Take Me to Funkytown
Well, I talk about it, talk about it
Talk about it, talk about it
Talk about, talk about
Talk about movin’
On Friday the Bank of Japan (aka, the Japanese Fed) cut the rate on current accounts that commercial banks hold with it to minus 0.1%, adding that it will push the rate even lower if needed. Effectively, this means that banks will be charged to keep excess assets with the central bank. This move sparked a big jump in stock markets around the world. Some mistook the rise as being predicated on the assumption that negative rates would work to spur growth and therefore earnings and therefore stocks. This is wrong. Stocks moved because as a financial asset they became slightly more attractive than they were the day before, especially when having cash has a tangible cost, and when the same people that just took rates negative said they will take them more negative if they have to. So asset allocators did the logical thing and decided that the prospect of losing money in stocks was more attractive than the guaranty of losing it in bonds. So stocks went up.
The common explanation for negative rates in countries that have implemented them is that negative rates will encourage banks to lend and consumers to spend rather than save. It’s the same argument for keeping rates low all over the world – low rates drive lending which drives consumption by individuals. But this isn’t happening. Japan has had ultra-low rates for years and its economy has been terrible. Trillions of debt in Europe now trades at negative interest rates and its economy isn’t exactly booming. Denmark, Sweden and Switzerland all have negative interest rates, but consumer spending isn’t going up there. In fact, savings rates have been going up in lockstep with the decrease in interest rates, exactly the opposite of what the geniuses at the various central banks expected. Welcome to Funkytown.
Why is this happening? Simply, savers are scared. Lower rates have wrecked their retirement plans. Say you were doing some financial planning 10 years ago and plugged in 3% from your savings account. Now its 0%. You still have to plan for your retirement. Plug in 0%. What happens to your planning now? 0% compounded for X years is 0%. The math is simple. So in order to have your target savings at retirement, you need to save more, not spend more. But for some reason, the economists that run central banks around the world can’t see this. They are all stuck in their offices talking to one another and self-reinforcing this myth that they can drive spending up by reducing the rate of return on investments. Want to see consumer spending go up? Don’t wreck their savings plans so that they are too scared to spend. But that’s too simple. Instead, central banks use a chain of causation that doesn’t exist to try to create change 3 or 4 steps down the line. It hasn’t worked, and it won’t work. It isn’t in an individual’s self-interest to go out and spend their money on more “stuff” in order to spur economic growth.
Won’t you take me to Funkytown?
So how do you get people to do collectively what isn’t in their own best interest to do individually? Put another way, how to you get people to take the savings they think they will need in the future to ensure some basic level of survival, and instead spend it today?
I think governments need to be very explicit in what they are doing. Right now, they use terms that the average person doesn’t really understand, or, put differently, people don’t understand how the policies being tried over and over are supposed to affect them. So they ignore them.
Why do central banks want higher inflation (of about 2%)? Because they think that this is the optimal level that will make people spend today instead of waiting for something to be cheaper tomorrow. At 0% inflation, there is no incentive to spend today versus a year from today, as prices will be the same. The Fed targets 2% because it believes that is the “right” level that will make consumers move to spend sooner. They are wrong. Consumers don’t think that way. They think in terms of what do I need, what do I want, and what am I willing to pay for it. Needs are bought somewhat irregardless of price. Think food, and homes. Most people in the U.S. actually like it when home prices appreciate at a level that they can see – like 4-6%. I’d hazard to guess that this is the level of interest that would make them feel comfortable spending a bit of their savings too. The Fed is literally “too cute” by half. No one cares about 2%. It’s meaningless. People don’t shop their credit cards, or even call the issuer of the ones they have, for 2%. It’s seen as not worth their time. So all this talk about quarter point moves, half point moves, negative rates, is just that – talk. The people the message is intended for aren’t listening.
So again, how do you get people to do collectively (spend now) what isn’t in their best interest to do as individuals (if the prices of goods are going down or are flat, then saving and waiting for the better quality TV, or car, or clothes, makes perfect sense). Insuring against disaster – like losing your home altogether because you didn't save enough for retirement – carries a lot more weight in people’s minds than losing 2% in purchasing power through some unseen inflation that doesn’t even exist at the moment anyway. Central bankers are so divorced from reality that they really think (or at least act like they think this way) that these small moves in borrowing rates, even to negative rates, will scare people enough about their future purchasing power that they will throw caution to the wind and go buy stuff they don’t really need now. Because if they really needed it now, I mean, needed it to survive, they probably already bought it, don’t you think?
