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 Wasted time
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. For more ideas and interesting reading, Email me for a free trial of my StockPicker newsletter. No credit card or other financial information is required. 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. Double, Double Toil and Trouble
Double, double toil and trouble; Fire burn and caldron bubble. Cool it with a baboon’s blood, Then the charm is firm and good. - William Shakespeare, Song of the Witches, Macbeth At about the halfway mark for earnings season and with the S&P 500 back to near its highs, this is a good time to review what is working and what isn’t. While the overall stock market moved higher in October by 8.4%, stock performance has been decidedly mixed post-earnings releases. We’re going to review four stocks that highlight the differences not only in this quarter’s releases, but in the way to create shareholder value long-term. The last 4-5% rise in the S&P 500 at the end of the month was not due to companies creating new products or markets – stock markets went up because of a continuation of the global race to the bottom in rates, in particular after dovish comments from ECB Chairman Draghi and more rate and reserve cuts from China. This re-prices cash flows higher, but it is not, in and of itself, creating value. Companies do that, not central banks. All the central banks can do is change short-term discount rates, which is a one-time shift up or down in the valuation of cash flows, but doesn’t create value over time. It’s a push in the back, but only companies can actually run forward. Nike (NKE) highlights this difference. After reporting earnings earlier this month (which we talked about in our last Musings), it held its first analyst day in a few years last week. Nike is really running fast and creating value. They expect that between now and 2020 they will increase sales annually by high-single digits to low double-digits percentages (going from $30 billion to $50 billion in sales) while increasing both their gross and net margins. This translates into 15% annual earnings growth over that time frame. Nike is doing this by creating brand loyalty in new markets. It is extending what it has done in basketball and men’s fitness in the U.S. to women’s fitness (where it has lagged historically), girls sports, and to new markets. In contrast to some of the other companies we will discuss today, Nike is growing fast in China, as a fitness craze reminiscent of what took place in the U.S. in the 1980s takes hold there (Under Armor is also doing well). My quibble with Nike is price – at 21 times EV/EBITDA, a lot of its future success is already in the stock. If it trips, it will get bloodied pretty easily. Apple (APPL) is in many respects ahead of Nike, but that means to me that is it nearer the finish line where revenues and earnings growth becomes much more difficult. Like a runner nearing the end of a race, it is tiring and slowing rapidly. In fact, it expects to grow its revenue next quarter at a decidedly slow annual rate of 2.5%. That is reflected in its lower EV/EBITDA ratio of 8.1x. Apple in many ways makes an aspirational product that relies on branding, similar to Nike, but Apple is nearing the end of the differentiation stage of its product lifecycle. There really isn’t any functionality that distinguishes an iPhone from a Samsung from a HTC. Making phones is a tough business, yet Apple has been able to maintain margins that rival those of luxury brands, where exclusivity or perceived quality can drive higher margins. If Apple is able to maintain those 40% margins in the future, it will be the first technology company to do so. Blackberry used to make great phones. The first Palm Pilots were amazing. Dell used to have margins that were the envy of the world, with negative working capital to boot. I am constantly reminded of another consumer electronics company that made beautiful consumer electronics, that created a new category of portable electronic devices, that was able to charge a premium for them and whose designers were regarded as the best in the world. That company was Sony (SNE), which not only created a new category with its Walkman music players but also some of the most elegant laptops ever. (The Vaio, which still exists, was light, powerful, and beautiful ten years ago). But Sony was eventually caught and eclipsed by the current king of music players Apple. Who will replace them? We’ll find out someday… Freeze, freeze, thou bitter sky, That dost not bite so nigh As benefits forgot: Though thou the waters warp, Thy sting is not so sharp As friend remembered not.
This does not bode well for the company’s ability to grow earnings long-term. But let’s say that the analysts and I am wrong, and that McDonald’s turns things around, and instead of growing earnings per share by the 8.6% that is implied in the consensus it is able to grow EPS via some combination of drastic expense cuts and stock buybacks by 23.5%, or to $6.00 per share. What is that worth? I’d argue that a company with low-to-no revenue growth should probably trade at or below the overall market, but let’s be generous again and say that McDonalds, being the icon that it is, should trade at a premium. Ok, fine. At 20 times that $6.00, it would trade at $120 per share, or 7% more than its closing price of $112.25 on October 30th. Why would someone be willing to pay 20 times earnings for McDonalds when its clearly struggling to grow and faces an uncertain future for its product? Why not buy Apple at 13 times earnings instead? Or Nike at 33 times? Because the investor buying McDonalds is basically buying a corporate bond at an earnings yield of about 5%, and hoping that if there is inflation in the future that McDonalds will be able to increase earnings enough to keep up with it. That’s it. It’s a bond replacement. Apple trades lower because while it makes great products, investors are aware that it could be the next Sony, and are pricing in that obsolescence risk. The market thinks that McDonalds is unlikely to become obsolete in the very near future, and so it trades accordingly. That said, McDonalds today is not the McDonalds of 20 years ago – for the next generation, it truly is a “friend remembered not”. Fear no more the heat o’ the sun, Nor the furious winter’s rages; Thou thy worldly task hast done, Home art gone, and ta’en thy wages: Golden lads and girls all must, As chimney-sweepers, come to dust.
And then there is Yum! Brands (YUM), which is further along the path of secular decline than the other fast food chains. It reported a fairly bleak quarter on October 6th and lowered its forward guidance, with full-year same store sales in China expected to be in the low single-digits negative. The stock reacted accordingly, falling nearly 20% on the report. (Full Disclosure: As of September 30th, Yum! was my fund’s largest short.) I have been negative on Yum for quite some time, as its almost blind exuberance and faith in the future growth of China (the cover of its annual report a few years ago featured the Great Wall of China and excited tales of the opportunity there) ignored the reality of operating a business in a tightly controlled, state run economy. As I have said many times before, if you build a successful business in China, eventually it will either be copied ruthlessly, forced to partner with a local enterprise, or regulated to death. Yum is experiencing a mix of all three, as food quality issues have created negative brand perceptions, the government has made it the target of investigative reports in state news media, and now competition is increasing rapidly. When YUM first entered China it was a novelty, and people flocked to its stores to experience a piece of Americana. But the novelty appears to have worn off, and it is facing a tough battle ahead. The recent decision to split the company into two pieces, with a China focused company and a separate company focused on its brands elsewhere in the world, does nothing to address these issues. The company intends to highly lever its balance sheet to buy back stock – in fact, it stated it intends to become non-investment grade as part of its plan. While financial engineering can create incremental EPS growth, over time it stops working as you reach your upper debt limits, and valuations decline accordingly. Yet, despite its recent stock price drop, YUM still trades at nearly 23 times 2015 earnings and 20 times 2016 estimates. While McDonalds is fighting a secular decline in fast-food, particularly for lower-quality, mass produced fare, YUM is fighting the same battle in the U.S. without the benefit of McDonalds stronger brand equity, and is fighting against significant competition in a market that represents about half its revenues. I don’t see how it fixes it. These four global companies demonstrate the power of brands, and what they can do for your earnings power over time. Nike is aspirational, and makes its customers believe they can be healthier, better people. It can raise prices and increase its margins over time and its stock trades at a high multiple as a result. I’d love to own it, but I think at these prices it is priced for perfection. Apple used to be aspirational, but recently its flagship products have been replicated by the competition. It has high, 40% margins on iPhones, but maintaining those margins over time will be difficult. In addition, the consumer technology field is littered with once-great companies that over time lost their pricing power and distinctiveness (like Sony, Blackberry, Xerox, HP, etc.), and its stock trades accordingly. McDonalds also used to be aspirational, but that was a long time ago. Today, its best case scenario is a slower than expected decline, as specialty chains eat away at its new customers and its core customer base remains extremely price sensitive. McDonalds serves a role in providing low-cost food to a customer base that can’t afford its competitors offerings, but it is not growing. The market basically assumes that it will be stable enough to continue to pay its dividends and buy back stock and provide a low but consistent return. YUM! Brands is basically McDonalds without the brand equity, and has a weak management team that was blinded by its own hype on China. It has finally faced the reality that China is a tough place to operate, and is going to engage in a spin of the business and financial maneuvers to try and stem a further decline in its stock. However, I think long-term it’s a going to have a tough time fighting against the secular headwinds in the U.S., its China business deserves a single-digit multiple at best (versus 22 times for the whole company today), and levering the balance sheet will only make it more susceptible to the next downturn. As a result, I am staying short the stock for now. Nike is creating value. Apple did. McDonalds is up because its cash flows are being valued higher in a low rate environment. And YUM is down because its cash flows are uncertain at best and a large part are at risk of going away at worst. ______________________________________________________________________________ This week’s Trading Rules:
SPY Trading Levels: Support: 208, 205, 200, then 188/189. Resistance: 211, 212, 213.5, then not much. Positions: Long and short U.S. stocks and options, Long SPY Puts. Short MCD and YUM. For more ideas and interesting reading, Email me for a free trial of my StockPicker newsletter. No credit card or other financial information is required. Come writers and critics Who prophesize with your pen And keep your eyes wide The chance won’t come again And don’t speak too soon For the wheel’s still in spin And there’s no tellin’ who that it’s namin’ For the loser now will be later to win For the times they are a-changin’ - Bob Dylan, The Times They Are A-Changin’ Earnings season gets into full-swing today, so I thought it would be a good time to go over some recent data that points to a potential changing of the guard in the global economy and what that means for earnings and stocks. We’ve had a few interesting pieces of news lately. First, Nike reported a few weeks ago, giving us a good look at what is working and what isn’t in the consumer space. In the U.S., women’s apparel and the sport-leisure trend there continues to grow. Interestingly, this same trend was seen in China, which despite the turmoil in their stock market showed strong growth for Nike. There appears to be a shift occurring in the Chinese economy. As it moves towards a more consumer driven economy, at least for those with good jobs and pay, the winners and losers are changing. Nike wins, while copper and coal producers lose. Expensive, flashy brands like Kors and Prada have had a rough time in China, as the anti-corruption push hit their gift-giving business. It appears that the less-conspicuous consumption dollars are flowing to athletic apparel, because, hey, who can argue with going out for a run? Another interesting data point was that foreign currency translations (ie, the effect of the strong dollar) hit Nike’s earnings by 6%. That’s a number. I suspect that they will not be alone. Nike got a pass because their future orders were very strong, but I suspect that the markets will not be so kind to others that miss. While it is common for companies to try to gloss over the effects of currency moves on their income, at the end of the day, cash is cash, and the logical takeaway is that if currencies remain right where they are, the effect is permanent. You don’t get those dollars back. And our multinationals are valued in dollars, on U.S. exchanges. I have a feeling this earnings season could see a lot of volatility as people try to figure what “core” earnings power is going forward given the current level of the U.S. dollar. That won’t be easy to do in 5 minutes, so this could be an interesting time for short-term moves in stocks. The logical takeaway is to focus on domestic U.S. companies with small or non-existent foreign operations, as they should be immune to the currency problem, and may even benefit if they source their products overseas but sell them in the U.S. In fact, that has been a popular trade. The problem with this thesis is that the U.S. economy appears to be slowing down dramatically right now. The most recent jobs report was not a pretty read unfortunately. The most startling statistic to me what that the Labor Force Participation rate has dropped to a level not seen since its inception in 1977. The U.S. wasn’t exactly booming back then either. The LFP dropped to 62.4%. (What the other 37.6% are doing all day is an open question, but since one of the strong spots in the report was restaurant hiring, maybe they are hanging out in coffee shops more?) Some parts of the economy are doing well. Food service continues to be a bright spot in the U.S., and hospitals also continue to hire. But these are generally not well paying jobs. Restaurants and bars added 349,000 people in the past year, but the mining industry, which includes oil and gas drillers, has shed over 100,000 since last December. I’d hazard to guess that the average oil drilling job pays at least twice a bartending gig, so it’s easy to see how wages are stagnating at up about 2%. Retailers added 24,000 in September, but again, these tend to be lower-paying jobs. And 6 million people are working part-time because they can’t find a full-time job, pushing the “real” unemployment rate to above 10%. More high-paying job losses are coming. Chesapeake announced recently that it is cutting 750 jobs at its headquarters in Oklahoma and Conoco is cutting 2,800 more jobs. Construction is weak in shale areas, with many projects stalled in places like the Bakken. Come senators, congressmen Please heed the call Don’t stand in the doorway Don’t block up the hall For he that gets hurt Will be he who has stalled There’s a battle outside and it is ragin’ It’ll soon shake your windows and rattle your walls For the times they are a-changin’ - Bob Dylan, The Times They Are A-Changin’ The stock market initially thought the weak jobs numbers were bad, and the stock market sold off 1.5% in quick order that Friday morning. However, after a few hours it reevaluated the situation and decided that this meant that the Fed wouldn’t be raising rates anytime soon. So banks got hit, but everything else ripped, and then market closed up 1.5%, for a big 3% swing intraday. Personally, I’d rather have a strong economy with good paying jobs so that consumers have more money to spend, but apparently I’m old fashioned. Combine all these data points and you have economists cutting their estimates for U.S. GDP growth to 1-2% for the third quarter of 2015 from 3.9% in the spring from a combination of weaker trade numbers and lower energy activity. This earnings season, we will be very focused on the outlooks coming from corporate America, as the companies on the front line of this shift will provide us with the best insight into what is happening in the economy in real-time. Given the changes in global markets this quarter, their conference calls will be mandatory listening. There is another aspect of this quarter’s reports that makes them very important: the third quarter is when outlooks for the coming fiscal year are adjusted. This is due to the timing of budgeting. Companies typically budget for the coming year in the late third and early fourth quarters, in order to have the process finished before the year-end bonus review work begins. I think this is why you see estimates come down the most in the third quarter each year – left to their own devices, Wall Street analysts default to making growth assumptions that tend to be too optimistic. As the companies themselves face the reality of actually putting a budget together for the next fiscal year, they release this guidance to the Street, which often has to adjust down their expectations. I believe that this reason, more than anything else, is why September and October tend to be the worst for stocks – this is simply when the companies finally acknowledge that their long-term goals are not short-term reality. The line it is drawn The curse it is cast The slow one now Will later be fast As the present now Will later be past The order is rapidly fadin’ And the first one now will later be last For the times they are a-changin’ - Bob Dylan, The Times They Are A-Changin’ The U.S. consumer (and the Chinese one too) seems to be resilient in the face of a weaker job market. Clearly lower oil prices have helped a little (hence the strength in restaurants). The problem area will be multi-nationals, particularly those with large foreign sales. There, we’re going to see a lot of “adjusted” earning for currency changes, but I think the right investment play will be to continue to focus on predominantly domestic companies and avoid those levered to the previously fast-growing Emerging Markets. For the times they are a changin’. The upcoming StockPicker newsletter will be focused on Nike and valuation. During earnings we will shift from a bi-weekly schedule to more frequent, brief notes on actionable items. Email me for a free trial. ______________________________________________________________________________ This week’s Trading Rules:
SPY Trading Levels: Support: 199, 195, then 188/189. Resistance: 201/202, 205/205, then 208. Positions: Long and short U.S. stocks and options, Long SPY Puts. For more ideas and interesting reading, Email me for a free trial of my bi-weekly StockPicker newsletter. No credit card or other financial information is required.
