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.

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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  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.

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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.

 

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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  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.

Fall Is In The Air

As much consternation was shown this week the S&P 500 was only down 1.4%. While markets have slowly marched ever skyward since 2015, lulling investors into complacency, market internals seem to be breaking down of late and just in time for the traditionally weak fall season. Our friends over at Lucena Research are at the forefront of applying Artificial Intelligence and Machine Learning to investment decision making. Their note to us on Monday researched some market internals as they dug up some dirt on the recent divergence of the S&P 500 and the Dow Jones Industrials. Their research came up with 39 instances of this type of divergence in the last 17 years. According to their research, over the next year the S&P 500’s average drawdown was 8.5% with the bottom of the expected bearish move coming within 7 months on average.  Here is the link to their note. Brilliant stuff.

http://lucenaresearch.com/wp-content/themes/lucena-theme/predictions/8-7-17.html

Also showing the internal weakness of the market is that the market has grown increasingly narrow in its ascent. An article from CNBC this week shows that 20% of the S&P 500 is in correction territory. A “correction” is generally accepted to be when a stock has retreated more than 10% from its high. 200 of the 500 stocks in the S&P 500 are in correction territory including Amazon, General Electric and Exxon. The S&P 500 is up over 9% in 2017. It shows how narrow the rally in stocks has become. The article goes on to note that less than 60% of the Russell 3000 is trading above its 200 day moving average (DMA). The 200 DMA is the dividing line between being long term bullish on a stock and long term bearish. The market’s strength is slipping.

Things are starting to get interesting. The market rejected 2475 on the S&P 500 as that area still holds as resistance. The bulls need to get back in gear. We closed the most eventful week in months in the middle of our range. We still see support at 2400. The likelihood of an actual shooting war in the Korean Peninsula is very low but we have never seen diplomacy by Twitter. The bulls need to hold 2400. As a side note we do find it refreshing that the market is actually taking geopolitics into account. The biggest contributor to the downside move this week may have been the short volatility trade. Shorting volatility has worked for years but we have been noting that it is a crowded trade and traders were due to get burned. Those traders looking for cover may have made an outsized contribution to the swings in the market this week. Might be time to take some chips off of the table if you haven’t already.

 

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.

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.

Taking Away the Punch Bowl

Happy Anniversary “Darling”!! The 10th anniversary of the GFC

This past month marked the 10th anniversary of the beginning of the Great Financial Crisis (GFC) and the dawn of the Era of Easy Money. It was also a 10 year anniversary for us. Last month marked 10 years since our move to Georgia.  Not a coincidence I assure you. Just for a second let’s take you back to the bubble before the Real Estate bubble- the Internet Bubble. We were on the floor of the NYSE during the great Internet Bubble when stocks went higher every day making college kids in their dorm room paper millionaires. That is until the bubble popped. We had the great fortune of spending our time as part of the team trading Lucent Technologies. In a world where it was usually one trader and one clerk for multiple stocks Lucent was in a league of its own. There were days that were so hectic with historical volume that it would take a team of three clerks and four traders just to handle Lucent. Such was a day in the life of the “Darling” of the Internet Bubble.

The greatest trading lesson of my life was learned through the bursting of the Internet Bubble and Lucent Technologies fall from grace. When bubbles burst things will get as bad as they were once good.  We watched as over the next several years Lucent Technologies traded from $79 all the way down to 79 cents.  Fast forward to 2006. We knew we were in a bubble in real estate in late 2006 when, with each passing week, my wife would tell me how much our house’s value had increased. We know that any object is only worth what someone else is willing to pay for it. We also knew that as the real estate bubble formed it would eventually, also, have to get as bad as it was good…and in 2006 -07 it was very good.

At that time we were following US housing starts as a way to judge the health of the housing market. In the spring of 2007 we noticed that housing starts had peaked the year prior and then they rang the bell. It is a legend on Wall Street that they never ring a bell at the top. Well, this time they did. In March of 2007 New Century Financial was the second largest subprime mortgage broker in the United States. A month later it would declare bankruptcy. We felt that we might be too late to escape from New York. We fortunately caught a buyer 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 investment lessons learned well. Trees do not grow to the sky, Know when to cut back on your risk and Sometimes, they do ring a bell at the top.

QT

We feel like central bankers are ringing the bell. While US monetary policy is foremost in our minds bankers from Europe to Japan to England to Canada have been promoting the idea that after 10 years of crisis it is time to normalize policy. While central banks have spent the last 10 years injecting liquidity into the system to pump up asset prices they are now talking about taking liquidity out – Quantitative Tightening (QT).  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. Ironically, during our time on Wall Street the phrase QT meant that you had 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. The reason growth is slow is due to the immense amount of debt on the United States balance sheet. In their economic paper Growth in a Time of Debt, Carmen M. Reinhart and Kenneth S. Rogoff, demonstrate quite effectively that the rate of growth in an economy shrinks as the level of debt when measured in comparison to GDP rises above a certain level. The slow growth economy in the United States is now being met by a central bank that seeks to raise rates and shrink its own balance sheet. Now instead of a tailwind, our slow growth economy and markets are looking at another headwind.

