It’s Never Different This Time

 IT’S NEVER DIFFERENT THIS TIME

“I learned early that there is nothing new in Wall Street. There can’t be because speculation is as old as the hills. Whatever happens in the stock market today has happened before and will happen again. I’ve never forgotten that.” – Jesse Livermore

Jesse Livermore was a legendary Wall Street trader and his biography “Reminiscences of a Stock Market Operator” is a must read for anyone that is in the investing game. As an investor one of the most important things to remember is that it is never different this time. As much as we think that our time or era is unique to history we are all still human. We react psychologically to whatever stimuli are present at any given time just about the same way that our caveman predecessors did. The names change but the game stays the same.

Up-and-down cycles are usually triggered by changes in fundamentals and pushed to their extremes by swings in emotion.  Everyone is exposed to the same fundamental information and emotional influences, and if you respond to them in a typical fashion, your behavior will be typical: pro-cyclical and painfully wrong at the extremes.  To do better – to succeed at being contrarian and anti-cyclical – you have to (a) have an understanding of cycles, which can be gained through either experience or studying history, and (b) be able to control your emotional reaction to external stimuli. – Howard Marks Founder Oaktree Capital

The Federal Reserve and central banks around the world have added and drained liquidity over and over again repeatedly over the last century. What is slightly different this time is that the Federal Reserve and central banks around the world have added more liquidity than they have ever done in history and in concert. That is different but the results are always the same. When central banks add liquidity asset prices will soon follow suit and rise with the new found liquidity. When the Fed subtracts liquidity the market will also soon follow in negative course. You cannot predict when or how far the market will move but there is no point in fighting the Fed. Whatever they do the market will do in time.

I am not saying that the market will crash. I am saying that as the Fed and other central banks remove liquidity then markets at some point will begin to price that into the equation. I can’t tell you how far markets will move because I cannot tell you how far the central banks will move. It was the former NYSE President and Fed Chairman William McChesney Martin who coined the phrase that is was the central banks job to take away the punch bowl when the party was just getting started. Central banks around the world are now hinting that it is time to think about removing accommodation and draining the punch bowl. The Federal Reserve has raised rates twice in 2017 and it looks like they may do it one more time in December of 2017.

Along with these rate hikes committee members have voted to start reducing the Fed’s balance sheet this month. What does that mean exactly? The Federal Reserve will be mopping up some of the liquidity that has been splashing around markets and enabling inflation in asset prices. Eventually, (QT) Quantitative Tightening will have the desired effect from the Federal Reserve. The other major central banks around the world are still adding liquidity but the Bank of England and the European Central Bank (ECB) appear ready to at least stop adding liquidity. The Bank of Japan is charting its own course and continues to add liquidity. The US Federal Reserve has begun draining liquidity as its journey has been mapped out and begins this month. The pace is slow and steady but there will be a tipping point where the reduction in liquidity will impact asset prices. When is that tipping point? That is the $4 trillion question.

While the Federal Reserve is trying to extricate itself from its monetary experiment the first place we will look for clues to the trajectory of asset prices will be the US Dollar. As the quote below from Ambrose Evans Pritchard explains the US Dollar is our barometer and we do expect it to generate a headwind for equity and credit alike.


“The message from a string of BIS [Bank of International Settlements] reports is that the US dollar is both the barometer and agent of global risk appetite and credit leverage.
Episodes of dollar weakness – such as this year – flush the world with liquidity and
nourish asset booms. When the dollar strengthens, it becomes a headwind for stock markets and credit.”

Ambrose Evans-Pritchard International Business Editor of The Telegraph.

In the last several weeks the US Dollar has headed higher and the yield on the 10 Year US Treasury has headed north of 2.35%. If the US dollar continues to rally as the Fed takes away the punch bowl and tightens policy then we may see a reversal of what has transpired so far in 2017. Small and mid cap stocks may outperform while gold and emerging markets under perform. 

THE BEAR CASE

It is getting harder and harder to make the bear case. That alone is troubling. Markets have shrugged off a potential hot war with North Korea, US Presidential investigations, and the complete and utter failure of Republicans to pass any legislation of consequence in Washington DC.  But if we were to point to any one thing that the bears can hang their hat on it is the historically high valuations in asset prices. The most astounding valuation that we have seen is that European High Yield debt now yields less than US Treasuries of the same duration! European junk debt is less risky than US government debt? Incredible. While valuations alone do not a bear market make, historically, valuations in the highest percentiles portend lower than average returns in the future. Here are some of those excessive valuations.

