institutes Global conference in Los Angeles comes a voice from the private equity world in the form of Josh Harris who is one of the founders of Apollo Global Management. Harris believes that deals are getting harder and harder to come by and that is due to over exuberant monetary policy from the Federal Reserve. Here is what Mr. Harris had to say.

The quantitative easing and the excess money and the low interest rates have driven pricing up of almost all financial assets to beyond what their intrinsic value might be.

So even though we can all chat about the benevolent growth environment that exists in the U.S. and to a lesser extent globally, the ability to make money and invest wisely on that is very, very challenging right now because you’re starting at a point in the valuation cycle that is very, very aggressive.

Almost every asset is overvalued.

He seems to have company with Daniel Loeb the founder of Third Point and one of the more successful hedge funds managers over the last 18 months.

Early optimism about the U.S. economy may have been “misplaced”, Third Point said on Thursday, adding that key sectors were showing “bubblelicious valuations” and were poised for more volatility in the months ahead.

In a letter to investors obtained by CNBC, the hedge fund said that Federal Reserve Chairman Janet Yellen’s shifting of monetary policy tightening was a contributing factor behind the market’s dour tone.

The correction, however, was “healthy”, said Daniel Loeb, Third Point’s chief, adding that the economy was beginning to accelerate after the punch of a brutal winter and heightening rate hike expectations. As the second quarter cranks up, “it now seems evident that investment performance will require a combination of good stock selection, patience, and deft trading,” he said. –CNBC May 1 2014

Another voice that we always stop and listen to is that of Jeremy Grantham founder of Grantham Mayo and manager of over $100 billion in assets. We spotted an interview of Jeremy Grantham brought to us from the folks over at Fortune. Grantham and his crew over at GMO in Boston have done extensive work on bubbles going back throughout investing history. He is very critical of the policies enacted by the Federal Reserve but goes on to note that most bubbles go to at least two standard deviations above the market’s mean valuations. For those of you scratching your heads trying to remember your college Stats 101 course Grantham feels that a bubble in the overall market would not exist until the S&P 500 hit 2,350 although his models suggest negative returns over the next 7 years based on current valuations.

 Okay, but then I guess that means you think stocks are going higher? I thought I had read your prediction that the market would disappoint investors.

We do think the market is going to go higher because the Fed hasn’t ended its game, and it won’t stop playing until we are in old-fashioned bubble territory and it bursts, which usually happens at two standard deviations from the market’s mean. That would take us to 2,350 on the S&P 500, or roughly 25% from where we are now.

So are you putting your client’s money into the market?

We invest our clients’ money based on our seven-year prediction. And over the next seven years, we think the market will have negative returns. The next bust will be unlike any other, because the Fed and other central banks around the world have taken on all this leverage that was out there and put it on their balance sheets. We have never had this before. Assets are overpriced generally. They will be cheap again. That’s how we will pay for this. It’s going to be very painful for investors.

In Grantham’s GMO Q1 2014 Letter he goes one to quote the Presidential Cycle which you have heard us refer to from time to time. Grantham and his team note how its effects are seen worldwide and in fact the effect is even greater in the United Kingdom. He calls for more bumps in the road and volatility to increase as the Fed exits from QE. He sees Year 2 of the cycle to be negative but Year 3 is the best year of the cycle and very positive.

Here is the link to the entire letter. A great read if you have the time.

GMO Quarterly Letter Q1 2014

The central theme here is that investors seem to be expecting an increase in volatility as the Federal Reserve tries to exit its loose monetary policy. Even more directly comes another voice telling us to prepare for more volatility while the Fed winds down its purchasing in the open market. This time it comes straight from the FOMC and departing Fed Governor Jeremy Stein.

Jeremy Stein, in one of his last speeches as a Federal Reserve governor, warned that the central bank still may face more bouts of market volatility as it winds down the most aggressive easing in its history.

Some investors may be “underestimating the degree of uncertainty about the future path of policy and are placing levered bets accordingly,” Stein said yesterday in a speech to the Money Marketeers of New York University. “So we may have some further bumps in the road as this all plays out.”

In response to an audience question, Stein said “it’s important that we not get goaded into thinking we’re responsible for minimizing market volatility.” -Bloomberg 5/7/14

A not so subtle shot across the bow if you will. We will take that as a warning that the Fed knows that volatility is coming. Read that last line from Bloomberg again. The Fed knows volatility is coming and it appears that they do not intend to do anything about it.  A 10% correction could easily morph into a 20% correction as the Fed tries desperately to remain on the sidelines in the event of a market retreat.

I think that I have depressed you enough. Remember though that there may be some light at the investing tunnel and no it is not a train. At least we hope. Volatility this summer and early fall as the Fed eliminates QE could lead to nice gains come spring time as the Presidential Cycle reasserts itself. Patience is a virtue. Small Caps continue to tumble and diverge from the broader market which is usually a warning sign. The 10 Year US Treasury keeps flirting with breaking through recent highs. That also could be signifying a weaker market.  Treasuries and Gold continue to be our risk temperature gauge. Keep an eye on Small Caps and the 10 Year US Treasury.

The changing opportunity set over time means you will do well by reducing risk significantly when faced with a less favorable set of expected returns and increasing risk when looking at a particularly favorable set of asset valuations. -Ben Inker GMO Q1 2014

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.

Correction Looming??

