One of These Things is Not Like the Others

It’s been a few weeks since we’ve published a Miller’s Market Musings, not for lack of material, but because there is too much going on and I’ve been on the road visiting with management teams and industry contacts. I have about 5 good Musings sketched out and ready to go, but recent market events demand attention first. Maybe I’ll do a few special issues soon to catch up. Meanwhile, back to our regularly scheduled programming.

Sesame Street provided us with some great trading lessons. First, cookies are good. Second, there’s always a grouchy guy at the office. Third, it’s important to recognize when something is not like the others. An investor in U.S. stocks is betting on the thing that is different, which can be a dangerous game to play when most other risk assets are singing a different song.

U.S. stocks are definitely looking different these days. The most widely followed market index, the S&P 500, is sitting near its all-time highs, while at the same time most other risk assets range from just sorta weak to horrific. High yield bonds, as represented by the HYG, are off  14 % from their highs.  West Texas crude is down to $38 from over $100. Copper? Forget about it. Iron ore is down about 80% since its peak in 2011.  Ok, those are bonds and commodities. What about other stocks?  Those are weak as well. The Russell 2000 is down 10% from its recent high set in June. And outside the top 10 stocks in the SPX, the rest of the S&P 500 isn’t doing very well. A number of writers have pointed this out recently, but it bears repeating. As of the end of November, the top 10 stocks in the S&P 500 were up an average of over 13%. The rest of the S&P 500 was down about 4% on average. That is a huge difference. It’s why the equal-weighted S&P 500 is underperforming the cap-weighted index by such a large margin. It is wreaking havoc with fund managers’ relative performance, and is causing them to crowd into those top performers in an effort to keep up and not get fired.

What’s so bad about crowding? Well, look no further than the German market on Thursday, when the ECB “disappointed” insiders who thought that the ECB was going to loosen its purse strings even more than it did. The German stock market was the easy trade into an easing. It fell 4.5% that day. The problem with crowds is that it makes people do things they otherwise wouldn’t do. The crazy trading spilled over into U.S. markets, with normal trading relationships coming unhinged as traders rushed to unwind their bets.
 
One of these things is not like the others,
One of these things just doesn’t belong,
Can you tell which thing is not like the others
By the time I finish my song?
  -  Sesame Street

Emerging markets, commodities, leveraged loans, high yield bonds, biotechs, MLPs and oil, to name just a few, are in bear markets. U.S. large cap stocks, and really just the largest of the large cap stocks, are hitting new highs. Granted, some of these companies are truly unique, game-changing companies. They have winner-takes-all business models with which they are crushing the competition. The so-called FANG group of stocks (Facebook, Amazon, Netflix and Google), along with Nike and a few special situations, are what is driving this market to the upside, with basically everything else falling. Can this continue? Sure, why not? Those are some amazing companies. Would you want to run Wal-mart today, with Amazon out there? Facebook is playing at a different level than Twitter, and the only real competition for it is Instagram and Whatsapp, and it owns those too. Netflix? This is probably the most susceptible business model to disruption or replication, but it is trying hard to stave this off by creating original content. Still, in content I’d prefer Disney to Netflix anytime. Finally there is Google, which, along with Facebook, captures a majority of all digital advertising on the web today. Which is really quite amazing when you think about it.
But most other companies out there aren’t like these leaders. Most are fighting declining demand for their products. Most industrial businesses in the U.S. are in a recession right now. Energy was a big driver of demand for industrial products, from pipes to trains to drill bits, and that demand is evaporating. OPEC’s latest meeting made sure that was clear. The consumer remains weak, with retail sales overall coming in very light versus expectations. Only autos look good, and a large part of that is driven by very low rates on auto loans. You don’t need much cash today to buy a new car, but you do to buy a house, or clothes. So you have this great bi-furcation occurring in markets, where a few winners go up and up, deservedly so, while the rest of the market stagnates at best. That’s not a healthy environment for overall investor returns.
Did you guess which thing was not like the others?
Did you guess which thing just doesn’t belong?
If you guessed this one is not like the others,
Then you’re absolutely…right!
   - Sesame Street

One of the things I’ve learned in the past 20 years of trading is that commodity prices can often be false signals for equities. They can be weak, or strong, for a host of reasons, none of which reflect any underlying weakness or strength in the economy. A commodity can go up because a mine or refinery goes offline, it can go down because a central bank sells its reserves, it can go up because there is a lack of storage, it can go down because there is a lack of storage, and so on. But there is one market that is my go-to, stop the music and listen signal. That is high-yield bonds. High-yield bonds and equities are cousins. They share some characteristics with each other. They differ in the nature, certainty and timing of the payments they receive, but both markets tend to look at the same things when valuing companies. Cash flows, and particularly the sustainability of cash flows, drive valuations of both. High yield, however, has limited upside. At the end of the day, they get back par. So in order outperform, high yield investors need to lose less when they’re wrong, or get paid accordingly for the higher risk when things turn down. And right now, high yield markets are signaling that something is wrong in corporate America. High yield spreads are very wide, particularly relative to BBB yields, which indicates that stresses are starting to appear. There may be technical factors at work as well. Matthew Levine has written extensively about worries over bond market liquidity (it’s kinda become his signature thing, but his daily piece is a must-read for many other reasons), and while overall bond liquidity is down, I think that the lack of bids for many high yield bonds shows cracks in the system that we should be paying attention to in equity markets. When the high-yield canary sings, equities should listen. But right now, equities are the thing that is not like the others. And that’s not good for stock investors.
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This week’s Trading Rule:

• When it comes to the workings of financial markets career risk drives asset bubbles.Institutional managers behave as if their jobs description was “keep it”. There is safety in numbers even if you suspect what you’re doing is risky. And after a while, when there are no consequences, you legitimize it in your mind. Then your inhibitions become attenuated and risk compounds. For example, not one of the biggest banks (or two FED Chairmen!) saw the mortgage crisis coming, despite warnings from strategists, economists and hedge fund managers. So those who played the game of musical chairs were safe in their chairs because they were all on the Titanic. They all sank together. No one got fired. Missing the crisis and the huge profits attendant during the run up was the real career risk. Keynes really understood this: “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.”
   

Most asset classes are signaling trouble, but U.S. large-cap stocks push on, oblivious to the signs that trouble may be lurking ahead. High-yield in particular is singing a warning song, and I think we should listen. Next week is fraught with event risk, as we have the Fed meeting and then a very large option expiration on the 18th.  Buckle up.  

SPY Trading Levels:
Support: 205/206, 202.5/203, 197, then 188/189.
Resistance: 210/211, 213.

Positions: Long and short U.S. stocks and options, Long SPY Puts. Long GOOGL, DIS.  

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Miller’s Market Musings is a free weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. If you no longer wish to receive this letter, simply hit reply and put “Remove” in the subject line.  Prior posts can be found at www.millersmusings.com. 

Miller’s Market Musings is a free weekly financial market e-letter written by investment manager Jeffrey Miller.  Mr. Miller has been quoted in financial publications including the Wall Street Journal and New York Times, and he has appeared on Fox Business News, PBS and CNBC.  More information and past articles can be found at www.StockResearch.net.  Sharing and quoting from this letter is permitted.