  • The S&P 500 is selling at 25 times trailing-twelve-month earnings, compared to a long-term median of 15.
  • The Shiller Cyclically Adjusted PE Ratio stands at almost 30 versus a historic median of 16.  This multiple was exceeded only in 1929 and 2000.
  • The “Buffett Yardstick” – total U.S. stock market capitalization as a percentage of GDP – new all-time high last month of around 145, as opposed to a 1995-2017 median of about 100.
  • The lowest yields in history on low-rated bonds and loans.
  • All time low yields on emerging market debt.
  • The CNN Money Fear & Greed Index of market-based risk-appetite gauges is at 95 on its 100 scale.
  • S&P 500’s Longest streak without a 5% drop of over 330 days
  • Institute of Supply Management’s manufacturing Index above a reading of 60 and highest reading since 1994.

Equity markets are in the midst of a multiyear run as seen by the rise in values since the Great Financial Crisis (GFC) in 2008-09. Those valuations have risen to historical levels and are now in the 90th percentile historically. Research shows us that returns in the 90th percentile run below average. Investors are acting as if there is no risk in holding assets. The definition of investing lies in the risk return tradeoff and that is seemingly being ignored.

Another factor in the bear case is the bond market and the possibility of rising yields. In our last quarterly letter we wondered about who was going to be right – the bond market or the stock market. We have always gravitated to the bond market as the older, wiser brother of the stock market.  The bond market is not done giving us clues as we believe that rates, while still mired in the range between 2.1% and 2.7%, may yet break out one way or the other. A rate rise through 2.7% could quickly generate much higher rates and that could douse the enthusiasm of the stock market bulls.

THE BULL CASE

While the shrinking of central banks balance sheets has us cautious we need to remember that, even with the Federal Reserve telegraphing to the market that they intend to shrink their balance sheet, central bank balance sheets worldwide have still grown at 8% year over year. The bulls may keep control of the market if central banks other than the United States continue to expand their balance sheet. It is now the world’s balance sheet that has our attention and not just the US Federal Reserve’s.

As central banks remove the punch bowl they will be telegraphing their moves to the marketplace and moving ever so gently to the sidelines and that may appease markets for now. The conditions for a market crash do not seem to be in place. In contrast, the conditions of a spiraling melt up seem to be more likely as we have said for some months now. Investing is an exercise in mass psychology.  Investors have gotten used to investing gains and see no risk on the horizon. Over inflated valuations have professional investors trimming their sails and cutting equity and bond exposure. We continue to hear the same arguments of distorted valuations and have made those same arguments ourselves but high valuations alone will not stop a raging bull market. While seemingly every investor is expecting a sell off from such high valuations they may find themselves falling behind their client’s expected returns. That may force professional investors to chase returns in the last quarter of 2017.

Jeff deGraaf, chairman and chief technical analyst at Renaissance Macro Research, is telling clients this week the risk of a “melt-up” in stocks is “very real.”

“Given the good economic data, loose credit conditions, benign inflation data and investor’s sentiment, we think the risks of the Fed (and G7 central banks) blowing an asset bubble are above average,” he says. Cyclical indicators such as the ISM purchasing-managers index above 60, with unemployment under 4.5 percent, are arguably “too good,” correlating with poor 12-month returns for stocks. “But until credit conditions deteriorate, we’re holding on to this tiger’s tail,” deGraaf concludes. -CNBC

We will continue to keep a close eye on the bond market. If equity markets were to move drastically lower we believe that the Federal Reserve will act quickly to support the market. It has widely telegraphed its intention to slowly roll down its balance sheet. If that roll off should cause trepidations in the stock market we believe that they will quickly reverse course and, in dire circumstances, perhaps even begin buying equities. The Fed Put is alive and well.

While we have foreseen a 1987 type of market since the election it is impossible to predict the “top”. What makes us most uncomfortable about calling an end to this bull market is that seemingly everyone else is attempting the same. When everyone expects something to happen – something else will. (H/t Bob Farrell)

WHAT TO DO 

It is impossible to know where the top of a market is and no one wants to feel foolish for having left the party too soon. In order to meet our investing goals we cannot afford to leave the party too soon but what we can do is re-calibrate. When historical valuations are in their highest percentile we can move to investments with better risk reward profiles and if that investment is cash, then so be it. Successful investing is accomplished by doing what is unpopular or uncomfortable. 