Millers Market Musings and StockResearch.net are not making an offering for any investment. It represents only the opinions of Jeffrey Miller and those that he interviews. Any views expressed are provided for informational and entertainment purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony for Miller's other firms. Jeffrey Miller is a Partner at Eight Bridges Capital Management and a Member of Eight Bridges Partners, LLC. Eight Bridges Capital Management, LLC is an exempt reporting advisor with the SEC. Eight Bridges Capital Management solely manages the Eight Bridges Partners, LP investment fund and does not provide any advice to individual investors in any capacity. This message is intended only for informational purposes, and does not constitute an offer for or advice about any alternative investment product. Past performance is not indicative of future performance. Any views expressed herein are provided for informational purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any manager, fund, or program mentioned here or elsewhere. Any opinions about any individual stocks, commodities, or other securities expressed in this article or any linked articles or websites are solely for informational purposes only and are not an offer or inducement to buy or sell any securities. The author and/or funds he manages may hold positions in the securities mentioned and his positions may change at any time without an obligation to update this disclosure. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. Jeffrey Miller and/or funds he manages may or may not have investments in any securities cited above as well as economic interest. Jeffrey Miller can be reached at 503-333-9725 or jmiller@stockresearch.net. “In theory there is no difference between theory and practice. In practice there is.” – Yogi Berra Yogi Berra passed away last week. He was a writer’s dream, providing me with great quotes over the years. Plus he was my grandma’s favorite player, so that counts for a lot. He will be missed. This week’s letter is a little late due to some outside events. Literally outside. It’s grape harvest time in the Columbia River Gorge and as the owner of a vineyard, it’s all hands on deck over here. The kids are taken out of school, given clippers and a bucket, and get to learn what it means to do real work. Then last night we spent a few hours watching the lunar eclipse from the Rose Garden in Washington Square Park in Portland under a cloudless sky. I hear it was cloudy in a lot of the country, but at this time of the year in the Pacific Northwest it’s usually crystal clear, and last night was no exception. Family first… I had a plan all week to write about actual stocks. Not the Fed, not interest rates, not macro stuff. Just a few stocks. And then the market fell 2.5% today and I had to scrap that plan, but I’m still going to talk stocks, just different ones than initially planned. The others are getting moved to our StockPicker newsletter instead. Email me for a free trial. In theory, issues affecting other markets, or sectors that are peripheral to our markets, shouldn’t knock down the whole U.S. stock market 2.5% in a day. But they did. And I think they will continue to have an impact for a little while longer for a few reasons. Right now, cars, credit, and commodities are creating some more of those nasty correlations we have been talking about lately. The cars in the title are Volkswagen. VW isn’t a part of U.S. indices, but it is a huge part of the German market, and along with other German carmakers (Daimler, BMW) and their suppliers accounts for nearly 775,000 jobs and 20% of all German exports. VW is the new Greece for the German economy. One company’s scandal won’t cause a recession, but the issues dogging the company have made the DAX fairly uninvestable at the moment. This isn’t good for global funds that thought Germany was the safe haven in Europe. And we know what happens when global macro funds get hit in one market – they sell in all of them. "A nickel ain't worth a dime anymore." – Yogi Berra Credit and commodities are linked. Oil and copper and other commodities are in a free-fall, creating problems for companies that borrowed a lot to build the capacity to mine or drill for them. High yield spreads (see the chart below) are widening out. This creates problems for investors who lent at very low spreads last year, when a record amount of debt was issued. Now add in the unfolding saga at Glencore. The correlation here is from potential counterparty risk if Glencore gets downgraded to junk. Risk resides somewhere – but the question is where and in what form. Glencore is a big borrower ($26 billion comes due in the first half of 2016) and its credit default swaps are blowing out to extreme levels. My inbox has a number of reports on what banks have exposure to Glencore debt, which is never a good sign for the company in question. However, this is not just a Glencore problem -- high yield spreads overall are widening (albeit from very low levels), and new deals are coming below par with higher-than-marketed spreads. As usual, high yield was the canary in the coal mine for the stock market – spreads started widening in late June. The new capital given to the oil industry earlier this year was banking on a recovery in oil prices – and when oil prices fell over the summer instead of sustaining their rebound, credit markets got more realistic about the industry’s prospects. "Nobody goes there anymore. It's too crowded." – Yogi Berra So what is different today that hasn’t been known to the markets for a few months? Commodities have been terrible for awhile. Glencore has been in the news for weeks. Energy is about 7% of the S&P 500 and Materials are under 3%. Well, today the markets got word that Hilary Clinton’s tweet from last week about price-gouging in drug prices (after Turing’s CEO did a star turn as the douche-bag CEO of the year), which wrecked biotech stocks, has now gone viral, as House Democrats asked to subpoena Valeant for documents related to drug price increases. Valeant was off over 12% today, and 4 other pharma companies stocks fell more than 10%. This healthcare selloff is what caused the most pain in the markets today, as U.S. stock fund managers have more exposure to healthcare than to materials and energy combined. Pharma was the place fund managers could hide – there was a lot of M&A, companies had activists backing them, borrowing for deals was cheap. Now M&A is in doubt, as the industry has apparently become the new whipping boy for Congress. (Does this mean the banks are now finally out of the hot seat? If so, they’re cheap…). Healthcare is a very crowded trade. Suddenly, with all this risk, nobody goes there anymore… "The future ain't what it used to be." – Yogi Berra This is where those nasty correlations come into play again. High yield has always been a leading indicator for equity markets for me – high yield spreads widening imply that equity risk premiums are also likely to increase. High yield spreads widened on energy worries late last year, but then tightened again as companies issued equity and refinanced debt. However, the most recent spread increase has coincided with bigger worries about global financial markets overall. If you were a simple stock fund that sensibly avoided all this mess by staying away from energy and commodities, you may well have been hiding in the “safe” auto and healthcare industries. Which is what makes the car problem and Clinton problem big problems – they are hitting stock investors where it hurts. J.P. Morgan said it well in a note today: “HC isn’t just big (~15% of the SPX) but has also been a massive contributor to fund performance over the last 1-2 years (thus the HC stock plunge has inflicted enormous amounts of P&L pain throughout the fund community and that is only adding to the broader risk-off trend).” "If people don't want to come out to the park, nobody's going to stop them." – Yogi Berra I think investors feel under siege. Global macro players have been hit by emerging market and currency volatility, global bond investors have been hit by credit spreads widening, and now stock investors are being hit in what they thought were their safe havens too. Buyers who were patient and added to their favorite stocks on the recent pullbacks are now sitting on losses on almost all of those buys. If you had a plan to buy a position in thirds, and you bought your first third on the first drop and the second third last week, well, now you’re looking at your book and thinking “do I really need to buy those last shares here? Why not wait a few days and see what happens?” Buying the dips, unless you were really good on August 24th, means you’re starting to feel some pain. (See the SPY chart below). And the thing about the stock market is, if you don’t want to come out to the park, nobody is going to stop you. This week’s Trading Rules:
Resistance: 192, 195, a lot at 197/199, then 201 and 205. Positions: Long and short U.S. stocks and options, Long SPY Puts. For more ideas, charts, and market information, Email me for a free trial of my bi-weekly StockPicker newsletter. No credit card or other financial information is required. Mad Hatter: “Why is a raven like a writing-desk?” “Have you guessed the riddle yet?” the Hatter said, turning to Alice again. “No, I give it up,” Alice replied: “What’s the answer?” “I haven’t the slightest idea,” said the Hatter. - Alice in Wonderland A lot of investors are feeling like Alice in Wonderland, trying to figure out the riddle that is the Federal Reserve’s thought process. Investors are trying to understand why the Federal Reserve is so reticent to raise its target for the federal funds from its current 0 to ¼%. Its press release is fairly concise and offers quite a bit of insight into their thinking – I highly recommend actually reading it, not just a newspaper summary of it. As someone who thinks that rates should be higher, and banking regulation lower, because that is what will drive our economy upward, I’m trying to see what the Fed sees. What matters in investing is not what you think things should be but instead understanding what things are. And what things “are” today is lower rates for longer. So why are things the way they are? What does the Fed see that the rest of us don’t? Taking the press release as a guide, the Fed is focused on the following areas of the economy: Household Spending Business Fixed Investment Housing Sector Exports Labor Market From the release, they state that all of these areas are “improving” or “increasing moderately”, with the exception of exports, which have been “soft.” While they are worried about “global economic and financial developments” restraining economic activity, they believe that “with appropriate policy accommodation” (ie, lower-than-normal Fed Funds rates) that “economic activity will expand at a moderate pace.” “Take some more tea,” the March Hare said to Alice, very earnestly. “I've had nothing yet,” Alice replied in an offended tone, “so I can't take more.” “You mean you can't take LESS,” said the Hatter: “it's very easy to take MORE than nothing.” - Alice in Wonderland Implied in the release is that each of these areas, absent the magical interventions of the Fed, would not be expanding at a moderate pace. It also implies that these areas of the economy are helped by low rates – in fact, that these areas need rates at zero to improve even moderately. That is not a very bullish outlook for the state of the economy years after Lehman imploded. Seven years later and we still are barely expanding, and the Fed thinks that MORE of the same, more of nothing, is the answer. But if, seven years on, more of nothing isn’t really working, according to your own analysis of the situation, then maybe the right thing to do is to try something different. That would be the logical approach in my mind. Zero rates did not jump start Japan – in fact, they have had zero rates for 20 years without inflation, and their economy has been stuck in a rut the whole time. Here in the U.S. we have had zero rates for seven years and inflation is going down, not up, and the Fed thinks our expansion basically stinks. At what point will the Fed realize that setting interest rates really low doesn’t help the real economy much? It did help avoid an apocalypse in financial markets in 2009/2010, but those risks are behind us (at least here in the U.S.). But now, what is holding back our economy is not the level of rates but the level of regulation and bureaucracy in our economy. If you are GE or Coca-Cola, you have refinanced your debt and lengthened your maturities a number of times in the past seven years. Slightly higher (say 200 basis points) rates aren’t going to hurt you. If you are a home buyer, unless you have pristine credit, lower rates haven’t really helped you because you can’t get a mortgage without herculean efforts – the paperwork, the regulations put in place by the Consumer Finance Protection Bureau (CFPB), make lending very onerous for community banks and borrowers. All the fines and penalties the Justice Department has been imposing on the banking industry have made bankers question whether mortgage lending is worth the risks. It was already a marginal business pre-2008. Now, its fraught with risk – if you lend someone money and they do pay you back, you make say 3.5% to 4%. If they don’t, you have a hard time collecting because of all the processes and legal maneuvering that needs to take place. It’s basically a lose-lose proposition for the banks today. If the Fed really wants to move the economy into a higher gear, it should remove the barriers to lending it has put in place in the past seven years, it should work with the regional and community banks it regulates as partners, not as adversaries, and it should make it profitable for these banks to make loans again by raising the level of interest rates so that they can make some money from their lending. “But I don’t want to go among mad people," Alice remarked. "Oh, you can’t help that," said the Cat: "we’re all mad here. I’m mad. You’re mad." "How do you know I’m mad?" said Alice. "You must be," said the Cat, "or you wouldn’t have come here.” - Alice in Wonderland I wonder what it must be like to live in your own dreamworld, divorced from reality, where you actually believe that what you do matters so much to the world’s economy that you must be extremely careful with what you say and do, otherwise people will stop working, companies will stop producing, whole economies will come screeching to a halt with rioting in the streets and starvation everywhere. It must be so strange to believe that raising the Fed Funds target rate a mere 25 basis points will cause all this havoc, so strange to believe that you have this magical power over people’s decision making as to whether or not to start a company, expand one, sell one, or close one. Personally, I don’t know how they sleep at night, thinking that by making this momentous decision that they will unleash these catastrophic forces that they will be unable to stop. But what if.. instead of unleashing hell, a strange thing happened. Nothing. The economy didn’t stop, kids still went to school, people still went to work, and life went on. What if the only thing that happened is that a few emerging markets currencies depreciated, and a few macro funds took some losses, and maybe in a worst case, our stock market went down a bit. Would that end the world as we know it? Would we be in a recession again? I seriously doubt it. It used to be that market declines of 10-20% happened fairly regularly, a normal ebb and flow as markets adjusted to earnings and changes in the real economy. Stocks are not being so finely modeled that 25 basis points changes the NPV calculation (or at least they shouldn’t be if you have any common sense). “It’s no use going back to yesterday, because I was a different person then.” – Alice, Alice in Wonderland I’m not saying that interest rates play no role in the real economy. What I am saying is that the Fed has gotten so caught in its own world that it thinks that every little move it makes matters. Volcker used a sledgehammer to stop inflation. Greenspan used a fire house to jumpstart our economy in 2002. Big moves in rates do matter, and do impact things like lending and banking and investment decisions. But small ones don’t. The Fed has gotten caught in a weird dream world where it thinks that it is like Jacques Seurat, where every fine detail in their painting matters, when instead they should be thinking like Jackson Pollock, where the broad, dramatic movements are what creates the masterpiece. We’re very far from yesterday, where the Fed made big moves in rates to have a real impact on the economy. Today, we’re in a world where rates will be lower for longer than they should be, and that is the reality we have to live with and adjust to. What we think rates “should be” is irrelevant – you can’t invest on “should be”, you have to invest on what will be. And after Thursday’s statement, it’s clear that this Fed is definitely led by a different person than in the past. ______________________________________________________________________________ This week’s Trading Rules:
Support: 194.5, 192, 188/189, then not much. Resistance: a lot at 197/199, then 201 and 205. Positions: Long and short U.S. stocks and options, Long SPY Puts. For more ideas, charts, and market information, Email me for a free trial of my bi-weekly StockPicker newsletter. No credit card or other financial information is required. 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. Millers Market Musings and StockResearch.net are not making an offering for any investment. It represents only the opinions of Jeffrey Miller and those that he interviews. Any views expressed are provided for informational and entertainment purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony for Miller's other firms. Jeffrey Miller is a Partner at Eight Bridges Capital Management and a Member of Eight Bridges Partners, LLC. Eight Bridges Capital Management, LLC is an exempt reporting advisor with the SEC. Eight Bridges Capital Management solely manages the Eight Bridges Partners, LP investment fund and does not provide any advice to individual investors in any capacity. This message is intended only for informational purposes, and does not constitute an offer for or advice about any alternative investment product. Past performance is not indicative of future performance.