Gotta make a move to a town
That’s right for me
Town to keep me movin
Keep me groovin’ with some energy
I think the only way to get people to spend their savings now, especially in stagnant economies like Japan’s, is to skip all the intermediate, opaque steps and just tax their financial assets. Just do it directly. Reduce their purchasing power today. That’s all inflation is – a reduction in purchasing power in the future. So pull it forward, and make it crystal clear to the masses that aren’t reading central bank pronouncements what they are doing. Do it in size. And do it monthly. Charge 25 basis points a month on all financial assets – stocks, bonds, banks accounts. Every month that goes by, savers will see less money in their accounts. This is no different than inflation running at 2% or 4% or whatever the target is, but it is a lot more visible to the people you’re trying to affect. So pull a Nike and Just Do It. I’d bet that after about a year, you’d see consumer spending up, inflation up, growth in the economy, and businesses expanding, at which point you could rescind the tax and go back to normal. But you need to shock the system to get there. Incrementalism hasn’t worked yet and won’t work in the future. Hiding what they are doing – trying to boost the rate at which consumers’ purchasing power decreases – isn’t working either. Sometimes you need to use a defibrillator to shock a stopped heart to restore its normal rhythm. Apparently you need to do the same to a whole economy. So do it.
This week’s Trading Rules:
Markets have bounced very nicely in the past week and a half. Will it continue? I think the S&P 500 could easily move up to 2000. After that, I expect it to bounce between 1900 and 2000 for a while. What’s really interesting is what is happening beneath the surface. I think a wave of M&A is coming to community banks, and that companies that have been crushed on the back of oil’s decline and aren’t actual oil drillers are, for the most part, interesting investments down here. Leadership in the markets will shift from growth to value and large-cap to small. When? Soon…
SPY Trading Levels
Support: 188/189, then 181/182, then a little at 175.
Resistance: A ton at 200, 204.5/205, then it’s not going above 209/210 soon.
Positions: Long and short U.S. stocks and options, long SPY and IWM options.
Are We There Yet?
Are We There Yet?
I’ve been getting (and asking) that question a lot in recent days. Not only from other market professionals but from people that normally don’t follow the markets. I noticed that in the past few days one of the channels at the gym that is usually tuned to Ellen or some other dreck was now set to CNBC in the afternoons. My answer until today has been consistent – not yet. Today something changed in the market however. Small caps, which had been getting hit for months, and are down significantly more than large cap stocks, turned up at midday day and rocketed higher. The Russell 2000 ETF, or IWM, shot from $95.12 at 12:30 to over $100 before closing at $99.79. This is a huge intraday move. In addition, many of the small and midcap stocks that I watch closely also moved strongly higher in the afternoon.
This is a significant short-term trading turn. As of yesterday’s close, the Russell 2000 was down 13.1% over the trailing 12 months and was off a whopping 22.4% from its 52 week high. The average stock in the index was off even more. When you wonder why so many funds are having a rough time, this is a main reason. Only the largest stocks in the benchmarks have been doing well, making it very hard for those managers that don’t want to take on the concentration risk inherent in large index positions to outperform in this environment. But eventually, I think there will be a serious reversion – and it may have just started. For comparison, the S&P 500 was off just 4.6% for the past 12 months, and the S&P 100 even less, at a 3.3% decline. Put another way, the top 100 stocks by market cap beat the smallest by over 10% in the past 12 months, and the performance versus the 52 week high is similar. Since the selloff started in June, large caps have beaten small caps by over 11%. Where do active managers shop for bargains? Not usually at the top of the food chain. Hence the recent pain.
How Did We Get Here?
While the recent divergence between large and small cap stocks is fairly well known, what hasn’t been discussed much is why this happened. The stocks that have been performing the best are not those with the most cash flow or the cheapest valuations. They are the ones that have the best revenue growth and perceived ability to sustain that growth for the next few years. But I think there is something more pernicious at work. This has been a terrible year for fund flows into actively managed investment funds and a great year for fund flows into index funds and ETFs. How do most index funds and ETFs invest? By buying the largest stocks. Even funds that supposedly invest in large numbers of stocks, like the S&P 500 index funds that are so popular, have the bulk of their assets in the top 50 companies. The bottom 50 are essentially meaningless. So what you have seen this year, and in prior years, is that as more investors move into index funds, they are all buying more and more of only the largest stocks, and their redemptions from active funds that invest in smaller companies are forcing those managers to sell. The result is not only the large disparity in performance we’ve seen recently, but an increasing concentration of market risk in fewer and fewer stocks. Put another way, breadth stinks, and when breadth stinks, its hard for the market indices to continue to move higher. This has happened over and over again in the history of markets, as investors get into crowded trades at the top of the market. Vanguard and its mouthpiece Jack Bogle perpetuate this myth that indexing is always better than actually selecting stocks based on objective measures of value, when the facts prove otherwise, because it is good for business. Their (misleading) sales pitch has made them the largest mutual fund manager in the world. This concentration risk is also inherent in many index-based ETFs (the dangers of which have been extensively discussed here previously). Despite this obvious structural problem, their sponsors are some of the fastest growing asset gatherers in the industry.