Even though no one can ascertain when we’re at the exact top or bottom, a key to successful investing lies in selling – or lightening up – when we’re closer to the top, and buying – or, hopefully, loading up – when we’re closer to the bottom. 

“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. Howard Marks

 That is why we have taken steps to reduce duration at Blackthorn to very low levels. Duration is a measure of bond holdings sensitivity to a rise in interest rates. Our lowering of bond duration in client’s portfolios will cushion any blow to our portfolios given higher rates from the Fed. In fact, our duration is so low that higher rates could conceivably help our performance in the longer run as we will be reinvesting at higher rates.

September is historically the weakest month of the year. 2017 has not been kind to seasonal adjustments as shown by the market’s strength this summer (Sell In May and Go Away) and evidenced by its strong showing in September. But when a traditionally weak period is strong it gives more weight to the bull thesis. A strong September has been shown to be good for stocks, historically, as they portend a strong 4th quarter. According to the Leuthold Group, an equity research firm, since 1928 there has been 29 Septembers where the S&P 500 reached a 12 month high. In the 4th quarter following those 29 new highs the S&P 500 was up 80% of the time for an average return of 3.7%.

We, at Blackthorn, attempt to achieve excellent risk adjusted returns over a full market cycle and not to mimic a benchmark in the short term. We strive to give the best service possible while being as transparent as we can in order to give the client confidence in our managing of their assets. It is that confidence that is the basis of sound decision making during market extremes. We continue to be risk averse amid historical valuations that have proceeded less than stellar returns over the last 100 years whenever they presented themselves. Successful management of assets emphasizing risk adjusted returns over time requires patience and a thoughtful investor base which we have been fortunate to attract over the years.

Our risk adjusted returns show that we have chosen the right assets to rotate into while we continue to be on guard and show patience as this bull market evolves. Our experience has been that chasing returns over time does not work and paying strict attention to valuations in the marketplace and expecting some reversion to the mean is the correct approach. We manage risk. Right now investors are not getting paid an appropriate premium for taking risk, and so, we recalibrate. As Jesse Livermore once said, that it was never my trading that made me money, it was the waiting.

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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Diogenes and The Bond King

Jeffrey Gundlach from DoubleLine Funds gave another one of his webcasts this week. In a world of investing you have to know who is telling you their honest thoughts and who is just talking their book. We believe that Gundlach tells you his honest thoughts and his track record shows that he is well worth watching. The first thing that you need to know is that Gundlach is a bond fund manager who is not that high on the bond market right now. The “Bond King” doesn’t like bonds. How is that for honest? The Greek philosopher, Diogenes, would have never found what he was looking for on Wall Street, but then again, Gundlach is in LA.

Gundlach is constantly on the search for anomalies that may warn of an impending recession. In his “chart of the day” Gundlach presented a chart showing a ratio of the value of commodities to the S&P 500. The median value over the last 50 years stands at 4.1. That ratio is currently less than 1. That tells us that either commodities are very cheap or equities are expensive (or a combination of both). The last two times it got this low was just before the 1970’s Oil Crisis and during the Dot Com Bubble. Gundlach predicts that commodities will gain steam next year when the US 10 Year rate rises. Time to look at commodities.

One chart that Gundlach brought up was what we would term “The Chart of Next Year – 2018”. It shows the growth in the G4 Central Bank balance sheets since the beginning of the GFC until now and it overlays the rise in Global equity value. If you accept that the rise in equities was fueled by the rise in central bank balance sheets understand that the G4 balance sheet is projected to shrink beginning in 2018. Stalled growth in central bank balance sheets will equal stalled growth in equity prices and lower returns. A decline in central bank balance sheets will lead to a decline in equity prices around the globe.

QE has been highly correlated with risk assets (specifically the S&P 500) “levitating,” Gundlach said. That has been true since 2009 and on a global basis, he said. The actions by other central banks have lifted the prices of non-U.S. equity markets.

Gundlach said that when earnings are revised down, equity prices fall and vice versa. Except that wasn’t true when QE was going on. Now that central banks are tapering globally (“quantitative tightening”), it is a bad sign for equities, according to Gundlach.