Any views expressed herein are provided for informational purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any manager, fund, or program mentioned here or elsewhere. Any opinions about any individual stocks, commodities, or other securities expressed in this article or any linked articles or websites are solely for informational purposes only and are not an offer or inducement to buy or sell any securities. The author and/or funds he manages may hold positions in the securities mentioned and his positions may change at any time without an obligation to update this disclosure. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. Jeffrey Miller and/or funds he manages may or may not have investments in any securities cited above as well as economic interest. Jeffrey Miller can be reached at 503-333-9725 or jmiller@stockresearch.net. First, a note about 9/11. It appeared to me that the press seemed to ignore it this year. The Wall Street Journal ran one small article on Saturday. That’s it. This is a big deal, a seismic event in our nation, and we get, just 14 years later, almost nothing on it. The New York Times continues to make its rememberances available online, which is very nice. I’m sure next year, being the 15th anniversary, there will be more coverage, but I for one was very disappointed that it appears that the events of that day seem to already be fading away. That’s just wrong. Now, as someone that used to work in the World Trade Center and lost many friends that day, I’m sensitive to the issue. But still, I think the dearth of coverage in the press was pretty sad. If you want to read some of the profiles of my former co-workers at KBW who died that day, you can go to their website here. On to the markets… It vexes me. I'm terribly vexed. – Commodus, Gladiator This is Fed week. As much as I want to talk about stocks and what is going right or wrong for individual companies, the reality is that right now, most of that doesn’t really matter. What will be moving stock prices for the next few weeks is all macro. The Fed, and how the rest of the world reacts to its actions, is what matters unfortunately. David Tepper gave a very lengthy and interesting interview on CNBC last week. I highly recommend looking it up online and watching it. Mr. Tepper has an excellent long-term track record, and he’s also able to communicate simply and clearly. A few of his comments captured the angst many investors are feeling today. Teppper said “there are times to make money and times to not lose money. Which one do you think we are in now?... Right, don’t lose money times.” He mentioned he has a fairly low net exposure to stocks, which is the same position my fund is in – we have longs and shorts, but our hedged net is zero. Indexers and mutual fund relative-performance-game players don’t really care about making money or losing money – they just want to beat their peer group, or more cynically, just be in the middle of the pack. Then they can let their marketing departments take over. But if you are in the business of thinking about capital preservation, in the business of generating absolute, not relative, performance, then you need to figure out what kind of time it is. And right now, I think we’re in a don’t lose money time. Tepper also commented on the market’s recent increase in volatility. Volatility was very low for a very long time because the flow of money was moving in one direction (lower rates, lots of global liquidity), and now that river is going to run into resistance, some flows heading into the other direction (higher rates, capital outflow from emerging markets). When you get flows that run into each other, like a river entering the ocean, you get waves. That’s what we’re getting now. His conclusion: this volatility is normal, to be expected, and will be here for awhile, so get used to it. That conclusion seemed fine when I listened to it – it made sense, and didn’t seem like a big deal. I personally like higher volatility, as it creates more opportunities for mis-priced stocks. But then the Bank for International Settlements (BIS) released its quarterly review. It was pretty eye-opening, and made this recent volatility sound like a precursor to something much bigger. There was a dream that was Rome. You could only whisper it. Anything more than a whisper and it would vanish, it was so fragile. Marcus Aurelius, Gladiator The BIS is basically the central bank of central banks, and Claudio Borio, head of its Monetary and Economic Department, said the following in a presentation on the latest review: “This is…a world in which interest rates have been extraordinarily low for exceptionally long and in which financial markets have worryingly come to depend on central banks’ every word and deed, in turn complicating the needed policy normalization.” “It is unrealistic and dangerous to expect that monetary policy can cure all the global economy’s ills.” “We are not seeing isolated tremors, but the release of pressure that has gradually accumulated over the years along major faultlines.” Source: Financial Times That got my attention. In a recent letter we mentioned that the U.S. economy is clearly strong enough to handle higher rates, so why is the Fed so afraid to do so? What do they know that we don’t? Apparently, they are worried about their tiny, irrelevant 25 basis point hike triggering an earthquake, that the pressures and imbalances in emerging markets will unleash a disaster that it can’t contain. And if, as BIS states above, we are seeing “the release of pressure” in an increasingly interconnected world, does delaying this release help anything? Will these pressures dissipate with time, or will they just remain hidden below the surface, ready to rear their ugly heads any time the Fed tries to raise rates in the future? I think that time will not help, that the dollar denominated loans that companies in emerging markets are holding will not become easier to pay back later. The odds of the currencies of these countries meaningfully appreciating against the dollar long-term are low, so the repayment burden will continue to increase over time. Which is why I think it’s better we raise rates here in the U.S. while our economy is still relatively strong – waiting is only likely to lead to bigger problems for emerging markets down the road. "They lied when they told me he was dead. If they lied, how can they respect me. If they don't respect me, how can they love me?" Commodus, Gladiator The Fed wants to be loved. And that is a problem. Personally, I’d be much more comfortable with a Fed that didn’t so obviously care about being loved. It wants to be loved by everyone - by our bond markets, stock markets, foreign markets, and everyone else. The Fed should do what it thinks is right, not what it thinks will be popular. Then it would earn our respect. This is a weird moment in time we find ourselves in, a time when the Fed focuses more on investor expectations and financial market reactions then on the impact of their actions on the real economy. We need to get past this desire to be loved that seems to be driving the Fed’s decision making so that the real economy can expand at a brisker pace. Velocity of money is at all-time lows, and the only thing that is going to get it moving again is higher rates, which will make banks much more willing to lend. Until then, we’ll be stuck in this “ok” economy, where things are neither really bad nor really good, and everyone genuflects before the almighty central banks, who in turn genuflect before financial markets. This is a weird time, and it’s a time to focus on not losing money. This week’s Trading Rules:
Last week the market rose the most in 6 months, which was surprising not because it rose, but because a 2.3% increase was the largest in 6 months. We really were in a low vol world… The market’s been coloring within the lines. This week’s trading levels for the SPY are: Support: 192, 188/189, then 183.50/184. Resistance: a lot at 197, 198, then 201 and 205. Positions: Long and short U.S. stocks and options, Long SPY Puts. Robert Baron at BTIG has been spot on with his trading calls lately. He has been sending a regular chart that I am copying below. It overlays today’s market with the fall of 2011, when the U.S.’s debt was (foolishly) downgraded. That was also a time of concern about linkages, pressures in markets, and how these macro factors would impact the real economy. The correlation is fairly amazing. Check it out: For more ideas, charts, and market information, Email me for a free trial of my weekly StockPicker newsletter. No credit card or other financial information is required. 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. Whenever people agree with me I always feel I must be wrong. - Oscar Wilde