What say yee in 2014? Thanks to Arthur Cashin and the Trader’s Almanac we can see that the first day of any year is not much of an indicator but the first five days have a very good track record. That is, if the market is higher. The track record of a down start is a bit spottier.

According to the very helpful Trader’s Almanac, the last 40 times the market rose in the first five days, it closed up on the year 34 times (85%).  – Cashin

We were struck by a statement out of the International Monetary Fund (IMF) this week that 1930’s style debt defaults are likely. The following is a good portion of the article which outlines approaches governments may need to take to counteract the large levels of debt. High on their list is inflation.

Many advanced economies are likely to require financial repression, outright debt restructuring, higher inflation and a variety of capital controls, a new research paper commissioned by the International Monetary Fund (IMF) has warned.

The magnitude of today’s debt in Western economies will mean fiscal austerity will not be sufficient, Harvard economists Carmen Reinhart and Kenneth Rogoff said in the report, as policymakers continue to underestimate the depth and duration of the downturn. 

“It is clear that governments should be careful in their assumption that growth alone will be able to end the crisis. Instead, today’s advanced country governments may have to look increasingly to the approaches that have long been associated with emerging markets, and that advanced countries themselves once practiced not so long ago,” they said.

The economists suggest that there are five different outcomes in dealing with this debt and highlight a “prototype” recovery period from their previous research. Economic growth is discounted as being too rare by both economists and austerity packages (as seen in Europe since the financial crash of 2008) are deemed as being insufficient. Instead, the size of the problem suggests that debt restructurings would be needed, they add, particularly in the periphery of Europe. The solution they propose, based on a typical sequence of events in history, shows some combination of capital controls, financial repression (like an opaque tax on savers), inflation, and default.

“In light of the historic public and private debt levels…it is difficult to envision a resolution to the current five-year-old crisis that does not involve a greater role for explicit restructuring,” they said. – CNBC 01/03/2014 Matt Clinch

From an interview in Barron’s this week comes Ned Davis’ opinion on the year ahead. Ned Davis is the head of Davis Research and is very well respected in the street for his take on markets.

However, we’ve looked at all the bear markets since 1956 and found seven associated with an inverted yield curve [in which short-term interest rates are higher than long ones] – a classic sign of Fed tightening.  Those declines lasted well over a year and took the market down 34%, on average.  Several other bear markets took place without an inverted yield curve, and the average loss there was 19% in 143 market days.  We don’t see an inverted yield curve anytime soon.  So, whatever correction we get next year is more likely to be in the 20% range.

Thanks to CNBC and Piper Jaffrey comes a further outline of the US Presidential Cycle where we can look for more hints as to what 2014 has in store. Last blog post we noted the Presidential Cycle. Here are some further tidbits on the cycle and what that means for markets in 2014.

More particularly, the second year of the cycle—the year when midterm elections are held—tends to be volatile, with substantial pullbacks, corrections or outright bear markets not at all uncommon. The typical return during such years is just 5.3 percent, or barely half the norm.

Piper Jaffrey points out that since 1930, pullbacks during midterm years have averaged 17 percent.

“We suspect 2014 may be a good, but not a great year for the broader market (high single-digit to low double-digit return), with a higher level of volatility, and that relative strength-based sector exposure will be key to outperformance.”

Since 1945 the S&P 500 has posted 21 annual gains of more than 20 percent. The average gain the next year was 10 percent, with the index up 78 percent of the time.

However, every one of those “good” years saw drops of at least 6 percent and up to 19.3 percent. Four of those years triggered new bear markets.

So it seems that just about everyone is looking for a bumpy year ahead with a definable correction along the way. On an anecdotal basis we were in a small café in northern Georgia just west of the “middle of nowhere” when we heard two ladies chatting about the stock market. The one woman assured the other woman that there is a correction coming. That confirms it. Exactly everyone expects a correction this year. They could be right but we have learned that the market usually doesn’t work that way. The market has a habit of making a fool out of the most people that it possibly can. Could it be that the correction never comes? It is also possible that the correction is deeper than most expect. Always the contrarian and looking to second level thinking.

Emerging markets have suffered in the first two trading days of the New Year. The Emerging Markets ETF is down 4% in 2014. Thailand’s market is bearing the brunt and Turkey is off to a poor start. The end of QE brings money back into safer assets like the US 10 year as it flows out of stocks and hot money destinations like emerging markets. Keep an eye on emerging markets like Turkey and Thailand.

The 10 year is looking to bust out over 3%. The holiday may have kept the stock market in line. Seminal changes tend to occur on the calendar. Oil is down 8% over the last 4 trading days and gold is looking to bounce off of lows. Tax loss selling may be responsible for pushing gold to recent lows and bargain hunters look to be jumping in here. We certainly have oil, gold and the 10 year on our radar. We suggest you do the same.

Remember that the turn in the calendar in 2014 may entice managers to raise cash levels early on in the year as to not suffer any outsized losses at the start of 2014. A large loss early in 2014 would make for a tough slog all year. However, missing out on some upside early on in the New Year would be far easier to make up for on the performance side. That could make for a sloppy January. The Fed is back buying in the open market next week so that could help provide some support. They did not participate in the first two days of 2014.

Here is to a happy, healthy and prosperous 2014!!

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

I learned that courage was not the absence of fear, but the triumph over it. The brave man is not he who does not feel afraid, but he who conquers that fear. – Nelson Mandela

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.