“Maybe we will start getting into trouble in mid-2018, as QE goes away and the German 10-year yield goes up,” Gundlach said.

West Texas Crude is still below $50 a barrel but is challenging that critical level of resistance. The Saudi Arabian government is rumored to be looking at delaying its very important IPO of Saudi Aramaco.  Saudi Aramco is their state owned oil company and the biggest oil company in the world. It is valued in the Trillions of dollars!! Could it be because they are seeing higher oil prices on the horizon? $60 a barrel in crude would bring in substantially more money in the IPO than $50. It’s a big bet by a big and knowledgeable player.

Just to review. This week we experienced Hurricane IRMA, North Korea test fired a missile across Japan, terrorism in France and England while hard economic data continued to deteriorate in China and the US. So, logically, we should have new all time highs in the stock market and the best week of the year for the Dow Jones Industrials. By the way, if you needed any more evidence that the computers are in charge the S&P 500 closed Friday at exactly 2500. While we are on the subject of crazy Jeffrey Gundlach pointed out in his webcast that European junk bonds have the same yield as a U.S. Treasury basket (the Merrill Lynch U.S. Treasury Index). He said that spread is typically 700 basis points or more.

Gold was able to hold $1300 this week.  The ten year Treasury rocketed off its lows of 2.05% to close the week at 2.20% it what looks to be a failed breakdown. The S&P 500 broke through 2480 to close the week at 2500. That makes the next target on the S&P 500 2540. The caution signs are still there but the market is still firmly in an uptrend. The punch through 2480 on the S&P 500 could instigate the animal spirits and give the bulls room to run. Friday was a Quadruple Witching meaning that 4 sets of options expired on the same day. It happens four times a year. Things can change suddenly after expiration as all hands were more concerned with the options market than the stock market itself. Early next week is going to give us better clues as to if this breakout in the S&P will get legs. 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.

 

 

 

Caution Flags

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

“…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 Jackson Hole 8/25/17

In Janet Yellen’s speech this week at Jackson Hole she brokers the subject of market structure and her anxieties surrounding the structural integrity of the market given additional stress.  Will current market structure provide the liquidity needed given a stressful event? We think that it will not and a temporary condition will be created consisting of a lack of liquidity will happen for a time. The pessimist sees what would be a very scary moment if market structure lets us down in the next stressful period. What we see on the horizon is a market structure that we think will fail and will create a big opportunity. Market structure. We see the risk as real and evidently we are not the only one.

Dow Theory is the long running thesis that if Dow Jones Industrials are hitting new highs then its brethren in the Dow Jones Transports should be hitting highs as well. The Industrials make the goods and the Transports ship the goods. So if the one is doing well shouldn’t the other? We are not the only one concerned. By way of Arthur Cashin, comes Jason Goepfert recent notes on the topic.

Jason Goepfert, the resident sage at SentimenTrader noted the recent wide divergence between the Dow Industrial and Dow Transports. He recalls that prior similar divergences have rarely been resolved in a bullish fashion. Here’s a bit of what he wrote: The Dow indexes are out of gear. The Dow Transportation Average continues to badly lag its brother index, the Dow Industrial Average. The Transports are not only below their 200-day average, they just dropped to a fresh multi-month low. Yet the Industrials are more than 5% above their own 200-day average, a divergence which has tended to resolve to the downside for both indexes, especially in the shorter-term.

While we have the caution flag up we are intrigued by how many analysts and investors are calling for a downturn. When everyone expects something to happen something else usually does. From Bloomberg this week comes notes from Morgan Stanley, HSBC and Citigroup that markets long term relationships are breaking down and signaling that a correction is in store.

Analysts at the Wall Street behemoths cite signals including the breakdown of long-standing relationships between stocks, bonds and commodities as well as investors ignoring valuation fundamentals and data. It all means stock and credit markets are at risk of a painful drop.

