Don’t worry about a thing,
‘Cause every little thing gonna be all right  
Bob Marley, Three Little Birds
                       
The past few weeks have given us a steady parade of top investors speaking at conferences. From the highly entertaining panel at Milken featuring Steve Cohen, Cliff Asness and Neil Chriss (see the whole discussion here), to the somewhat disappointing Ira Sohn conference to the recently concluded SALT extravaganza, we’ve gotten a hit parade of downbeat hedge fund managers lamenting the fate of their chosen profession (full disclosure: I’m a hedge fund manager too). Apparently, managing money is hard. Especially when you get too big to be flexible. Why this is new news isn’t clear to me, but apparently it’s a bit of a surprise to all those who allocated money to the top 10 or 20 funds. Size is the enemy of performance. Any manager who tells you differently is either a fool or lying. Not sure either is good.  But smaller managers who remain flexible in their net exposures and can move in and out of positions without moving the markets should still be able to perform well over a full cycle.  And I think we’re getting near the end of the bull run in this one.

At SALT, Leon Cooperman said he wasn’t sure it was worthwhile managing outside money anymore. At Sohn, Stanley Druckenmiller said to get out of all equities. I feel like I’m experiencing a weird sense of de ja vu. Because these same guys were saying the same things in late 1999 and early 2000. Also back then, Julian Robertson famously gave up fighting the internet bubble and threw in the towel on managing money (a terrible bet on US Air didn’t help things either). At that time, the market was doing irrational things for longer than the hedge fund community could take it. Sound familiar?  It does to me. And then the bubble burst, hedged strategies proved their worth, and hedge funds that were positioned defensively enjoyed a great 5 year run. I know we did – we had great performance in 2000, 2001 and 2002, while the “market” struggled. I think we’re heading for a repeat performance. The overall market is due for a steep fall, but managers positioned properly can make good money both long and short in the next few years.  So don’t worry about a thing.

Real long-short hedge funds, not the highly-concentrated private-equity-like things that folks like Bill Ackman run, will do well in coming years. Long-short funds have had a tough run, and the press is full of stories about the pension plans run by California and New York City pulling out billions of dollars because the performance hasn’t been good lately. To me, these large pension plans are the perfect contra-indicators.  The U.S. stock market is sitting right under its all time high, and now the pension plans want to go bigger in long-only index funds?  Wow, it is late 1999 all over again. Hedging doesn’t look so good when the market goes up for 6 years. But how good will indexing look when the market is flat-to-down for 5 years or more? Not so good. And then I bet that these same sheep, ah, pension funds, will come running back to chase performance in hedge funds again. Probably at a market bottom.   

Rise up this mornin',
Smiled with the risin' sun,
Three little birds
Pitch by my doorstep
Singin' sweet songs
Of melodies pure and true,
Sayin', "This is my message to you-ou-ou "
     Bob Marley, Three Little Birds
 
Why do I think that the stock market in the U.S. is heading for a fall?  There are a number of reasons, none of which on their own will tip it over, but which in combination will make it harder for the market to continue its rise.  So here is my message to you:

Stock and bond valuations are both very high. On a number of metrics, we’ve almost never been higher. And when were stocks higher? 1929, and early 2000. If growth was strong, earnings were going higher for most sectors, and rates were benign, then we’d have some room to move up in the markets despite the high-valuations. But growth isn’t strong (revenue growth is hard to find – just look at the retailers this past week), earnings are down year-over-year, and rates are just weird. Every time the Fed mentions raising them, the markets throws a fit. Not a good setup when rates are too low for the financial markets to effectively allocate capital and the banking system to function well. Rates should be higher in the U.S. (and around the world), but the Fed is afraid of its own shadow, so it does nothing, as we’ve discussed many times before.

Geopolitics are not great. The Middle East is a mess, but this somehow has moved from the front pages despite “issues” in Syria, Iraq, Yemen, Lebanon, Egypt, Libya, etc. Oh, and the refugee crisis -- it’s still ongoing, in case you forgot. Europe is facing a crisis in its banking system, its political union, and its economy, all without the will to jump-start their economies through infrastructure spending and labor reforms. It is a slow motion train wreck, and won’t get better any time soon.
And then there is China. Forget about its militarization of the seas around it, and the personality cult that Xi is creating around himself. Now we have The People’s Daily, the mouthpiece paper of the ruling Communist Party, publishing a piece on May 9th quoting a leading party official who is warning of significant problems, including a bubble in real estate, industrial overcapacity, rising debt and non-performing loans, among other issues. We have been harping on these issues in China for a long-time, as have others, such as Kyle Bass and George Soros. So to see the official paper actually admit that these issues are real and a problem for growth there going forward was quite shocking, since up to now the government has resolutely stated that “there is nothing to see here.”  Well, apparently now there is. Pay attention.

Here in the U.S. things are getting weird too. We have the bizarre story from last week about how the Obama administration played the media for fools in order to get his Iran deal passed.  It’s a crazy read. Then we have the ongoing circus around the nominations for both parties. Sanders keeps winning, but Clinton doesn’t seem to notice. So now Sanders is threatening a contested convention on the Democratic side, in addition to the potential for fireworks at the Republican convention (while the other candidates besides Trump have “suspended” their campaigns, there is still the strong likelihood of a failed first ballot and then chaos on the second). This should be interesting.

