Back to the Future

It has been our central operating thesis since the Great Financial Crisis that low interest rates+ low volatility+ larger central bank balance sheets would = higher asset prices. We are now entering an environment where we are seeing higher interest rates+ higher volatility+ smaller central bank balance sheets. We surmise that will = lower asset prices. It’s just math.

The big news this week was probably Trump’s trade policies and tariffs on steel. On that subject we do not believe that those tariffs will see the light of day. He will lose when he goes to the WTO and will be forced to retract them but, then again, we think that his threatened imposition of tariffs is probably only a negotiation tactic. We had several discussions this week on tariffs with people we respect. They made several interesting points about trade and steel and tariffs. My contention is that none of that matters. Wall Street and investors see tariffs and they think trade war. They think trade war then they think about the Great Depression and Smoot Hawley with a shooting war to follow. When it comes to trade wars investors will shoot first and ask questions later. A trade war = lower asset prices.

This week we saw the new Fed Chair go in front of Congress and act hawkish on inflation. Markets reacted negatively. The very next day he seemed to walk back his earlier comments. This is precisely why, as investors, that we need to prepare for inflation. No one wants to fight it. It is not politically acceptable until it is too late. No Fed chair will have the political will to fight inflation until it is raging and it begins to hurt Main Street. The biggest beneficiaries of inflation are the largest debt holders. Who are the largest debt holders? Governments. They need to inflate away their debt. They want inflation because it allows the very existence of bigger government. The political will to fight inflation will not be there until it hurts and hurts Main Street badly.

CONFIDENCE ON INFLATION GETTING STRONGER” – “Hawkish” Fed Chair Powell

NO STRONG EVIDENCE OF DECISIVE MOVE UP IN WAGES, MORE LABOR MARKET GAINS CAN OCCUR WITHOUT CAUSING INFLATION” – “Dovish “ Powell

By far, the most interesting part of the week for us was an interview from Goldman Sachs of Paul Tudor Jones, a legendary hedge fund manager who called the 1987 crash. He has run a Global Macro hedge fund for over 30 years investing in stocks, currencies and commodities. Check out the whole interview if you can. Here are some of the highlights (emphasis ours.)

Interview with Paul Tudor Jones

Allison Nathan: Is the market underestimating commodity-related inflation today? 

Paul Tudor Jones: Absolutely. The S&P GSCI index is up more than 65% from its trough two years ago. In fact, relative to financial assets, the GSCI is at one of its lowest points in history. That has historically been resolved by commodities putting on a stunner of a show, stoking inflation. I wouldn’t be surprised if that happened again.

 Allison Nathan: Does all of this just boil down to the Fed being behind the curve?

Paul Tudor Jones: … The mood is euphoricBut it is unsustainable and comes with costs such as bubbles in stocks and credit. Navigating these bubbles will be one of the most difficult jobs any Fed chair has ever faced.

 Allison Nathan: In this context, what do you want to own?

Paul Tudor Jones:  I want to own commodities, hard assets, and cash. When would I want to buy stocks? When the deficit is 2%, not 5%, and when real short-term rates are 100bp, not negative. With rates so low, you can’t trust asset prices today.

 Allison Nathan: You are well-known for calling Black Monday. Is the recent surge in volatility behind us?

Paul Tudor Jones: In my view, higher volatility is inevitable. Volatility collapsed after the crisis because of central bank manipulation. That game’s over. With inflation pressures now building, we will look back on this low-volatility period as a five standard- deviation event that won’t be repeated.

If you are a regular reader you know that one of our biggest concerns is rising bond yields. By way of our friend, Arthur Cashin, comes some insight on those rising bond yields. Barry Habib is quoted from time to time in Arthur’s Daily Letter and his track record is nothing short of amazing.

 We are going to see 3.04% on the 10-year within the next couple of weeks. That will be the moment of truth. The level of 3.04% matches the top of the 30-year downtrend in yields, as well as the 0% retracement from the highs 4 years ago. In other words…it’s a big deal if this is convincingly broken to the upside, and strongly suggests that the 10-year will hit 3.80% before summer.

Interestingly, Paul Tudor Jones spoke of rising bond yields in his interview. His thought is that the 10 year goes to 3.75% by year end and that was a conservative target. We thought that the S&P 500 would make a run to the old highs but it seems that talk of trade wars has aborted that attempt. The struggle between the bulls and bears is a push right now. Either could take over. Markets are a bit oversold here which gives the edge to the bulls but the failure to trade to old highs and trade war talk tilts things in favor of the bears. So much to say in such a small space. We are looking forward to our quarterly letter where we will get more in depth in some of these issues.

