August 3rd, 2016
By Jeffrey Miller, Partner, Eight Bridges Capital Management
My last letter was the most forwarded letter I have written, so in case you missed it, it can be found here. You can subscribe to receive this letter in your inbox here. It is always free.
Lost Boy from Neverland
"Run, run, lost boy," they say to me
Away from all of reality
Neverland is home to lost boys like me
And lost boys like me are free
Ruth B, Neverland
One of the advantages of a long/short hedge fund is that the portfolio manager is generally free to invest whatever way makes the most sense, without worrying about blindly benchmarking to various indices, something that often occurs when running a mutual fund. I should know – over the past 20 years, I’ve managed both mutual funds and hedge funds. Hedge fund managers are definitely freer. In a bull market, this freedom can be a hindrance, as my natural inclination is to never be 100% net long, but to hedge a bit in case the unknown macro event decides to wreak havoc with the markets. But when markets are frothy, and smart investors are lost, its nice to be free to hedge, raise cash, and just wait. Because right now the reality of financial markets is something that many big investors are saying to run away from.
For example, in just the past week:
Bill Gross: “I don’t like bonds; I don’t like most stocks; I don’t like private equity. Real assets such as land, gold and tangible plant and equipment at a discount are favored asset categories.”
Jeffrey Gundlach: “The artist Christopher Wool has a word painting, 'Sell the house, sell the car, sell the kids.' That’s exactly how I feel – sell everything. Nothing here looks good,” Gundlach said in a telephone interview with Reuters. "The stock markets should be down massively but investors seem to have been hypnotized that nothing can go wrong."
Some other strange things have been happening in financial markets lately, and many of them contradict one another. For example, the S&P 500 closed higher for 5 months in a row when it finished in the green for July. This has happened 23 other times since 1950. In all the other 23 times, the market was higher 12 months later. Buy buy buy! But then you have the fact that the market traded within a 1.04% range for the 11 days ending August 1st. What makes this extremely tight trading range really unusual is that it occurred exactly when over 70% of the S&P 500 reported earnings, which is when stocks are usually their most volatile. Maybe this is what is spooking the professionals so much – they see lots of insane pricing in bond markets and bond proxies in the stock markets, but the overall market doesn’t move. They’re lost, but they’re stuck being long in most cases. It’s nice to be a lost boy who’s free from that reality.
He sprinkled me in pixie dust and told me to believe
Believe in him and believe in me
Together we will fly away in a cloud of green
To your beautiful destiny
Ruth B, Neverland
When the consensus is that everything is crazy and the only prudent course is to sell all assets, I’m inclined to disagree. If bonds are about to go lower and rates higher, there will be winners and losers – the trick is to find the stocks that benefit, believe in them, and fly away in a cloud of green to your beautiful destiny.
This market reminds me of early 1995. Bank stocks had rebounded from their recession lows hit in the 1990-1991 bear market, but were stuck trading under book value, as investors refused to believe that they would be able to produce sustainable earnings growth. At the same time, the Fed had begun raising rates, and the mantra at the time was don’t fight the fed – especially in financials. Fast forward 20 or so years, and you have a similar situation in the big banks in the U.S. Valuations are quite reasonable, but the stocks are stuck in a trading range, as investors debate whether or not they can generate sustainable earnings growth in the face of ultra-low rates. Unlike 1995, this time around investors clearly understand that banks do better in a higher-rate environment, and the “don’t fight the Fed” trade today will manifest itself in other sectors like bonds, utilities, and staples. Banks have started moving higher, not because Fed Funds are moving up, but because LIBOR has. Take a look at the chart below of 1-month LIBOR, and you’ll see that it spiked up in December, when fears about European banks introduced risk back into the system, and again in the past few weeks, once again on European bank capital worries. This is nirvana for U.S. banks, as most price their loans not off of Fed Funds, but off of LIBOR. If LIBOR is moving up on worries about European banks, U.S. banks benefit. If this continues, earnings for U.S. banks could surprise on the upside. Just like 1995 and 1996.
1 Month LIBOR 7/27/2015 to 7/27/2016. Source: St Louis Federal Reserve
Looking at a chart of the S&P 500 today is like looking at the ocean at low tide – it appears calm, but beneath the surface there is a lot of churning going on. If this churning continues, we could see a leadership change in the U.S. stock market, from defensive sectors to those that benefit from economic growth and higher rates. I think we are on the cusp of such a change. So sprinkle on a little pixie dust and get long select banks, technology, and media stocks, and short, or at the very least avoid, bond proxies like staples and utilities. My fund has net zero stock exposure and is short international sovereign bonds via ETFs, so I’m not saying go crazy long here, just saying that even if the overall indices don’t move much, there is opportunity to pick some winners and losers for those that like me are free.
I don’t usually put a lot of charts in my letters, mainly because they make it hard to read on a phone, but here a few that I think are important right now. In particular, take a look at how while the SPY is flat, the XLU and XLP are rolling over, and the KBE and XLK are moving higher. The KBE in particular has room to run, as it’s still well below its level of late last year. In addition, I have put in a chart of the Japanese 10 year bond yield today versus 2003 (when the bond crashed on a VAR delivering) and versus the German Bund a year ago. Danger ahead? If you’re long negative yielding sovereign bonds, I’d say you’re pretty lost right now.
S&P 500 (SPY)
Finally done going up? Utilities (XLU)
Rolling over? Consumer Staples (XLP)
Room to run? U.S. Regional Banks (KRE)
Japanese 10 year Bond Crash: 2003 vs Today:
Japanese 10 year Bonds vs. German 10 year Bonds: Will History Repeat Itself?
Tech Breaking Out? SPDR Tech ETF (XLK):
Charts courtesy of Interactive Brokers, LLC and Bloomberg
This week’s Trading Rules:
In my June 24th, 2016 letter, I wrote: “The broader market has been performing worse than the S&P 500, as utilities and staples hold up the index. Tech and financials have been especially weak lately. I’d go shopping there for bargains if you have a time frame longer than a week. Financials are being hurt by the prospect of “lower for longer” again in the U.S. and weirdness from negative rates abroad. Tech is being hurt by weak global growth outlooks, but the best businesses will be fine, especially those with a U.S. focus.”
Since then, tech and financials have done well, and utilities and staples have stalled out. I’d stick with the trade.
SPY Trading Levels:
Resistance has been set by the top end of the tight trading range of the past 2 weeks. Lots of resistance at 216.50/217. Not a lot above that.
Support: small at 214/214/50, a decent amount at 210, then 205, 200, and 185.
Positions: Net neutral long/short. Long U.S. Stocks, short U.S. stocks, XLU, SPY, XLP, BWX.
Miller’s Market Musings is a free bi-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.