“Equities have become less correlated with FX, FX has become less correlated with rates, and everything has become less sensitive to oil,” Andrew Sheets, Morgan Stanley’s chief cross-asset strategist, wrote in a note published Tuesday.

https://www.bloomberg.com/news/articles/2017-08-22/wall-street-banks-warn-winter-is-coming-as-business-cycle-peaks

At the beginning of this week stocks were very oversold and due for a bounce. Equities were so oversold, in fact, that we did buy some equities for underinvested and new clients. The S&P is now approaching very important resistance levels at 2450 and again at 2475. 2475 is THE resistance level that the market has been struggling with since mid July. The market looks tired here and the seasonality is not in its favor with September and the October debt ceiling approaching. A failure at 2475 could give the bears confidence. The S&P 500 saw support at its 100 Day Moving Average (DMA) and the 2420-2400 area is support for now. The next support is the 200 DMA at 2350 which is down about 3.7% from here. If markets fell to that level that would be a 5.5% drop from the all time highs, certainly, not a major crisis. However, the bulls would need to hold the 2350 level or then the bears are in charge. We are still concerned that while the S&P 500 has held in there the Russell 2000 is struggling. That coupled with high valuations and a negative Dow Theory signal has us sending up caution flags.

 

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.

Fear and Greed

While most of America seemed to be mired in statue controversies and rumored and real resignations we choose to focus on making money for our clients. Our focus was on the FOMC Minutes that came out this week. We think that it has real clues as to policy and market direction (i.e. making money). Here, as follows, is the garbled Fed Speak hidden deep in the minutes which we will interpret for you.

This overall assessment incorporated the staff’s judgment that, since the April assessment, vulnerabilities associated with asset valuation pressures had edged up from notable to elevated, as asset prices remained high or climbed further, risk spreads narrowed, and expected and actual volatility remained muted in a range of financial markets…

 recent equity price increases might not provide much additional impetus to aggregate spending on goods and services.

 According to one view, the easing of financial conditions meant that the economic effects of the Committee’s actions in gradually removing policy accommodation had been largely offset by other factors influencing financial markets, and that a tighter monetary policy than otherwise was warranted.

We interpret the committee’s thoughts as, while the committee likes higher stock prices, a further rise in stocks isn’t going to help much. In fact, higher stock prices may actually increase risk. No one seems to be noticing that risk is elevated and hedging accordingly which only heightens risk even further. And by the way, our (the FOMC) tighter policies (raising rates) haven’t really done much and we are going to need to tighten policy much more than we thought. Was that a warning shot across the bow? The Fed doesn’t want stocks to go up much more and tighter policy is coming.

As always, from Arthur Cashin and his sources, comes a very interesting note about the technical aspects of the market. We study technicals because it gives us insight to the psychology of the market. The numbers show where Fear and Greed reside. After Jason’s note came out earlier this week markets were repelled by the 2475 area and fell 2% from that level. Here is Jason’s note.

While they closed within hailing distance of the day’s highs, the session had some very odd aspects. Here’s what the sharp-eyed Jason Goepfert of SentimenTrader noted in his report. More lows. Despite a 1% surge in the S&P 500, its best gain in months, and being within sight of an all-time high, there were more combined new 52-week lows than 52-week highs on the NYSE and Nasdaq exchanges. This is highly abnormal. Since 1965, it has only been seen a handful of days in 1998, 1999, 2000, and 2015 -Cashin’s Comments 8/15/17

NY Federal Reserve President Dudley sees chances of a Fed rate hike higher than the market is currently forecasting in December. Chances for that rate hike are now close to 50% and rising. The market continues to reject the 2475 area on the S&P 500. As a resistance area it is growing in its importance. The bulls still have the ball but they need to get their act together.

The S&P 500 is at its 100 Day Moving Average (DMA) and the 2420-2400 area is support for now. The next support is the 200 DMA at 2350 which is down about 3% from here. If markets fell to that level that would be a 5.5% drop from the all time highs, certainly, not a major crisis. However, the bulls would need to hold the 2350 or then the bears are in charge. The S&P 500 is 2.5% from its highs while the Russell 2000 is down more than 6%. The broader market indicator failed to hold its 200 DMA this week. Not a healthy sign. Always have some dry powder on hand.

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.

 

 

 

Anyone Have a Match?

The debt ceiling is coming! The debt ceiling is coming! Not quite Paul Revere but the Treasury market is showing signs that investors are getting concerned about the debt ceiling being reached in mid October as the CBO has warned. If Republicans can’t get a bill through that they have been working on for seven years how will they get the debt ceiling passed through the most polarized congress in history? Months ago we were looking at sweeping changes with the Republicans controlling both houses. Now, instead of tax reform, we are looking at a government shutdown. For once, gridlock in DC may not be so good.