From the Back to 1987 Department:

Gluskin Sheff’s David Rosenberg summed it all up nicely“Hmmm. Let’s see. Tariffs. Sharp bond selloff. Weak dollar policy. Massive twin deficits. New Fed Chairman. Cyclical inflationary pressures. Overvalued stock markets. Heightened volatility. Sounds eerily familiar (from someone who started his career on October 19th, 1987!).”

lighthouse

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

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

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

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

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Trump Stepping on The Gas

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

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

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

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

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

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

pexels-photo-722664.jpeg

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

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

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

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

Paradox

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

Seaman Jones – Hunt for Red October

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

Paradox

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

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

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

New Regime

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

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

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

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

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

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

 

Moral Hazard

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

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

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

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

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

Giddy Up and Getting Giddy

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

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

SWENSEN: That’s correct.

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

SWENSEN: Slightly more, yeah.

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

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

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

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

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

 What’s Next?

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

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

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

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

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

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

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

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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.

Very Superstitious

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

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

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

-Marks

 It is never different this time. Risk is still risk and the widely accepted reason for the excessive price action that day was portfolio insurance. The selling of volatility and risk parity are today’s version of portfolio insurance. Investors are selling volatility with abandon. That creates a lower implied risk environment. Those figures go into automated strategies that take on more and more risk as stocks rise and volatility falls. More stocks with less risk- Great idea! In the next sharp market move volatility will be the driver as investors scramble to cover their shorts wiping out many involved in that trade.

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

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

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

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

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

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

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

 

 

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

Trump Troubles

A roller coaster runs up and down spins around and around while finishing where you started and it probably cost you money. – Arthur Cashin

We all rode the rollercoaster this week.  While there was plenty of noise and bluster the market fell less than one half of one percent this week. We feel that the volatility in the market was more about the massive positioning of trader’s being short volatility and not as much about Trump. Trump is just the excuse. Could this be a warning shot across the bow in the crowded volatility trade? Perhaps. Be careful. We are entering a slow period for the market seasonally. There just aren’t as many players around during the summer months and moves could become more pronounced. I, for one, would welcome back some volatility. It keeps investors onsides.

Financials are very important to the bullishness of the US stock market. The yield curve is flattening. That means that the bond market sees the economy slowing and the prospect of higher rates on the long end decreasing. The Fed will not be able to continue to raise rates if the economy is faltering. Financials are probably the most important sector of the stock market. Without financials it is hard to get the index to extend higher. The market is pricing in a June rate hike but chances are diminishing that the Fed will be able to raise rates a third time in 2017. Trump’s troubles make a fiscal bump less likely. If you have followed our blog you know that we made the case that a Trump bump from fiscal stimulus would give the Fed cover to raise rates. If that gets lost in the swamp then it makes the Fed’s job a lot more difficult. Our next point of interest is the Fed’s balance sheet. They are making noise that shrinking it is becoming a priority. That will be a huge factor in 2018.

West Texas crude was able to hold its recent lows and was able to close this week above the psychologically important $50 a barrel level. It could be just a bounce off of the OPEC meeting and Russian compliance or we could be seeing more growth worldwide. Oil has a top on it as if crude goes higher as more shale players will come online capping the price of oil but it is worth watching as an indicator of growth around the world.

Given all that happened this week the market is still stuck in consolidation mode. Emerging markets and Europe have been the place to be but Brazil took a hard shot this week. Keep an eye on Brazil. Impeachment is a strong word. Given the very small sample of US Presidents that have been on the impeachment trail stock markets have not reacted negatively in the longer term based on the impeachment process. Having said that, impeachment is also not likely given that Republicans control the House, that is until the midterm elections in 2018.  It is hard to argue against the bull thesis as the market continues to hold its recent range of 2330-2400 on the S&P 500. Until we break decidedly below 2330 we hold on to the bullish thesis.

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.

Published in: on May 20, 2017 at 8:24 am  Leave a Comment  
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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.

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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

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.

1987?

Most investors are primarily oriented toward return, how much they can make and pay little attention to risk, how much they can lose.”

— Seth Klarman

Every week I read Steve Blumenthal’s from CMG Capital Management’s letter On My Radar . It is an excellent source of insights and research that Steve’s puts out every week. I really admire Steve’s style, wit and ideas on the investing universe. This week he mentions a quote attributed to Seth Klarman. We read everything we see from or about Seth as he is an investing legend. The quote struck us this morning as we had conversations this week with two of our more aggressive clients. They are able to be aggressive because they push risk to the back of their minds and continue to push forward and focus on returns. They have both been very aggressive from the financial crisis in 2008 until this week. Coincidentally, both have backed off and are ready to take some risk off of the table. Anecdotal I know, but, I think that it does have some value as it seems that a wide swath of investors now see the market as fully valued. What does that mean? The second level of thinking tells us that the market, since the market has been able to hold an overvalued level it could have further to run. Investors have pulled some risk out waiting for markets to take a breather and give them a better entry point – which it has not. They may be pulled back in chasing prices higher. We believe the animal spirits still have control of this market. The Trump Trade is still moving forward. Could tax reform be the “sell the news” event?