As we have written in prior posts, the Federal Reserve has 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 core which would have been stimulative to the economy. If you recall from previous musings we felt that the Federal Reserve was going to be obligated to get out in front of Trump’s plans or end up behind the curve. The Federal Reserve has indeed sought to get ahead of the curve by applying tighter money policy. Well, Washington is at a standstill and has not provided anything in the way of stimulative fiscal policy.

Given the lack of fiscal stimulus out of Washington, is the Federal Reserve making the ultimate central banker mistake? Are they now 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.  The Federal Reserve has raised rates three times in seven months while stating that they intend to raise rates again this year and three more times in 2018 while also beginning to decrease the holdings on their balance sheet starting in September of this year.

If the Fed is tightening policy then the logical question is why have rates moved from 2.62% on the US 10 year in March of this year down to the recent lows of 2.15%? Shouldn’t rates be going higher? The reason that rates are lower is that markets, quite simply, do not believe that the Fed will keep tightening and shrinking its balance sheet because the economy is not growing with enough pace and is in danger of hitting stall speed. That is shown in the flattening of the yield curve.

First the US then the World

While the United States is the most influential central bank around the world there is a coterie of central bankers who seem to be talking down asset prices in the last several weeks. They include the vice chairman of the FOMC Stanley Fischer, NY Fed chair William Dudley, John Williams from the San Francisco Federal Reserve, Mario Draghi from the European Central Bank (ECB) and Mark Carney from the Bank of England (BOE).

While we have known for some time that Equity Price Earnings ratios are in the upper quartile historically Stanley Fischer noted last week that “high asset prices may lead to future stability risks”. That is as about as close to saying “sell” as a central banker will come to actually doing so. He went on to say that it would be “foolish” to think that all risks have been eliminated and that it calls for “close monitoring” of rising risk appetites and that the corporate sector is notably leveraged. Yes, that sector is quite notably leveraged because of central bank policy. Historically low rates encouraged corporations to financially maneuver to borrow and buy back stock rather than borrow to grow their companies.  It is quite clear that central bankers are becoming more and more concerned about the levels of asset prices and their current trend ever higher.

The Federal Reserve’s John Williams spoke last week on Australian television and also made mention of the increased appetite for risk as he stated that “there seems to be a priced to perfection attitude out there” and that the stock market rally “seems to be running on fumes”. While John Williams is not a trader we respect his opinion when it comes to excessive risk taking in financial markets. He went on to say that, “as we move interest rates back to more normal; I think that that will, people will pull back on that”. Williams specifically mentioned a reach for yield when speaking of excessive risk taking.

 

“I am somewhat concerned about the complacency in the market. If you look at these measures of uncertainty, like the VIX measure, or other indicators, there seems to be a priced-to-perfection attitude out there”

                                                                                                                                           

The stock market still seems to be running very much on fumes, or is very strong in terms of that, so something that clearly is a risk to the U.S. economy, some correction there, is something that we have to be prepared for, and to respond to, if it does happen” – John Williams SF Fed

when financial conditions ease — as has been the case recently — this can provide additional impetus for the decision to continue to remove monetary policy accommodation. William Dudley NY Federal Reserve

Quite clearly we are seeing a shot across the bow from members of the Federal Reserve. 2018 is going to be a year in which central bank largesse is withdrawn to the tune of approximately $2Trillion. What we have seen so far from the United States central bank represents an opportunistic tightening from the Federal Reserve and a chance to cool down asset pricing while other countries were still pumping liquidity. 2018 represents a backing away from the decade long crisis era emergency policy measures.

Taking Away the Punch bowl

We think what we have here is a good old fashioned game of chicken. We believe that the Fed is raising rates and shrinking its balance sheet for two reasons. One is that they need bullets in the gun for the next recession. The second reason, and where we think the stock market has it wrong, is that the Fed is tightening due to financial conditions and not economic conditions. We believe that the Fed is tightening because asset valuations are becoming excessive. Basically, they are trying to pop the bubble before it gets any bigger.

We believe that 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 the balance sheet are headed. The Fed also believes that the market will discount their talking points as they move towards QT. Perhaps most importantly, we believe that the market will change when the flow changes.

We believe that is what the bond market is seeing that the stock market does not. The Fed wants markets to cool. The stock market thinks that the Fed will have no stomach for a market downturn as the Fed will be blamed for a recession that they themselves created with tighter monetary conditions. 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 to raise rates. Someone is going to blink first.

