Can you teach me 'bout tomorrow
And all the pain and sorrow running free
'Cause tomorrow's just another day
And I don't believe in time
Just a few days after writing our last letter about the warning sign that the high-yield market was flashing, Third Avenue went and closed an open-ended mutual fund to redemptions because it, essentially, couldn’t find reasonable bids for its bonds. In the aftermath, some commentators have noted that this fund was an exception, because its portfolio was particularly risky, made up of really low quality bonds, and that it wasn’t symptomatic of larger issues in high-yield. I kinda agree and disagree. The issue was clearly that what they owned was a bunch of dreck, bottom of the barrel-type stuff, in a structure that really shouldn’t own such things. They forgot one of the key risk-factors in managing money – time.
The issue of time is often recast as one of a liquidity mismatch – owning assets that are less liquid than the liquidity terms offered to the investors in the structure. Mutual funds offer daily liquidity, which is great for assets like stocks and government bonds that have deep and liquid markets. Low quality junk bonds aren’t quite as good a fit – a much better fit would be closed-end funds, where there are no redemptions, or in a private equity type fund of the sort that Oaktree and others run. But owning them in a regular retail mutual fund? Not a good idea. Is this going to be a systemic problem? Probably not. It appears that a lot of the mutual funds that own high-yield bonds only have portions of their funds in them, or, even better, are closed-end. Interestingly, many closed-end funds run by decent managers are trading for extremely deep discounts to NAV currently, and probably are good buys here. Our fund has been buying a few of these in the past week. Closed-end funds don’t have to worry about this liquidity element of time. However, another asset that is often confused with closed-end funds definitely does – ETFs.
Time the past has come and gone
The future's far away
And now only lasts for one second, one second
ETFs have been hailed as the savior of retail investors. Some claim ETFs eliminate the risks in investing alongside other investors whose time horizons may not match your own. In the case of Third Avenue, this issue was made clear by the fact that those who sold early realized a much better return than those who sold later, because Third Avenue was able to sell its better quality bonds to redeem them. But ETFs suffer from the same problem. They have investors who can not only redeem daily, they can redeem at any time throughout the day as well. Amazingly, the Wall Street Journal published an article on the front of its Business and Finance section yesterday that is 100% wrong. Very wrong. Incredibly, I can’t believe this got published wrong. In it, Jason Zweig, who writes their weekly Money Beat column, states that ETF managers don’t have to sell their holdings to meet redemptions. Instead, they give a prorata share of those holdings to ETF dealers called authorized participants (APs) who in return gives the ETF back some of its shares. This part is correct. But what Zweig misses completely, and I really don’t know how he does, is that the APs then turn around and sell those securities. APs are not in the business of just holding onto whatever the ETF manager gives them. Zweig says “The ETF doesn’t have to fan the flames of a fire sale by dumping its holdings into a falling market.” Well, actually, it does. APs are in the business of arbitraging, for very small amounts of money, the differences between the price at which the ETF trades and the underlying value of its assets. That is why ETFs have to publish their holdings daily. It is why ETFs that invest in less liquid assets will trade with a higher bid-ask spread. Its why – oh man, its why a lot of things. But one thing ETFs are not are closed-end funds with an unlimited time horizon. They are a fund with an even shorter redemption time period than regular mutual funds. And yet, the Wall Street Journal has it completely backwards. Amazing.
Time why you punish me
Like a wave bashing into the shore
You wash away my dreams
But there is a more subtle, and more pernicious, aspect of the time factor in investing. That is the mismatch between investor expectations and time-horizons for returns on the underlying investments. Different investors have different time horizons of course, but I’ve found in the more than 20 years I’ve been investing that what people say their time horizon is and what it really is are very different things. For all of its smug insularity and inability to hire women or minorities, one thing venture capital has gotten right is matching the duration of its investors with the duration of its investments. Investors in venture capital funds are conditioned to expect the investments to both take a long time to payoff and often not work out. It is a lesson that most retail investors miss.