A few weeks ago we highlighted how Value-at-risk models can exacerbate movements in various markets, even ones seemingly unrelated. Since then, this has become the topic du jour, as different pundits catch on to the fact that something is not quite right in today’s financial markets. It’s not that stocks are going down – stocks have been going up and down for hundreds of years. Going down is good. It resolves periodic overvaluations, and creates opportunities for those that have cash or new money to invest. It cleanses the markets of its occasional excesses, and there will always be excesses. But smart investors, who have been around for awhile, are sensing that something is amiss. When Art Cashin, one of the best writers on markets I’ve read, is worried about “another Lehman event,” as he stated on TV last week, I pay attention. So why all the angst? This is a complicated question. As I set out to write this week’s Miller’s Market Musings, I kept getting dragged down different paths, all of them legitimate, and all of them somewhat inter-related. But writing about them all would make this piece a lot longer than I like these Musings to be, so I will explore them in more depth in this week’s Stockpicker newsletter. You can get a copy of it for free by emailing me at jmiller@stockresearch.net. Some cause happiness wherever they go; others whenever they go. - Oscar Wilde A proximate cause of the recent volatility according to a subset of the financial press, particularly the talking heads on CNBC, is that a large part of the Street is out on vacation. I’ve heard this explanation for market drops many times in the well over 20 years I have been working on Wall Street, and I am convinced that this is simply not true. I’ve worked on the sell-side and the buy-side, and only once have I walked into the office or the trading floor and been like man, where is everybody? The one time I can recall this happening was the Blizzard of 1996, when New York was basically shut down. I was young and dumb and figured eh, I’ll go in, what’s a little snow? I lived in the West Village, and when I finally made it to our offices in the World Trade Center, I was literally one of about 6 people there. So I can see why volume was low that day. But who are these people that are a) so powerful that they move markets all by themselves – or, thought of differently, are so powerful that they calm markets by their mere presence and b) why are they on vacation all the time. I mean, I go on vacation occasionally, but even then I check the markets at both the open and the close and am able to monitor all my positions, in real time, from my Ipad and phone. If I was “the” person moving markets, the person able to arbitrage away the market mispricings and provide liquidity and dampen volatility, I’d like to think that not only would I be diligent and pay attention to markets, even from the Hamptons or St. Tropez, but that I’d have a few employees whom I trusted watching after things for me. You know, in case things happen that provide us the chance to make some money. Like a market selloff. And if things got interesting, and I do think the markets are quite interesting at the moment, and I was the person responsible for moving markets, I’m pretty sure I’d have spent the money on a nice computer and internet connection at my house in the Hampton of my choosing and be able to do the things that I do from there. So I’m not buying the vacation argument. The U.S. isn’t Europe. We don’t go away and do nothing for a month. We take a long weekend, we go away for a week, but if you go to the places where people like to vacation, you’ll see lots of people still on their computers and their phones. Is this healthy? I don’t know, probably not, but that’s how Wall Street works, and you don’t get to be the man behind the curtain by leading a healthy and balanced life. You get to be the man behind the curtain because you’re willing to work harder and longer and sacrifice things, like your vacations. Sure, at the end of the movie the Wizard is revealed to be old and sad and not that powerful, but for the time he’s the Wizard, he’s the man, and he likes it, so he does it. And the Wizard of the market has a good internet connection on vacation. To understand the driver of the recent market volatility, I think we need to understand the cast of characters in this movie. Markets have changed, and what we used to think of as the “investor” really has changed. In the 1800s, markets were dominated by syndicates of related investors who would sometimes corner markets, manipulate them, and profit from them at the expense of somewhat less sophisticated “punters”. In the 1920s, markets became dominated by speculators trading on extremely thin margins who resembled the momentum investors of the late 1990s. They mostly disappeared in the Crash of 1929, to be replaced by more sober investors like the great Paul Cabot, who founded State Street. As the markets churned through the aftermath of the Great Depression, they became slightly more institutionalized, and a diligent and smart investor like John Neff or a young Warren Buffett could thrive on the inefficiencies. A little sincerity is a dangerous thing, and a great deal of it is absolutely fatal. - Oscar Wilde The institutionalization of the stock market in the U.S. in the 1980s was initially a good thing, as an element of the guesswork involved in picking winners and losers was squeezed out. Peter Lynch and other star stock pickers became as well known to the investing public as sports figures were to sports fans. The lingering inefficiencies in the market, mainly due to a lack of easy access to data and information, were mostly removed with the advent of the internet and the widespread availability of financial data. Now, a database of comparable company data that used to take reams of analysts month to build can now be bought for a few hundred dollars, and be searchable and screenable in ways that were literally unimaginable 25 years ago. Today’s active stock picker has more fundamental data available to her than the head of research at a large investment management did at a fraction of the cost. This should have created greater understanding about the true value of a business, as estimating current and future cash flows becomes easier and more widely dispersed. But a funny thing happened along the way. This dispersed information and computing power led to the rise of a two parallel universes of investors who do not make judgments about the value of companies and their securities, but instead simply use the prices of those securities and/or the variability of those prices to judge their value and riskiness. Here is where the market’s structural weakness resides, in funds that have gotten too large relative to their strategy’s capacity. A parasite only survives so long as it doesn’t kill its host. A man who does not think for himself does not think at all. - Oscar Wilde The “Chicago School” refers to a group of professors that came up with the Efficient Market Hypothosis and effectively set in motion the odd market movements we are seeing today and will continue to see in the future. These professors basically stated that all information is immediately reflected in security prices, so there is no advantage to be gained from studying companies or markets. One can simply take a security’s price, at face value, as being correct at all times. This has generally been proven to not be the case, as all information isn’t generally known, some information is hard to ascertain, and some information requires judgement and experience (along with investors willing to give the manager sufficient time and variability in returns to extract this return – but that is a story for another letter) to understand. But unfortunately this idea, however misguided it may be, found a champion in Vanguard, which built one of the largest investment firms in the world based on this idea. Vanguard’s simplistic notion is that since the average investor can’t beat “the market” (whatever that may be defined as), then the average investor shouldn’t try. The only differentiator is cost in the Vanguard world. This is based on some really shoddy statistics (of course the average investor can’t beat the average investor by definition, just like the average person can’t outlive the average person, but that doesn’t mean that eating well and getting some exercise are fruitless endeavors either) and lazy thinking (why use market capitalization except that it is easy?), but nonetheless it has come to define a world called Index investing that has come to increasingly drive markets. Index investors don’t think. They take perverse pride in not thinking. Thinking is bad, it leads to bad decisions, and anyway, it’s not necessary – just define a “market” and then replicate that market. Simple, easy, done. One of the many lessons that one learns in prison is, that things are what they are and will be what they will be. - Oscar Wilde Except that there is a problem. When the parasite, aka, the world of index investors, was small, it didn’t really matter that it was relying on a flawed Efficient Market Hypothesis because it was “good enough” and the money invested in related strategies was small enough to not really matter. It was truly a parasite along for the ride. But the index fund industry forgot that eventually it will kill its host if it grows too large relative to the host. Trillions of dollars now reside in index funds and their related products, Exchanged Traded Funds (ETFs). ETFs are index funds on steroids, because while an index fund only needs to worry about inflows and outflows once a day, ETFs are constantly adjusting their holdings based on supply and demand during trading hours. Again, when the parasite was relatively new and small, the host market didn’t really notice them. They added volume but, critically, not much volatility. But as ETFs have come to be an asset class in and of themselves, somewhat removed from the underlying assets, the feedback loop has been reversed. Whereas once upon a time, the value of the underlying companies determined the price of the ETF, increasingly today it is the trading supply and demand for a particular ETF that is moving the underlying securities. I see it all the time – all the components of say, the Alerian MLP ETF (AMLP) or the KBW Regional Bank ETF (KRE) will rise or fall together. A change in an investment firms’ allocation to an “asset class” will immediately ripple across all the stocks or bonds in the ETF, regardless of whether or not all the stocks and bonds deserve to be treated the same. The defining characteristic of how their securities will