So after a long period of basically no volatility, we finally got some - in a hurry.  In case you were out, the S&P 500 (SPX) finally had a down day of more than 1%.  But that’s not the real story.  Look in bankland, where we have been cautious ever since the rip higher on the Trump Trade (lower taxes, higher rates, lower regulations).  The KRX (KBW Regional Bank Index) fell over 5% on Tuesday - yes, the bank index took a dive of 5% in one day.  And it didn't bounce.  The SPY was up a bit on Wednesday, but marginally, while the dollar continued to weaken versus the Yen and Euro.  The big questions being asked all revolve around whether the dip in the 10-year bond yield to under 2.40% is reflecting a weaker outlook for the Trump Trade, or, if it's just an unwind of a massive 10-year bond short after the Fed hike last week was perceived as dovish.  ​

All Calvin and Hobbes comics courtesy of Bill Watterson and Go Comics. Buy the books here.
 
The mini-rally in the 10-year bond could be the proximate cause of the banks selling off, but that is a little too old school - that implies that what is driving these stocks right now is a focus on fundamentals.  But as long-time readers know, fundamentals only matter in the very long term - in the short term, positioning, especially among the CTA/trend following/risk parity crowd, can become very important at inflection points.  These funds all tend to been leaning in the same direction at the same time, in size, and are designed to pull down risk and then flip the other way quickly on a steep decline.  In short, they are the embodiment of feedback loops that drove the big sell off in August 2015 and in early 2016.  But...this time I think we could be in for a bigger shock.  Just because the market didn't follow through to the downside after Tuesday doesn't mean we're done.  Instead, this may be a preview of coming attractions, as the KRX falling 5% in a day is a warning sign, not an all clear sign.  Because these funds can be easily spooked – especially on a hike.  ​

The issue isn’t that there are funds that trend-surf.  The issue is that there are now a lot of them, and there has been a recent push into using these funds to “hedge” risk.  The idea is that any downturn will evolve slowly enough for these funds to sell into it – which has happened in the past.  But that was when the group was a lot smaller.  A recent Financial Times article detailed how pervasive this has become. According to the article, clients of Pension Consulting Alliance (PCA) typically allocate 10-20% of their assets to a “CRO program.” What is a CRO program?  “Crisis Risk Offset.” PCA apparently coined the term.  Now, full disclosure: I know a few people who work at PCA and they are all great folks (and neighbors).  This isn’t about them. It’s about allocating to momentum strategies in a size that may be too big to execute properly.  Portfolio insurance anyone?  If you recall, that didn’t work out well (see October 19th, 1987).  Will that (down over 20% in a single day) happen again?  Unlikely.  But we could easily get a situation where a garden-variety 5% pullback in the SPX quickly morphs into a fast 10-15% decline, as funds de-lever their equity longs or flip short.  See these charts of where we are in terms of equity exposure in various trend-following systems, and the size of these funds today.  ​

The problem with everyone leaning in one direction is that they scare easily.  When realized volatility has been near all-time lows, as it has been in recent months, the simpler versions of these strategies view assets as less risky, so they lever them up.  What the models fail to capture is the speed with which volatility can return.  If volatility slowly creeps back up, then the models work fine.  But if it suddenly spikes higher, the models fall apart, other investors quickly de-risk, and everyone is up all night looking for ghosts.  Don’t say you haven’t been warned. ​

So what will be the catalyst to cause more than a 1% sell-off in the SPX?  While everyone is fixated with the non-bill in D.C., I think they are missing the big risk in the market, which is only getting bigger by the day.  Long-time readers can guess where this is going.  That’s right – China.  While we’ve been distracted in the U.S., China has been raising its equivalent of the Fed Funds rate and trying to stem a credit bubble there from ballooning out of control, while at the same time trying to make sure that if they do succeed in popping the bubble, it deflates slowly.  Good luck with that.  I’m not saying they won’t be able to do it.  I’m just saying that no country has ever pulled it off before.  The borrowing rates for their non-bank financial institutions (NBFIs) are rocketing higher (see the chart below) as they scramble for funds.  Evidently, the popular thing for these NBFIs to do is lend very long-term into risky ventures in order to generate higher yields, but borrow very short-term (under a year) because the funding is cheaper.  If this sounds just like our S&L crisis, version 2.0, you’d be correct.  I would have thought there are some things the Chinese may have wanted to avoid copying from the U.S., but apparently they’ll have to learn that lesson for themselves.
 
Take a look at the charts below.  You’re actually seeing defaults in China occur, and at an increasing rate (albeit from zero, as extend and pretend is the national motto in China, where everything is always awesome – it is always awesome, right?).  Remember, you’re also seeing short-term repo rates spiking.  A sign of renewed growth and inflation fears?   Ah, no.  It’s a sign of stress in the funding markets and increasing counterparty risks.  Put another way, credit is starting to fray in China right after the biggest increase in debt in the history of the world.  ​

​So to recap: the question investors need to ask themselves is what will happen if China’s issues start to manifest themselves in global markets (remember August 2015?  Me too.  We’re all in this together). The combination of large risk-parity funds and CTAs being quite long equities at the exact moment that China’s credit bubble is starting to show signs of stress could end quite badly.  The pension funds that have hired CTAs to sell into the next selloff will exacerbate what would have in the past been a normal correction.  And when retail investors who have been relentlessly told to invest their money in long-only index funds or ETFs wake up to a market that is down 10%, 15%, or 20% fast, are they going to hold on, or even buy more, or are they going to realize that their ship is just a plank, and decide to swim for shore while they can?  If history is a guide, we’re going to see lots of investors making a swim for it.  ​

For a more in depth look at the markets, along with some ideas on how to navigate them, just email me at [email protected] and I will add you to the list for Miller’s Market Matrix.
 