Which would all be fine if stocks were cheap and the biggest companies were doing well. But they aren’t.  For example, Apple continues to fall apart.  As we wrote back on November 3rd, 2015, when the stock was at $122.57 (self-congratulations: it hasn’t traded higher since then), Apple faces a host of issues, from its declining sales for its iPhones to its lack of a new category killer. Now it will be facing a hostile Chinese government if it doesn’t agree to provide the government with access to the data on its phones. So the company is stuck. By refusing to give the FBI access to data on iPhones in  the U.S., it has set itself up for failure with the same policy in China. Refuse and they are out. Capitulate and they lose the “victory” they claimed in the FBI fight. This is myopic strategic thinking and hubris at its worst. After it blows up, Apple might be a buy. But until then, it’s uninvestable, even here at $90, although it is due for a trading bounce.  
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This week’s Trading Rules:

• (Quoting Dr. Rudi Dornbusch) The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought possible.
• When you see smart fund managers talking about going out of business for being too conservative, the end of the bull market is near.  Play smaller and get defensive.

 
Stocks continued to follow our playbook the past 2 weeks in the U.S., as smaller stocks performed better than large cap and the SPY struggled twice at the 208 level. Nothing has really changed. Right-size positions and get ready to play more active defense. Macro issues have been quiet – too quiet. My sense is that the big move since February will continue rolling over. As Art Cashin would say, be wary and very, very nimble (yes, we quoted him last time). Because the crisis can happen faster than you would think is possible.

SPY Trading Levels: The market is still coloring within the lines. The SPY stopped right at the 209/210 resistance we mentioned last time as being a tough level to get through. Moving a lot higher will be hard, and I think we’re headed lower near-term, but if we do break 211, expect a sharp spike as shorts rush to cover and cautious investors play catch-up.

Support: 204/205, a little at 200 and 195, then 185
Resistance: A lot at 208, 209/210, 213, then not much.

​Positions: Long and short U.S. stocks, ETFs and options. Very hedged against a large decline. 

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 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.

Pay no attention to that man behind the curtain.
​     The Wizard of Oz in The Wizard of Oz, 1939
                       
So that was neat. I’ve always wondered what the hype is all about regarding the annual pilgrimage to Omaha for Berkshire Hathaway’s annual meeting. Since traveling to Omaha, Nebraska is not on my bucket list, and I can think of better things to do with half a week than wandering around a convention hall looking at booths from companies that have actual stores near home, I’ve never gone. So it was great that this year the meeting was webcast for all to see, because now I realize that I wasn’t really missing anything.

Were there some interesting moments? Most definitely. I spent a large portion of my Saturday glued to the webcast. Buffett has created a lot of wealth for a lot of people and built a very stable company. There are worse ways to spend a Saturday. But I was left wondering what all the hype is about, simply because for 99% of the people in attendance, who spent decent money on flights, hotels, restaurants, etc., they have zero chance of replicating, even poorly, what he has done. Especially since the only real investment advice he seemed to dispense was that most investors should simply put their money in an S&P 500 index fund and go home. And he’s probably right. Most people don’t have the time or the ability or the desire to spend most of their waking hours investigating potential investments and then waiting patiently for their thesis to come true (or not). But they flock there anyway to sit in an arena and listen to him talk for a few hours when the real lessons they want to learn are available in his annual letters, books that have been written about him, and myriad other sources that are basically free. Who says people are rational?

The most interesting part was when he was asked why Berkshire had changed from investing in companies with high returns on capital and no-or-low capital requirements to those that require massive amounts of capital, like railroads and pipelines.  His answer: because Berkshire is too big now to invest in those great low-capital businesses (even though they are superior to what he is buying recently and are what created the track record of which so many are envious).  My takeaway: smaller is better in asset management, because it opens up many more opportunities that are unavailable to investors that grow too large – like Berkshire Hathaway. Buffett hesitated before he answered, because the answer revealed an uncomfortable truth – that Berkshire is no longer able to maximize returns for its shareholders, but Buffett is unwilling to return the capital to them to go and find other investments. Ego? Probably. When everyone who you come in contact with is always telling you how great an investor you are, it makes it hard to think that someone else could do a better job than you with shareholder money. But when the alternative is to keep buying large, slow growing, capital intensive and economically cyclical businesses, maybe it’s time to pull back the curtain on the Wizard.

Coroner: [singing] As Coroner I must aver, I thoroughly examined her, and she's not only merely dead, she's really most sincerely dead.
     The Wizard of Oz, 1939
                                 
We are about two-thirds of the way through the first quarter’s earnings season, and so far the results have been decidedly mixed. Last year’s darlings, the cohort known as FANG (Facebook, Amazon, Netflix, and Google) have had a poor start to the year, although this week both Facebook and Amazon reported better than expected numbers, sending their stocks soaring. Netflix was fairly bad, and the stock got hit for over 15% as a result, while Google was fine (note: my fund is long Google). But the stock of the week was clearly Apple, which fell nearly 10% after reporting really lackluster earnings on falling iPhone sales. We wrote about the issues facing Apple back in November, detailing how its products were becoming hard to distinguish from its competitors, and how its future reminded us of the once-great company Sony, another consumer electronics manufacturer that was known for great design but missed a few product cycles and fell into a long slow decline. It appears to us that the time when Apple is a “must-own” stock is “really most sincerely dead.”  