We have been postulating for years that the reason that the economy is not doing well is that interest rates are too low and that there was no threat that interest rates would go higher. Think about it. There has been no incentive to borrow and buy a car, a home or invest in plant and factory. We can “put it off until next year” because we aren’t sure about the economy and rates aren’t going anywhere. We came across this blog post from Epsilon Theory and Dr. Ben Hunt. It is not the common thinking but that is usually where the answer lies.

The reason companies aren’t investing more aggressively in plant and equipment and technology is BECAUSE we have the most accommodative monetary policy in the history of the world, with the easiest money to borrow that corporations have ever seen. Why in the world would management take the risk — and it’s definitely a risk — of investing for real growth when they are so awash in easy money that they can beat their earnings guidance with a risk-free stock buyback?

(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 

I agree with Dr Hunt that at some point central bankers may be asking – Why is inflation accelerating as we raise rates? How come we cannot contain inflation? In talking to business leaders over the last several years we have not seen many talking up their industry as “hitting on all cylinders”. Last month we spent some time with a leader in the medical device field which he says is booming. Industry players are borrowing for plant and equipment for the first time in years. Combine some tax reform with higher rates and BINGO! That joint is jumping. Central bankers have been pouring gasoline on the pyre for years with no effect. Pushing on a string. Higher rates may be the match and with too much gasoline on the fire inflation may be the result.

Markets have been quiet. A little too quiet. We have read story after story about the volatility trade and how volatility has to spike higher to flaunt this overcrowded trade. We agree but this year has been very quiet. How quiet? This year has seen its largest drawdown of only 2.8% on the S&P 500. That is a far cry from the 14% average. According to LPL, the S&P 500 has not had a drawdown of 5% or more in a calendar year only 5 times in the last 60 years and it has not happened in 30 years. NASDAQ was up 11 straight days until Friday. According to LPL’s Ryan Detrick this has happened 21 times since 1980. The next month on average for the NASDAQ is up 2.6% with 16 of those 21 being positive months.

The tapering of the Fed’s balance sheet looks to be still on schedule to start in September. The debt ceiling is scheduled to be hit in mid October. Short interest is back down to levels last seen in the second quarter of 2007 at the market peak. Equities are at the top of their new range on the S&P 500. For now we see support at 2400 on the S&P 500 with 2475 providing resistance. 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 looms large. The animal spirits are still in charge as long as the flow of the Fed’s balance sheet is neutral to positive.

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.

Lucy’s Football

Remember Snoopy, Lucy, Charlie Brown and the gang in the Peanuts cartoon? There is the classic scene where Lucy convinces Charlie Brown to trust her and that she won’t take the football away again when he tries to kick it. Well, Lucy took the football away again this week. We have for months seen central banks moving closer to tightening policy and for risk to rise in the market. While members of the FOMC have been out in public in the last few weeks promising tighter policy, Janet Yellen , Chair of the FOMC, went in front of Congress this week and whispered sweet nothings in the ear of the market leading to one of the S&P’s best weeks this year.

In previous communications Yellen warned of the high valuations and the risks that are piling up as asset prices rise. She communicated to markets that financial conditions are getting out of balance and valuations are elevated. Markets seemed to accept the anticipated rate hikes along with a decreasing of the Fed’s balance sheet. Why did “Lucy” backtrack?  Markets are not headed lower. They have only slowed their ascent. Why is she panicking? This tells us all we need to know. ANY move lower in markets will be met with panic from the Federal Reserve under current leadership.

However, while the S&P 500 is having its best performance in months, underneath the surface, markets and internals are diverging. Movements among the large indexes are no longer in sync. We are seeing the large caps rise while mid and small caps refuse to play along. By way of Arthur Cashin’s Letter this week comes a warning from Jason Goepfert of SentimenTrader.

The correlation between the S&P 500 and the three other major indexes is the lowest in 10 years as they each go their own way. This kind of behavior preceded the market peaks in 2000 and 2007, back-to-back up days for the (NASDAQ) Composite while new 52-week lows grew and outnumbered new highs. That has only happened three other times – October 18, 2007, May 18, 2011, and October 27, 2014. The first two preceded major corrections while the latter led to a choppy market that set new highs then gave all the gains back.  7/11/2017

It seems as every day that goes by we read about another big name in the industry warning about a major sell off in the fall of this year. That make us nervous and not how you think. We are anticipating a selloff as well in what we have dubbed our “1987” trade. We have seen plenty of people we respect come around to our thesis. What makes us nervous is that when everyone agrees something else tends to happen.