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This week’s Trading Rules:

• Beware of consultants bearing models.  They usually work until they don’t.
• Credit leads equities.  When credit weakens, play defense.

 
At the end of our last letter, we wrote, “The market is fully-valued and is priced for Trump to get what he wants.  We’re holding cash in case he, and the market, are disappointed.”  Now we’re also fully hedged and short high yield bonds.  Can markets continue to power higher?  Of course.  But with hedging costs still very low, valuations extremely stretched, credit weakening in China (and in the U.S. in auto loans), at the same time the market structure is particularly fragile, not hedging would be irresponsible.  Do the right thing.  Get some hedges on. 

SPY Trading Levels:   Volatility remains low, but is moving higher.  Be careful out there.

This week’s levels: 

Resistance: This little selloff has created some resistance just above the current price, with a lot more at 236 and then 238. 

Support: 228/229 is the first level.  Then a drop little at 221/222, then 218/219, then a lot at 213/215.  After that it’s 209.  That said, on a move of more than 2%, expect selling to accelerate.

Positions: Net neutral stocks (both long and short stocks). Short SPY, HYG and other ETFs. Long put options on SPY and other market ETFs. 

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

Mr. Miller has been quoted in financial publications including the Wall Street Journal, Barron’s, American Banker, 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 with attribution and a link to www.millersmusings.com.

This edition of Miller’s Market Musings is going to be a little different.  Instead of the normal commentary on market conditions, I’m instead giving you a glimpse of what’s been happening inside the Matrix.  Miller’s Market Matrix provides a more in-depth look into markets, as well as specific buy and sell recommendations.  I am only providing the more in depth market views here – if you want the specific stock and macro trades, you will need to email me to be a part of the regular list and receive a sample edition.  This is because this letter is often reprinted on various websites over which I have no control, and it is not appropriate for all investors, especially unsophisticated ones.  I don’t want anyone blowing themselves up by shorting something they don’t understand.  Don’t be stupid.  It’s a simple rule…   Email me at [email protected] to be added to the list.

It’s been quite busy over here in the Matrix.  Earnings season was very interesting, as different sectors of the U.S. economy appear to be on wildly divergent paths.  Retailers with stores apparently are dead in the water, while Amazon continues to soar.  Healthcare stocks are battlegrounds of believers and doomsayers, while “Trump Trade” stocks like industrials, financials, and defense seem unstoppable – at least for now.  This week I am off to a community bank conference, where I am meeting with well over a dozen management teams of banks from all over the country.  I will report back with any interesting insights.  These are the folks on the front lines of the economy, those that actually see what small businesses are doing. As a result, they often have good insight into the broader economy and its outlook. 

So here we are about 6 weeks in to the new Trump Administration, and am I the only one that thinks that things are a little, umm, unsettled at 1600 Pennsylvania Avenue?  Just wondering. I’m a news junkie and my Twitter feed populated with reporters and politicians from both sides of the aisle and overseas.  For the first time in years, they all actually seem to agree with each other. The only thing is that they all agree that there is some strange stuff happening in D.C.  Whether strange is good or bad depends on your worldview and desired outcome from the retrenchment in the executive branch that is occurring.  But strange is the common ground upon which everyone seems to agree.  And strange isn’t usually a good thing for markets in the long term.
​
Let’s review a bit what’s been happening in the world, or at least that which is relevant to financial markets.  China is the middle of its annual National People’s Congress meetings. It just announced it will be targeting “about” 6.5% growth in GDP this year.  But will this level of growth be possible at the same time it is trying to manage a debt bubble the likes of which the world has never seen?  If they slow growth and tighten financial conditions to control rampant speculation in financial and property markets, they risk a rolling series of market crashes. Don’t slow growth and tighten financial conditions, and they risk continuing to inflate these bubbles further.  Can they walk this narrow path without incident?  Maybe.  Will they?  I doubt it.  We’re adding a short on China to the portfolio.  I think the risk-reward is favorable for a short, but it’s not for the faint of heart.  Check out these charts: 

​Elsewhere in Asia, Japan continues to struggle with an aging population and stagnant growth, although there are some signs of inflation and growth.  The bigger issue will be how Japan responds to an increasingly aggressive China operating just off its shores and claiming to own the bulk of the South China Sea.  Historically, Japan and China have not, how should I put this?  Oh right, liked each other very much.  They don’t tend to play nice.  I think the period of relative peace since the end of WWII may come to an end in the next 5 years as Japan is becoming less pacifist and China is becoming less isolationist.  These two forces could come into conflict, and I’d guess that will happen right around the time Xi decides he doesn’t really need the U.S. anymore as a trading partner, or when internal dissent in China makes having an outside enemy a convenient distraction.  Don’t think this could happen?  Then you haven’t been studying your history.  This almost always happens…especially when leaders start to lose control over their restless populations, which is happening to China in its western provinces.  China’s claims to basically all of the South China Sea are not sitting well either.  See the map below. Stay tuned…