 There are several possible outcomes. One is that the Fed keeps hiking until something breaks. The conundrum is that if the market believes that the Fed will blink first and stop tightening then the market will continue its rise higher. If the market continues higher then the Fed will be forced to tighten more aggressively. The second possible outcome is that the market blinks and the Fed backs off. We think that the former is still a greater chance than the latter. Animal spirits are in control of the market and it takes longer to kill greed than to kill fear.  Our thesis about a 1987 type market still holds. The animal spirits are in control above 2400 on the S&P 500 and will be encouraged to force prices higher until the actual flow changes in the balance sheet of the Fed with underinvested money managers chasing the market higher along the way. Then the Fed’s hand will be forced to take away the punchbowl as the party rocks ever higher.

It is very difficult to predict market moves especially when Washington is so deeply involved. Our job is not to predict the market but unveil possible scenarios which to prepare for. We have scaled back on risk both in equities and in bond duration while trying to maximize the benefit of our cash positions. When the facts change – we will change.

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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Terry@BlackthornAsset.com

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

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

Published in: on July 2, 2017 at 8:00 am  Leave a Comment  
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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.

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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  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

The Sun Also Rises

How did you go bankrupt? Two ways. Gradually and then suddenly. – Ernest Hemingway The Sun Also Rises

We have been pointing towards a looming crisis in the municipal finance area. No, this is not a repeat from last week when we talked about the fiscal problems in the great state of Connecticut. It was Illinois’ turn this week to make headlines. The two big ratings agencies, Moody’s and S&P lowered their rating on Illinois to one step above junk as its budget impasse dragged onward. Illinois will likely reach junk status by July of this year. It is now the lowest rated US state ever.

Big banks are complaining that their profit’s are drying up and this is mostly due to Federal Reserve polices. The yield curve is flattening which is stymieing bank’s ability to make money on loans while volatility in markets has dried up pinching trading profits. JP Morgan, Bank of America and Morgan Stanley all warned on profits this week as trading profits are blamed. We expect the Federal Reserve to heed their calls. The yield curve problem may take longer to solve but we should expect the Fed to allow for more volatility in markets. JP Morgan warned on trading in May of 2014. The market continued to march higher another 9% into December of that year.

The head of one of the largest asset managers on the planet, BlackRock’s’ Larry Fink, warned the equity market is not appreciating the message from the Treasury yield curve and we have to agree. The bond market continues to rally with the US 10 Year yielding a paltry 2.15% at week’s end. It is a caution sign that both the bond and stock markets are rallying while the yield curve flattens. Investors may be chasing the stock market a bit as there seems to be some evidence of FOMO. Fear of Missing Out as the market hits new highs. The laggards from 2017 YTD rallied this week and that tells us that money managers are chasing. This plays right into our animal spirits theory and the 1987 scenario. History doesn’t repeat but human beings are susceptible to making the same mistakes over and over again.

Oil had another rough week as it is still below the critical $50 a barrel on West Texas Crude (WTI). New pension and retirement money entered the market as the calendar flipped to the month of June. Equities have broken out of the range that they had been trapped in for the last 3 months. The range of 2330-2400 on the S&P 500 was broken last week and the market extended its move to just below 2440. We expect this breakout to extend to 2475.  For now, volume is low and the trend is your friend.

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.

 

Back to the Future – 1987 and Trump

The Trump Rally continues as we expected. Given our thesis in our January Letter the possibility of a policy error by the Federal Reserve and/or the Trump Administration looks to be increasing. We believe that a policy error could set the stage for a substantial rally and then fall ala 1987. 1987 should not be looked at in fear but in anticipation of an opportunity. The table looks like it is getting set. Combine the clamor and excitement over deregulation and tax reform with a slow moving Fed and you have room for the Animal Spirits to run as investor euphoria takes hold. A 30% run from the lows before Election Day would put us squarely in Bubble territory as the S&P 500 would approach the 2750 area. A subsequent 30% retreat would bring us back to the 2000 area. Currently at 2367 on the S&P 500 one can see the potential for misstep by exiting one’s holdings completely and trying to time reentry. One solution is to dial back risk as you see markets rising and adding when the risk premium is more in your favor. Always make sure that you have the ability to buy when discounts come.

United States 10 year yields peaked at 2.6% in mid December and have been steadily falling back to the 2.3% level. We still think that the lows are in for the 10 year but the steady drip lower in yields has us concerned. The bond market is the much wiser brother of the stock market. The actions in the bond market have us thinking that investors see risk on the horizon. 2 year bond yields in Germany have reached new lows of negative (0.90%). NEGATIVE!! You buy the bonds and pay the government!