Despite these issues, I think we are at a short-term inflection point. Long-term, there are some real bargains out there, but some serious issues in China and the Middle East may make a sustained rally hard to maintain. Many high-quality companies are off 15-20% year-to-date in 2016, and are now trading at attractive prices. Our fund has been buying well-run community banks in strong markets this week, and will continue to do so on further weakness. M&A is coming to this sector, and the market gyrations based on money-flows we’ve seen are giving investors a great chance to buy these companies at good prices. We also like some defense stocks and gaming companies at their current valuations, and are increasingly interested in a few companies that have been unfairly tainted with the specter of oil-related business declines.
Speaking of oil – Are We There Yet? I think we are. In August of 2014 my partner (who’s also my wife and our resident oil expert) and I attended an MLP conference at the Wynn Hotel in Las Vegas. Two-hundred and fifty different companies were there presenting their growth plans for new drilling, refining, storing and moving of oil and gas products. Some were bullish on fracking, others on LNG exports, still others on building new pipes from Colorado and West Texas to refineries on the Gulf Coast. Capital was cheap and easy to get, and no one was worried about over-capacity or the fact that everyone there was saying the same things. As the non-energy expert who was there to see what all the fuss was about, to see why there were IPOs and follow-on offerings coming every week that were many-times oversubscribed, I kept thinking that this reminded me, and not favorably, of the similar conferences I attended for sub-prime mortgage originators, REITs, and servicing companies in 2005 and 2006, and how back then I didn’t understand how companies could make loans to people that couldn’t pay them back and expect it all to work out well in the end. Well, just like with subprime, it didn’t’ work out well. Many of these same energy CEOs we met with who were bullish on the way up are now uniformly bearish at the bottom. I chuckle when I see them on CNBC proclaiming that oil at $28 isn’t near a bottom and that $20 is a possibility, when they didn’t have a clue that this selloff was coming when oil was over a $100 and they were growing like a weed less than 2 years ago.
Is oil done going down? I don’t know. But I do know that the exuberance is gone, that the CEOs are scared, and that capital spending in the industry is off nearly 75% from its peak. I know that the Saudis are losing money, the Brazilians are losing money, the Venezuelans are cooked, and the Russians are withering on the vine. Canadian oil sands? Done. Artic drilling? Done. Deep water in tough locales? Done. Lots of future production has been cut and isn’t coming back unless oil is back over $70 and stays there. That’s a long way from here. And lets not forget that the quoted price for WTI or Brent is for the best quality crude. Most crude trades at a big discount to that price. I read yesterday that some crude in the Midwest is being bid at $1.50 a barrel. Think that works long-term? Me neither. So what are we doing? We’re picking away at the best midstream MLPs, the best tank car maker, and the best refiners and field services company. Are we early? Yep. Are we losing money so far? As of today we are. But we think that, just like the best banks were a screaming buy in 2009, the best oil companies are a buy today. So that’s what we’re doing.
This week’s first two Trading Rules:
China continues to come unraveled, and the central government’s attempts to rescue its markets are failing. The suspicion on desks is that sovereign wealth funds have been dumping stocks to cover budget shortfalls. If so, we may be in for some unusual month-end trading going forward. ETFs and index funds are creating a herding effect in the largest of the large caps. This concentration will end badly, as it has every time in the past. Be wary of expensive “safe” stocks and buy some cheap SMID names instead. Value always wins in the end.
SPY Trading Levels:
Support: The market broke support at 188 today. Next is very little at 181/182, then 175.
Resistance: A ton at 195, 200, 204.5/205, then it’s not going above 209/210 soon.
Positions: Long and short U.S. stocks and options, long SPY and IWM options.
The Emperor’s New Clothes
So off went the Emperor in procession under his splendid canopy. Everyone in the streets and the windows said, "Oh, how fine are the Emperor's new clothes! Don't they fit him to perfection? And see his long train!" Nobody would confess that he couldn't see anything, for that would prove him either unfit for his position, or a fool. No costume the Emperor had worn before was ever such a complete success.