How are things in Europe?  Well, Erdogan is calling the Germans Nazi’s for not allowing some Turkish officials to hold rallies inside Germany, Italy’s economy continues to struggle while elections are coming up, France’s election has devolved in a comedy of sorts, with the leading first round candidate, Le Pen, looking more and more like the only one that might not get indicted before the election.  Fillon is the best they have?  Wait…where have we heard that before. Throw in some Brexit hard feelings on both sides of the channel, and an ECB still operating in La La Land, and you have a combustible mix of politics, a bond bubble, and potential Black Swan events.  Oh, I almost forgot – the EU decided it would be a good idea to require U.S travelers to get a visa before entering. Apparently, the U.S. hasn’t rectified some issues with visa-free travel for all EU countries, so they are going to take their ball and go home.  Ok…except someone should tell those geniuses in Brussels that tourism is 16% of the Eurozone GDP, and 67% of that comes from the U.S.  So my quick math shows that over 10% of Eurozone GDP is directly derived from U.S. tourism. Maybe they don’t know this, but over here in the U.S., we tend to be a lazy and petulant bunch when it comes to dealing with regulations and paperwork.  It’s already kinda a pain to take the whole family to Europe – you need to deal with different languages, currency, time zones, etc.  So now if we’re going to have to deal with getting visas from different countries for our 2 or 3 days in each, I’d bet a good number say aw, forget it, we’ll go somewhere easier.  Say it’s 1/3 of travelers.  That’s enough to throw Europe right back into recession.  Yes, sometimes politicians really are that dumb.

Countries are becoming more divided:

​Elections are coming in France and Italy – think the status quo will win?

​Yet…European High Yield Bonds act like Everything is Awesome!

The stock market in the U.S. appears to be on autopilot.  Everyone is now fully onboard with the indexing phenomenon.  Even Warren Buffet, in a bold demonstration of do what I say, not what I do, says that most investors should just buy index funds (despite the fact that he made his seed money running a hedge fund and still picks stocks for Berkshire.  Are there no mirrors in the Buffet household?)  When everyone says that there is only one way to do something, I immediately start looking at ways to do something else.  Are we at Peak Passive?  I don’t know, but we’re getting close. Nearly $8 billion went into the SPY S&P 500 ETF on Wednesday alone.  Over $7.9 billion has gone into the XLF Financial ETF since the election.  According to the Wall Street Journal, over $124 billion has gone into ETFs just since the start of 2017 in the U.S. alone.  And this is all happening at the same time the major market indices are hitting all-time highs nine years into a stock market rally.  Am I saying stocks are going to crash tomorrow?  Of course not.  I don’t know when it will happen.  But think about this for a minute: which is more likely, that stocks go up another 10% from here without a 10% pullback (which would actually put you down 1% - that’s how the math works), or that we get at least a correction, if not a real bear-market first.  The market hasn’t fallen by 10% for over a year, and it has only fallen by 10% or more 4 times since 2009. Historically, this happened at least once a year. Investors have gotten very used to markets only going up.  At the same time, realized and implied vol is nearing all-time lows.  Hedging has almost never been cheaper, yet fewer and fewer people are doing it.  Being contrarian just to be difficult isn’t a good strategy, but just like a year ago I was pounding the table to get out of “safe” income stocks and to buy “dead money” banks, right now I think we are getting close to a top in the overall market.  Consensus is clearly on the side of “higher forever,” and being cautious has not been a good strategy in recent years, but with hedging costs low and everyone piling in at the top, I’m going to take the other side of the trade.

I’m a visual guy, so I’m putting in some charts here to illustrate the above situations.  Extrapolating these trend lines forever is not recommended.  We have a saying at my hedge fund: mean reversion is a bitch.  Invest accordingly. 
​
Peak Passive?  SPY took in over $8 billion in one day.  That’s not normal.

A year-ago everyone loved “safe” defensive stocks.  Today they love cyclicals.  Overdone?
​

Macro Funds are leaning very long.  I don’t mean to be mean but…their timing can be off.
​

Does this mean we are about to crash?  No.  Markets like this can keep going up.
​

​However, almost all financial valuations are overvalued.  Look at US High Yield Spreads:

However, hedging costs are very low.  So why not hedge your equity exposure now? 
​

​Portfolio Review and New Ideas:  This is only available to those who have asked to be on the Miller’s Market Matrix distribution list.  Please email me at [email protected] to be added.  
 
The market is fully-valued and is priced for Trump to get what he wants.  We’re holding cash in case he, and the market, are disappointed.  Our portfolio recommendations returned a net 1.10% with a 10% net long stock and 15% net short macro position over the past 2 months. 
Best,

Jeff