behave in the short-term is now almost always their sector and their market cap, not their product or prospect for future success or failure. Absent the 4 times a year when companies report their earnings (in which case fundamentals do determine the near-term stock movements), the day-to-day movements in stocks have become more synchronized. Correlations are up because the driver of prices over short periods of time is simply money flows into an ETF. As index funds and ETFs have become the investment of choice for many investors, price movements within sectors have become more homogenous, and securities in them are more correlated to one another. However, I believe that the weird feedback loops markets are experiencing lately is because all financial markets are now tied to one another as a second parallel universe of investor – the “risk-parity” investor, has garnered more assets under management. These investors look at asset classes, like foreign bonds or emerging market equities or currencies, as just things to be modeled and leverage applied to based on expectations for future returns and volatility. I read an article last week where the head of a firm with hundreds of billions of dollars in risk-parity investments said, effectively, that his firm doesn’t make judgments about securities individually, but only about asset classes and their theoretical returns and the variability of those returns. They then lever up the asset classes with lower expected volatility to get to a “market” level of volatility, and they then do this across asset classes globally. Which led me to ask myself – if everyone is now an indexer, or a derivative of an indexer (ETF) who assumes that the prices being generated by the other indexers, none of whom actually thinks about things like the businesses these companies are in, or their values, or what the possibility of disruption to the business is, then who is driving the bus? In other words, who’s deciding what these companies are worth now that the parasites have taken over their hosts? Consistency is the last refuge of the unimaginative. - Oscar Wilde After initially being alternately annoyed and scared by the realization that multi-billion dollar businesses have been built on top of a faulty foundation and then new, even more fragile businesses have been built on top of them, I’m now quite happy that this has happened, because while it has made my job much more frustrating on a day-to-day basis (“Why is that stock down 4% on no news?), it is also creating many more opportunities for intelligent, rational, and most important, active fundamental investors to make money over time. I believe that we are nearing, if we haven’t already reached, a tipping point in markets in which the parasites have become the hosts, and the prior hosts can now become the parasites (in a good way of course, because I’m one of them), feasting off of the market disturbances that are occasionally created by these feedback loops and VAR model driven selloffs. Index investors and their risk-parity cousins have become the hosts for a new version of parasite (fundamental, active investors who are not benchmark huggers) that takes advantage of these dislocations to buy great companies at distressed prices. The opportunities that await those that are flexible enough to take advantage of them will be tremendous. This week’s Trading Rules:
Support: 191, 188/189, then 183.50/184. Resistance: a lot at 197.50/199, then 201 and 205. Positions: Long and short U.S. stocks and options, Long SPY Puts. For more ideas, charts, and market information, Email me for a free trial of my weekly StockPicker newsletter. No credit card or other financial information is required. Where Exactly is There? And Do We Really Want To Go?
Well we know where we're goin' But we don't know where we've been And we know what we're knowin' But we can't say what we've seen And we're not little children And we know what we want And the future is certain Give us time to work it out Talking Heads, Road to Nowhere If you were fortunate enough to be on safari without an internet connection and are just now checking your accounts, you might think that this was just another sleepy week on Wall Street. But as everyone by now knows, it was anything but, with some extreme moves in stock markets both here in the U.S. and abroad. Last week’s Millers Market Musings detailed the reasons for the upcoming volatility of the past week and the mechanism through which a slowing Chinese economy can reverberate through emerging markets and into our markets here, even for companies with absolutely no exposure to China. The feedback loops and VAR models I discussed immediately reared their ugly heads on Monday and Tuesday. The stock market was following its usual pattern in a de-risking selloff on Wednesday when a wishy-washy statement from NY Federal Reserve head Bill Dudley sent markets higher on the hope that the Fed will push back its expected September rate hike. While some people applauded the market’s recovery, I was left wondering - is that really where we want to go? To a place where simply pushing back a tiny rate increase is enough to launch a recovery? Because what that really means is that we’re in a pretty bad neighborhood already, we just don’t know it yet. Think about it – what is lurking out there that is so scary that the Fed is afraid to move up its target Fed Funds rate by – wait for it – 0.25%? What do they know that we don’t? Are we never going to have normal rates, because every time they get close, emerging markets throw a hissy fit? Isn’t not raising rates in September just kicking the can down the road, for, oh, I don’t know, forever? Because the issues that keep sending emerging markets, including China, into spasms every time the Dollar strengthens aren’t going away any time soon. These are deep seated, long term problems, and those emerging markets aren’t going to suddenly be de-linked in October, or December, or any time soon. So let’s figure out where we are going and get there already. Put another way, for all of the good news here in the U.S. (second quarter GDP here was revised up to 3.7% on Friday), a little 25 basis points shouldn’t knock us off the rails. So why are the folks at the Fed so worried? When you watch their interviews, they are clearly taking great pains not to upset anyone – so…who or what are they worried about? It can’t be large, public companies here in the U.S. Corporate America has been and still is able to borrow at extremely low rates for long durations. They’re set for the foreseeable future. They don’t need low rates anymore. I’m going to go on a rant here for a second: unfortunately, lower rates have not helped the real driver of our economy, small businesses, because an onerous regulatory environment for community banks makes it extremely difficult for them to lend. Loans are not getting to those that need them, because the FDIC has been on a witch-hunt since 2009 to bring down community banking. That may sound extreme, but I’m not joking. My background is as a bank analyst for KBW, and I still invest a large portion of my fund in regional banks. I speak to well over a hundred bank CFOs and CEOs a year – and their life is a nightmare. Banks that had nothing to do with making subprime loans and selling them to Merrill to be repackaged into CDOs are feeling the brunt of our new bureaucratic and regulatory regime, and it is ugly. Shelia Bair and her ilk have done more to destroy community banking in this country than anything else in the past 20 years. And when you destroy community banking, you destroy the heart and soul of our economy. That is the legacy Bair left us, and it is the reason why our recovery is so weak. But I digress. Higher Fed Funds rates will have absolutely no impact whatsoever on our economy, because large corporations have all the debt they need and small businesses can’t get money at any price. You see, it’s not the price of money that is the issue –it’s the availability. Real companies don’t make investment decisions based on 25, or 50, or even 200 basis point differentials in borrowing costs. If a project you are considering borrowing a significant sum of money to finance is make or break based on whether or not your loan rate is 4% or 6%, you have a problem. You shouldn’t do that project. Real people running real businesses get this. Academics who have never held a job outside of a university or a Federal Reserve bank don’t. They’ve never had to make payroll. They’ve never had to finance a new piece of equipment, or even go and sell a product to a customer. They don’t know how business works. To them, it’s all just numbers in a model. And in their model higher rates drive down economic activity. I’d argue the opposite. Higher rates will make banks more willing to lend because they will finally be paid to take on that risk. Right now, they are holding securities until rates rise. Let banks get paid for their credit risk and you’ll see them lending more money, will which drive our economy forward. It’s not the cost of money that determines whether or not a business will borrow – it’s the access. So, put another way – does the Fed think our economy is really so shaky, our recovery so fragile, that a tiny move higher in Fed Funds will derail it and send us careening back into a recession? I can’t imagine that, if they have any common sense left, they do. So what is lurking out there that is keeping the Fed from acting? It has to be a fear of a repeat of 1997 and 1998, when emerging market currency problems morphed into the Russian debt crisis and Long Term Capital blowing up, necessitating a rescue orchestrated by the Fed. In other words, maybe they are worried about, or should be anyway, the “unknown unknowns” as Defense Secretary Donald Rumsfeld once said. Maybe you wonder where you are I don't care Here is where time is on our side Talking Heads, Road to Nowhere But what if, instead, they really do know about the linkages that are lurking in the system, but can’t really say so, for fear of setting off the exact problem they are hoping to avoid? Our markets, and theirs, are apparently locked in a dance, where quant funds that trade across markets are going to have to de-risk, and quickly, and the Fed is hoping that time will solve the issue. We’ve been down this road before. Once fragile markets are over-leveraged and linked together, there is no turning back. You can slow down, but eventually, you’re going to get there. And “there” isn’t a place you really want to be. And it's very far away But it's growing day by day And it's all right, baby, it's all right Talking Heads, Road to Nowhere This week’s Trading Rules:
S&P 500 (SPY) Support and Resistance Levels: Last week’s top support of 197 and bottom support band of 182 seemed to be the right levels. This week’s are: Support: 195/196, 188/189, then 183.50/184. Below that, buckle up. Resistance: A lot at 199/200. 204.5/205, 208, then 210. Positions: Long and short U.S. stocks, long SPY puts. For more ideas, charts, and market information, Email me for a free trial of my weekly StockPicker newsletter. No credit card or other financial information is required. 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 (from pre-2012 can be found at www.millersmusings.com). 8/23/2015 Ever Dance with the Devil in the Pale Moon Light? Feedback loops, China, commodities, and VAR models.Read Now The Joker: Tell me something, my friend. You ever dance with the devil in the pale moonlight? Bruce Wayne: What? The Joker: I always ask that of all my prey. I just... like the sound of it. Batman, 1989 This post marks the return of Miller’s Market Musings, a free weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. For the past three years these posts were written exclusively for clients of my prior employer (understandable, they were paying for them), but now that I am back at my own firm, I am free to distribute these notes once again to the public. 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 (from pre-2012 can be found at www.millersmusings.com). Now on to the good stuff… In case you were out, stock markets around the world took a bit of a dive this week. In particular, the S&P 500, which had been stuck in an incredibly narrow trading range going back to February of this year, fell about 6% this week. There have been lots of pundits offering reasons for the selloff. These generally include the mini-crash going on in Chinese stocks, the mega-crash going on in commodities, and the prospect of interest rates rising here in the U.S. So which of these things caused the 6% fall in the S&P 500, and an even bigger fall in the NASDAQ 100? In particular, which caused today’s over 3% decline? None of them. At least, not on their own. What caused today’s decline was feedback loops, emerging markets and VAR models. Volatility had been low – until it wasn’t. One-year chart of the SPY: (source: Interactive Brokers, LLC). Think about it – what is new this week that wasn’t already fairly obvious to those paying attention? China has been slowing for a long time. Today’s data showing that its export-oriented small and mid-sized companies are seeing weakening prospects, while slightly worse than expected (Caixin China manufacturing PMI came in at 47.1 versus 48.2 consensus), wasn’t really unexpected. Japan and Europe actually posted better than expected PMIs today (but no one really mentioned that). But what the slowing does do is reinforce the fact that the world is over-supplied with commodities. Back when China was booming (you know, just a few years ago), it was absorbing huge quantities of raw materials. So supply was ramped up to meet that demand. Copper, oil, steel, coking coal – the need for these seemed insatiable. But today, as China’s economy slows, demand for these has declined dramatically. Companies that have a large China presence have been leading the decline in the U.S. in the past week (along with media companies for a completely unrelated reason).
Here is where the feedback loops come in. Emerging markets are generally commodity producers, either of raw materials or of goods that are so easily replicated that they are essentially commodities (think t-shirts, socks, or even basic memory chips). As demand goes down, so do their exports, so some central banks cut interest rates, hoping to weaken their currency to make their goods cheaper on the world markets. So their competitors do the same in a race to the bottom (which no one really ever wins). Now, combine this with expectations that the Fed is going to start raising rates sometime soon (maybe September, maybe December, but rate hikes are coming is the consensus). This, along with the fact that the Eurozone is a mess, has made for a very strong Dollar relative to almost every currency in the world this year. But…here is what the central bankers usually forget. A little depreciation is ok. A lot is not, because rarely is a country able to supply all its basic needs internally. It imports things. Like food. Or oil. Which just got more expensive. So as people shift a higher percentage of their already meager earnings into food and energy, their ability to buy other things goes down, driving down their economy. So their central bank cuts rates. And so on. Eventually, foreign investors in their markets do some math and realize that while they would love to have exposure to their long-term growth, if the emerging market currency declines more than the return on their investments versus their home currency, they just lost money. So they sell to cut their losses and take their money out, causing a further decline in the emerging market’s stocks and currency. Batman: I’m just going to hang around the bar. I don’t want to look conspicuous. Batman, 1966 Here is where the Value-at-Risk, or VAR models, and leverage come into play. Big global investment funds are, generally, managed from the U.S. or Europe and denominated in dollars or Euros. As the U.S.-based funds have seen their foreign investment returns diminished by the strong U.S. dollar and/or falling foreign markets, they have had to sell other assets to keep their leverage within their prescribed limits. If your leverage limit is a standard Reg T 2 to 1, and your emerging markets book drops 15% in dollar terms, and you were say 25% in emerging markets, you’re now levered 2.16 to 1. You need to sell that extra 0.16, or 16% of your underlying assets, just to get back into line. But if you were using higher leverage, say 4 to 1, and 25% of your book drops 15%, now you’re levered 4.7 to 1. Not good. That 0.7 needs to go, and needs to go now. But here is the kicker: you’re no longer allowed to be levered 4 to 1. Because volatility has gone up, which is the input into your prime brokers VAR model. When volatility is low (look at the last 6 months of the SPY above), VAR models allow you to lever more. And lots of macro and quant funds like to leverage up, especially if they are running low net exposures. When volatility is high, these models let you leverage less. And the inputs these models use are short-term – the volatility spike this past week has made highly-levered funds look very conspicuous to their margin departments. Volatility in China’s market spills into volatility in Thailand and Vietnam and other emerging markets, which feeds into VAR models and creates the sell-off you see happening now in U.S. markets. Penguin (organizing his election): Plenty of girls and bands and slogans and lots of hoopla, but remember, no politics. Issues confuse people. Batman, 1966 Unfortunately, China has made their stock market into a political problem, and markets don’t like politics. After the circus that was Greece and its dance with its “partners” in the Eurozone, U.S. investors were looking forward to a quieter August and maybe some time at the beach. But China has badly mismanaged its stock market, and has turned what should be an isolated issue into one that has spillover effects for us, mainly because China has become uninvestable. Issues confuse people. And confused people sell. Right now we are maintaining our zero-net exposure. Being conservative and coming into the month with nearly 50% cash has worked so far. We are going to see how China trades Sunday night and how our markets open Monday. I expect our markets will be ugly unless China and emerging markets are up at least 5%. We closed right on our lows on Friday, which in my experience is never a good sign. It means buyers are still scarce, and they probably should be. Despite the drama this week, the S&P is only off a bit over 6%. Compared to the declines I’ve traded in 1994, 1997, 1998 (August then was a good time – the XLF dropped 20%, driven by deleveraging), 2000, 2007, 2008, 2009, 2011 – this is nothing. This sell-off will give us our opportunity to buy and hold some quality companies. We’ve been picking away at our favorites this week. (Want to know what they are? Email me for a free trial of my StockPicker newsletter). In the meantime, dance with the devil if you must, but be very careful. Because, you know, issues confuse people. Trading Rules: The Trading Rules were always popular, so they are back. This week’s:
Support: 197/197.50, 192.50/193, then 182. Resistance: 204.5/205, 208, then 212/213. Positions: Long and short U.S. stocks, long SPY puts, long SPY calls. 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. |
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