This week it was JP Morgan CEO Jamie Dimon’s turn.

Central banks would like to provide certainty but “you cannot make things certain that are uncertain,”

All the main buyers of sovereign debt over the last 10 years — financial institutions, central banks, foreign exchange managers — will become net sellers now. 

“That is a very different world you have to operate in, that’s a big change in the tide,” he said. “The tide is going out.”

Ray Dalio Took his turn at the pulpit as well. We can’t help but agree with Dalio as it has been our contention since the dawn of the crisis that central bank largesse would have to end and when it did we would find that pumping money in would be a lot easier than taking it out. You can always buy in markets. You can’t always sell. That’s when risk rises and rises substantially.

For the last nine years, central banks drove interest rates to nil and pumped money into the system creating favorable carries and abundant cash. These actions pushed up asset prices… That era is ending. 

Central bankers have clearly and understandably told us that henceforth those flows from their punch bowls will be tapered rather than increase…..central bankers try to tighten at paces that are exactly right in order to keep growth and inflation neither too hot nor too cold, until they don’t get it right and we have our next downturn. Recognizing that, our responsibility now is to keep dancing but closer to the exit and with a sharp eye on the tea leaves.

Oil seems to be holding above the lows of January 2016 above $40 a barrel. Oil can’t seem to catch fire at the moment and seems range bound between $40-50 a barrel. Any time prices in the oil patch rise more supply comes on the scene. OPEC members are cheating as usual and pumping supply into the marketplace. Keep an eye on financials. Financials and oil could hold the key here. If financials rally the market will run with them. There are only about six more weeks of summer. The tapering of the Fed’s balance sheet looks to be still on schedule to start in September. We believe the market will change when the flow changes. Things are scheduled to start flowing out in September. Equities are still in the middle of the new range on the S&P 500. For now we see support at 2400 on the S&P 500 with 2475 providing resistance.   

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 Drive Higher

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

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

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

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

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

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

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

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

 

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

 

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

 

Crackdown, Smackdown and Fever

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

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

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

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

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

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

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

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

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

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

Until Something Breaks

Until something breaks. The old Wall Street adage is 3 hikes and a stumble. In his latest webcast this week, Jeff Gundlach, the current bond maven on Wall Street, made it clear that he expects the Federal Reserve to begin a campaign of sequential interest rate hikes until “something breaks”. In Cashin’s Comments this week, Arthur notes that David Rosenberg’s (Gluskin Sheff) research shows that since World War II, the Fed has embarked on 13 tightening cycles. Ten of those cycles led to recessions. While we do not see a recession on the horizon we do believe the Fed is behind the curve and may need to hike more aggressively than they would like. That will create imbalances throughout the system much like the sequential rates hikes in 1982, 1987, 1990, 1997 and 2007. The crises ranged from the Latin American debt crisis in 1982 to the S&L crisis in 1990 to the subprime debt crisis of 2007.

The question remains, will history prove right or are things different this time? I always hesitate to say “things are different this time” because that is always the death knell. It’s like when Jim Nantz says, “this kicker hasn’t missed an extra point all season” and the kicker then goes on to botch the critical extra point.  The reality is that the Fed may be so far behind the curve that this rate hike, the third of this cycle or even the fourth rate hike doesn’t affect the market but sooner or later the Fed will hike and something will break. They are academics and they never anticipate change. It’s like driving using the rear view mirror (h/t BR). The data is from the past and doesn’t show what is happening now. They will hike until something breaks. If they do not raise rates next week the animal spirits in the market may take equity valuations even higher. The Fed is boxed in.

Valuations are quite extended and perhaps rate hikes will bring things gently back to earth. Much is being made of the idea that there seems to be a global upturn in economies. The global upturn and Trump’s policies could provide more cover for the Fed to raise rates to try and cool valuations off. You have to remember that they are not the only central bank adding fuel to the fire. Japan, China and Europe are all doing the same. We see some cracks in the foundation as High Yield and small cap stocks lagged this week. It is no surprise that high yield struggled as West Texas Crude dropped 9% on the week to finish under the psychological $50 mark.

Momentum is very powerful and still in the hands of the bulls. Lots of positives out there but things are priced for perfection. Keep an eye on crude next week. Lower crude could continue to pressure high yield. High yield and oil could be the canary in the coalmine.

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.