Why?  Because Apple has a weakness that most investors aren’t talking about, but which I believe has a significant non-zero chance of happening. What’s the weakness? Its substantial sales in China combined with its unyielding stance on encryption during its clash with the FBI over unlocking the San Bernadino bombers’ iPhone. While CEO Tim Cook’s unyielding position of putting Apple’s customers’ privacy ahead of the government’s interest in protecting its citizens from terrorism may fly (sorta) in the U.S., it definitely won’t in China. And no one is talking about that. So what happens to Tim Cook’s moral outrage when China demands that Apple make its phones accessible to the Chinese government? Does he maintain his “high” ground? Or does he capitulate because he wants the business? And what happens to Apple’s stock when this debate happens? To me, this is not a question of “if”, but “when.”  Don’t think it’s gonna happen? From the New York Times: “Last week, the company’s iBooks Store and iTunes Movies services were shut down by a Chinese regulator, just six months after they started operating. The rare about-face by China suggests that Apple could face further pressure as the Chinese government increases its scrutiny of American companies’ operations within its borders.”  Don’t say you haven’t been warned…

Google already doesn’t operate in China. Neither does Facebook, or a host of other companies. But Apple gets about a third of its iPhone sales from China. So being banned there, or even just getting into a no-win fight with the Chinese government, will leave a mark. And by the way, growth in the overall market for smart phones in China is expected to slow to under 5% this year, down from 50% in 2014.  So even if they don’t end up in a battle over privacy, they don’t have the big tailwind from market expansion that they used to have. Maybe that’s what Icahn was referring to when he said he sold his whole Apple stake because he was worried about China. Those still holding should be too.
 
Scarecrow: I haven't got a brain... only straw.
Dorothy: How can you talk if you haven't got a brain?
Scarecrow: I don't know... But some people without brains do an awful lot of talking... don't they?
            The Wizard of Oz, 1939
 
I was fortunate enough to attend a long dinner with Vincent Daniel of The Big Short fame this past week. Besides reminiscing about our days as research analysts at Keefe, Bruyette & Woods, where we both used to work (although at different times), we spent some time discussing our favorite long and short ideas for our respective funds and the craziness that is happening in central bank board rooms around the world.

The world’s central bankers like to do a lot of talking, but they don’t seem to have a lot of brains. I suppose this is what happens when you spend your whole career talking only to other career economists and bureaucrats instead of actually doing something – like holding a real job, or building a business. Why our world’s policy makers are uniformly uninformed individuals who all believe more in their models than in rational thinking and problem solving is beyond dumb, but that’s the hand we’ve been dealt. You can’t invest based on “what should be,” only on “what is.”  And right now the “what is” is crazy.

We both agreed that while the insanity that is negative interest rate policies (NIRP) will end badly, the problem is that neither of us know when or how it will happen. My fear is that NIRP in say, Japan, will cause depositors to flee if they are charged for holding money at the bank. If they do, and the outflow reaches a tipping point, it could easily cause a liquidity crisis. Or will NIRP cause dislocations in overnight lending markets in Europe? In money market funds? Will it create distortions in sovereign bond markets that violently unwind? There are many potential outcomes. I just can’t think of one that ends well for someone holding a negative yielding bond, so the trade is probably to short negative yielding bonds in relatively strong economies if you can, since you are guaranteed a small profit if you can hold the short to maturity and a potentially large one if rates suddenly spike higher on a flight from “safety.”  I’d also continue to avoid equities in general where the situation is so dire that central bankers feel the need to engage in negative rates, because when the big unwind happens, stocks are not going to be where you want to be, unless you’re short.
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This week’s Trading Rules:

• You can’t trade on what should be, you can only trade on what is.  
• Playing chicken with authoritarian governments usually ends badly for the chicken. 

 
Stocks continued to follow our playbook the past 2 weeks in the U.S., as smaller stocks performed better than large cap, but now we’re at the high end of the trading range while earnings are coming in so-so at best. Nothing has really changed. Right-size positions and get ready to play a little defense. Macro issues have been quiet – too quiet. My sense is that the big move since February is rolling over. As Art Cashin would say, be wary and very, very nimble.

SPY Trading Levels: The market is still coloring within the lines. The SPY stopped right at the 209/210 resistance we mentioned last time as being a tough level to get through. Moving a lot higher will be hard, and I think we’re headed lower near-term, but if we do break 211, expect a sharp spike as shorts rush to cover and cautious investors play catch-up.

Support: 204/205, a little at 200 and 195, then 185
Resistance: A lot right here at 209/210, 213, then not much.

Positions: Long and short U.S. stocks, ETFs and options. Short XLP, XLU, long CPB puts. 

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.