Instead, retail investors say they are “long-term” investors, when in reality they are generally uninterested investors. Until, suddenly, they are very interested – at which point they usually panic. This panic creates a selloff that punishes those investors who thought they had a lot of time to let their investments grow and generate the returns they expected, at least on a marked-to-market basis. This sell-off then triggers fear of further losses in investors who thought they owned “safe” assets, or “liquid” assets, so they sell too, which leads to a downward spiral. This is the contagion effect we’ve discussed here previously. It’s being exacerbated by the destruction occurring in many retail investors portfolios, because they, despite all the clear warning signs, chased yield instead of total return in recent years. In a world of low interest rates, they looked at the yields being paid by MLPs, private REITs, BDCs, and other yield vehicles and decided that getting a high current income was so important that they invested in companies or funds they didn’t really understand. They were happy, so long as prices were going up and they were getting paid. But now that prices are going down, often dramatically, they are realizing that there is no such thing as return without risk, that their tolerance for volatility is lower than they thought, and that their time horizon for their investments is shorter than they thought. Not a good combination.
Time why you walk away
Like a friend with somewhere to go
You left me crying
In my experience, mutual fund boards are no different in their short-termism than retail investors, and in some ways are worse. They get regular reports showing how the funds under their purview have performed on monthly, quarterly, yearly and 3-5 year time horizons. Usually there is a 10 year comparison as well, but it is routinely ignored as not relevant, as most investors ignore it too. These fund boards will harshly question any manager that dares to deviate from their benchmark, even for good reasons, and even if it is just to hold more cash during times of market excess. A mutual fund manager may well believe that the bonds or stocks it holds are overvalued, but be unable to do anything about it since they are, for the most part, supposed to be fully invested at all times. This means that even if the manager fully believes that the most prudent course of action would be to sell and hold cash, he or she generally won’t, because making a market bet is a quick way to find yourself looking for another job. Therefore, when markets do selloff, mutual funds are generally not a good source of buying support – they have to sell something to buy something. Twenty or thirty years ago, fund managers had a lot more flexibility to use their judgement about markets and fund positioning, but today much of that flexibility is gone.
Similarly, another source of market buying during times of panic used to be the investment banks and bond dealers, but Dodd-Frank has killed that off. Today, dealers are just middle-men – they are not allowed to position securities on their books. When I interviewed at Goldman Sachs after business school, the interview took place on the equity trading floor, where I was surrounded by hundreds of traders and salesmen. Today, Goldman has less than 10 traders making markets in U.S. stocks. Think they are making a big two-way market anymore? I don’t think so either.
Time without courage
And time without fear
Is just wasted, wasted
One of them main advantages of hedge funds is that their investors, for the most part, understand that in order to make money you need to be willing to tolerate some volatility and wait out the markets recurring cycles. (Full disclosure: I manage a hedge fund, and am biased toward the structure). Another advantage is that, because their managers are granted flexibility to go both long and short, and to hold cash, they can take advantage of these market dislocations to buy good assets at distressed prices. They can cover shorts, sell one asset to buy another, or use leverage to buy when others panic. Granted, some managers will get their markets wrong, and fail spectacularly, but that doesn’t mean that overall the industry is flawed. It’s simply part of being in the markets – not everyone can be right all the time, and those that fail to manage their leverage and risk exposures will be carried out of the arena accordingly. But the impression that hedge funds are all the same, that they all are rapid day traders (some are, some aren’t) misses the point that they are one of the few sources of buying support left in the markets today. They are, as a group, the only ones that have both the time and ability to step into falling markets and buy when others are panicking.
This week’s Trading Rules:
The Fed hiked rates by 25 basis points for the first time in 7 years, and after initially popping higher, stocks have begun to fall again. Retail investors have seen most of the asset classes they flooded into in recent years decimated in the past 6 months. Large cap stocks have massively outperformed small caps over the past 6 months, with the Russell 2000 Index falling 12.7% versus a 4.9% decline in the S&P 500. This is inflicting pain on active fund managers and forcing performance chasing in the few winning stocks. Time ain’t no friend of these markets.
SPY Trading Levels:
Support: 200, 195, then 188/189.
Resistance: 204.5/205, 209/210, 213
Positions: Long and short U.S. stocks and options, long CEFs, long SPY Puts.
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.
This week’s Trading Rule:
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.