Hans Christian Andersen – The Emperor’s New Clothes
Long-time readers will know that we have been skeptical of China for many years. A corrupt, insular government run by men solely focused on maintaining their power and privileges at the expense of the people they govern is not a suitable manager of an economy. And yet, they try. And fail. Over and over. The “Chinese Miracle” that sycophants like to gush over while they hold their hands out for contracts from the state-run enterprises is a mirage. Chinese companies have issued $21 trillion in debt in recent years, much of it to finance inefficient, uncompetitive businesses that wouldn’t be able to survive without regular, large doses of new debt. The economy of China is walking around without any clothes, and yet they think they are a great success.
For some reason, the IMF recently admitted China’s currency to the top echelon of global reserve currencies. They stated that China was making moves towards an open economic system in which the renminbi would be freely exchangeable into other currencies. Ah, no they aren’t. A recent article in the Wall Street Journal noted that immediately after receiving this designation, the inner circle of the finance ministry congratulated themselves for a job well done, and turned their attention to weakening the renminbi against a basket of 13 currencies in order to boost their export economy. Free markets? Hardly. But, once again, the IMF and others don’t want to admit the obvious – that China is still a manipulated economy controlled by a statist, Communist government and large, state-run enterprises. It is not a free economy on par with those of Europe, the US, or Japan. The government basically borrowed its way into its current position, and so long as it pegged its currency to the dollar, it could control that debt and its economy. But when you open your currency to the world, and allow it to be valued based on fundamentals, a funny thing happens – you lose control. Either your debts go bad, or you continue to print more money to pay them, which in turn makes your currency less valuable. It is this dynamic that the central planners missed. They would be better off remaining a closed system in order to continue to fund their debts internally by simply printing more money. By then controlling their exchange rates, they could manage inflation and export balances. However, the prideful rulers decided that they wanted the status of a world power, and in order to be admitted to the club of first-world economies they were willing to sacrifice some control over exchange rates. This vanity is now coming home to roost.
The ruling party has limited choices. They maintain power by creating an aura of invincibility and infallibility. Criticism of the government is prosecuted and repressed (I’m guessing I’m not going to China anytime soon now). When the market is going up, it’s because the government is doing an amazing job of managing the economy and generating growth. When it goes back down, this same government accuses brokers and fund managers of manipulation and fraud. Numerous heads of companies and brokerages have gone missing recently – not week goes by now when the Financial Times doesn’t have a story on a CEO who is suddenly “unreachable”, and no one knows where they went. Sometimes they reappear a few days or weeks later, without commenting on their disappearance. Sometimes they don’t reappear at all. Want to do business in China still? I don’t. See this article I wrote back in 2011 on the issues in the Chinese economy and tell me if you do.
But he hasn't got anything on," a little child said.
"Did you ever hear such innocent prattle?" said its father. And one person whispered to another what the child had said, "He hasn't anything on. A child says he hasn't anything on."
"But he hasn't got anything on!" the whole town cried out at last.
The Emperor shivered, for he suspected they were right. But he thought, "This procession has got to go on." So he walked more proudly than ever, as his noblemen held high the train that wasn't there at all.
Hans Christian Andersen – The Emperor’s New Clothes
On Thursday China’s cabinet held an emergency meeting about the failed circuit breaker system that the Chinese stock market implemented on Monday and canceled Thursday night, after it clearly didn’t work. At the meeting, held “in the walled Zhongnanhai compound where China’s top leaders live and where few ordinary Chinese have ever set foot” (Wall Street Journal), Xiao Gang, Chairman of the China Securities Regulatory Commission was grilled about the failure of the system he had championed. For a government that needs to appear infallible, the fast fall from grace is unacceptable. The Chinese markets have been revealed to the world as the farce that they are. They have quickly gone from an economy held in awe to one viewed with derision. Social media in China, to the extent the posts are allowed to remain online, has been filled with mocking references to the government. If I was able to, I’d short Mr. Xiao’s career at the top of the Securities Commission, and will not at all be surprised to find him the subject of “corruption” charges or the victim of an untimely accident before the end of 2016. The Emperors are beginning to shiver in China.
This week’s first two Trading Rules are a repeat from last time, because they are very timely given that trading in China’s stock market is 85% retail investors, and they appear to be panicking...:
China is coming unraveled, and the central government’s attempts to rescue its markets over and over will eventually fail. At some point, it will either own most of the outstanding shares available on its stock exchanges, or have to abandon its strategy of propping up its markets. Eventually, if it wants to have open markets, prices will move to where investors again become interested in buying. I suspect this level is so far below where the markets are trading today, especially given that no one trusts the government anymore, that either the government will have to close trading for an extended period of time, or allow both the stock and currency markets to reset lower in a large, fast move. I’d bet on the latter.
SPY Trading Levels:
Support: 188/189. That’s it.
Resistance: 195, 200, 204.5/205, 209/210, 213
Positions: Long and short U.S. stocks and options, long CEFs, long SPY and IWM Puts.