The Fed is struggling to make the March meeting look Live. The Fed has proposed that they will raise rates three times in 2017 and that just might not be possible if they do not raise rates in March. We believe March is the first key to understanding where equity markets are headed. If the Federal Reserve drags their feet and does not raise rates at the March meeting equity markets could overheat. Fed officials will then be forced to overreact at later policy meetings as they get behind the curve. The time is ripe for a policy error and markets could react swiftly.

From our good friend and mentor Arthur Cashin’s Comments February 23, 2017.

Is The Past Prologue? Maybe We Should Hope Not – The ever vigilant Jason Goepfert at SentimenTrader combed his prodigious files to see how many times the Dow closed at record highs for nine straight days. Here’s what he discovered: The Dow climbed to its 9th straight record. Going back to 1897, the index has accomplished such a feat only 5 other times. The momentum persisted in the months ahead every time, with impressive returns. But when it ended, it led to 2 crashes, 1 bear market and 1 stretch of choppiness. The five instances were 1927; 1929; 1955; 1964 and 1987. Here’s how Jason summed up his review: Like many instances of massive momentum, however, when it stopped, it stopped hard. Two of them led up to the crash in 1929, one to the crash in 1987, one to the extended bear markets of the 1960- 1970s and the other a period of extended choppy price action. So a little something for everyone there.

Momentum is towards higher prices. Stocks are extremely overbought. The S&P 500 has not seen a close of up or down more than 1% in over 50 sessions. Complacency is high. Machines seem to be running the market. Right now we are wary of market structure and overreliance on ETF’s. Know what you own. Keep an eye on bonds both here and in Europe. Europe is bubbling again. What if Germany left the euro? Discuss.

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

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

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

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

Trump Train or Bulldozer?

All eyes are on Trump and Washington DC as the Trump Train rolls through our capital. Trump has been even more aggressive in using Executive Orders and in speaking to foreign leaders than most suspected and that has the Street on edge. Maybe we need to rename the Trump Train to the Trump Bulldozer. While most eyes are on Trump we are increasingly focused on the Fed. The Fed must attempt to act in concert with the President and his fiscal policy to avoid overheating or stalling the economy but good luck to them anticipating his next move. The Fed has made noise in recent weeks that perhaps it could shrink the size of its portfolio. The Fed has been consistent, in that, there was an inherent belief at the Eccles Building that the Fed did not need to shrink its balance sheet and that doing so would be the last maneuver in its process of normalizing rates. Ben Bernanke, former Fed Chairman, took the time out to explain in his blog why that is simply not a good idea. Could it be that politics are playing a role at the Fed?

…best approach is to allow a passive runoff of maturing assets, without attempting to vary the pace of rundown for policy purposes. However, even with such a cautious approach, the effects of initiating a reduction in the Fed’s balance sheet are uncertain. Accordingly, it would be prudent not to initiate that process until the short-term interest rate is safely away from the effective lower bound. 

…the FOMC may still ultimately agree that the optimal balance sheet need not be radically smaller than its current level. If so, then the process of shrinking the balance sheet need not be rapid or urgently begun.  Ben Bernanke

 Why is the Fed now talking about shrinking its balance sheet and not raising rates? We would like to see more consistency from the Fed. They have insinuated that three rates hikes are due this year. After taking a pass on raising rates this week and not setting the table for one in March the market is now pricing in just two rate hikes. The first rate hike is due in June and the second in December. If you have not read our Quarterly Letter you can take a peak for a further discussion on the topic. The short version is, if the Fed raises rates too slowly Trump’s policies may overheat the stock market which is at already historical valuations.

 If Fed Speak can’t jawbone a March rate hike back onto the table, policymakers will have precious little room for error to make good on their promised three rate increases for the remainder of the year. Danielle DiMartino Booth

February is the worst performing month in the October – May period but investors are heavily loaded up on equities regardless.  By way of Arthur Cashin , here are the widely followed Jason Goepfert’s notes on the market’s latest gyrations or lack thereof.

 After spurting to a new all-time high in late January, the S&P 500 has had a daily change of less than 0.1% for five of the six sessions since then. That’s almost unprecedented, but there have been times when it has contracted into an extremely tight range after a breakout. Several of those have occurred in just the past few years, and all of them preceded a tough slog for stocks over the medium-term. Hedge funds are betting that the rally continues. Exposure to stocks among macro hedge funds is estimated to be the highest since July 2015 and the 4th-highest in the past decade. The three other times it got this high, stocks struggled as the funds reduced exposure and eventually went short.

Stocks have stalled. Investors are heavily exposed to equities. February is not the best month for equities so investors aren’t expecting much. The market has a way of surprising you. Could the market finally be ready to make a move? Investors seem to be heavily tilted to the rally side of the boat.

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.