Our biggest question outside a possible shutdown of the federal government is about inflation. No. Not North Korea. I think the media has pumped that one enough. Inflation is our focus as some reports indicate this week that wage inflation could be on the rise. Wage inflation here in the United States could keep the Fed raising rates even while the economy sputters. The yield curve continues to flatten which is not good news for the banks while oil seems to be holding below $50 a barrel. Neither is good news for the market and bad news for both sectors makes it harder for the overall market to rally. These are two huge sectors; percentage wise, for the market and their reluctance to rally makes it harder for the tide to lift other boats. It also makes the any rally narrower with the likes of Apple, Amazon and Google leading the charge.

French election results give the ECB and the Federal Reserve the green light to be more aggressive in tightening policy. Inflation is also a green light. The pressure is building on central banks to take away the punchbowl. North Korea has the media on edge but I am more worried about inflation and Congress shutting down the government. The market is counting on movement out of Washington on healthcare and tax reform. It is never a good idea to count on Washington.

Mario Gabelli made mention that a 1987 style event could happen again this year. We do not disagree. We believe the market structure is in place that could lead to a moment where markets collapse quickly and temporarily. We believe it will be an opportunity for courageous investors but it will also be quick as there is a still a lot of money sloshing around markets looking for a home. Market is still stuck in its range for now between 2330 – 2400 on the S&P 500. Our thesis since last October has been a Trump win followed by a 30% rally with an equivalent selloff in the fall of 2017 much like 1987. Markets are still following that script.

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.

Published in: on April 29, 2017 at 6:16 am  Leave a Comment  
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Behind Closed Doors

Known for being press shy, unlike some hedge fund managers, Paul Tudor Jones broke onto the trading scene with a splash by calling the 1987 stock market crash just days before it happened. So it was big news this week when it was revealed that Paul Tudor Jones, at a closed door meeting this week at Goldman Sachs, said that the Federal Reserve should be freaked out by this one “terrifying chart”. The chart in question also happens to be Warren Buffett’s primary indicator of market valuations.

It makes for good headlines but we have to say we have followed this chart for years and it is not a very good timing indicator for market corrections. However, it is a very good guide to the valuation of the overall market here in the Unites States and it is quite high. Market s can stay irrational longer than you can remain solvent betting against them. Interest rates and ballooning central bank balance sheets have pushed asset prices around the world to new heights.

It remains to be considered that IF central banks ever stop buying or, god forbid sell, then markets should fall. More interestingly, Jones said that the catalyst to the market fall will be risk parity funds. A bit inside baseball but, basically, the explosion of risk parity funds is based on momentum. The lower the market goes the more risk parity funds will have to sell equities. It could exacerbate any run in the market just as it has on the upside. :

We have been weighing in on the active vs. passive debate in the last few weeks as we feel that we have reached an inflection point. We believe that the pendulum swings back when it reaches extremes and we believe that we may be at that point. Think of it like this.  If everyone is invested 100% in ETF’s, passive management, then wouldn’t it be prudent to employ an active allocation to try and capture what inefficiencies are created by blindly piling en masse into ETF’s. We have been vocal proponents of the benefits of passive management but the pendulum may have swung too far and more evidence, however anecdotal, was presented this week by the creation of an ETF for ETF’s. An exchange traded fund (ETF) was created this week to follow the companies that benefit from the growth in the ETF industry. Maybe sometimes they do ring a bell. Time for more research.

Congress has been closed so the Trump Reflation obsession was put on hold and investors and media grew obsessed with geopolitical concerns with a spotlight on the French elections and North Korea.  Rates are falling while gold is rising. Fear is rising as some are reaching for protection in what is known as the “fear trade”. A move to gold and US Treasuries is the usually accompaniment when fear rises, especially in light of geopolitical concerns. Investors have become a bit more defensive. We may see rates rise and gold fall when Congress gets back into session.

Last 30 minutes of trading thesis has been inconclusive so far. No definitive pattern yet. Market seems to be in a consolidation pattern. The market seems to be digesting its gains and gathering itself before a move to a higher summit. Markets do not top out like this – spending weeks at a given level. The odds are that markets, when leaving a consolidation phase, move in the direction in which they came in.

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.

Published in: on April 22, 2017 at 6:31 am  Leave a Comment  
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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.