As you may have heard, Silicon Valley Bank (SVB) was taken over by the FDIC on Friday morning. Or, more specifically, Silicon Valley Bank committed suicide last week with an assist from Goldman Sachs. This was both a sudden occurrence and a long time coming. We’ll start with the ending and then come back to try to explain how we got here. First, the ending: Silicon Valley Bank no longer exists as an independent bank. It technically got split into two parts by regulators, but that’s a detail that is unimportant right now. What is important is that insured depositors are of course fine. Their money at the bank is good and will be available for use Monday morning. What’s also important, and causing quite a bit of concern (rightly so) is what will happen to the uninsured depositors. (As a quick aside, equity owners will get nothing. Bond holders may get something, but that’s quite uncertain right now.)

So let’s discuss the possible outcomes for the uninsured depositors. First, who’s uninsured?  Basically any account with more than $250,000 in it. Which is almost all of SVB’s deposits, as it was the bank favored by a significant majority of technology companies backed by venture capital, as well as a large portion of the biotech industry. It was also the largest banker to the wine industry. What makes this situation particularly pernicious is that many of these technology companies, as best we can ascertain, do not have other banking relationships, and kept most of their funding at SVB.

This is causing a serious problem for these companies. As just one example of which we have firsthand knowledge, Rippling, a payroll provider for many smaller technology companies, was unable to process its payroll ACH payments on Friday because its account at SVB was frozen. So employees expecting their paychecks to be direct deposited Friday weren’t paid. As another example, a company that had their account at SVB was told that unless they were able to get a new bank relationship open by the end of the day yesterday, they would not be able to process next week’s payroll either. The angst these companies are feeling is real, as they don’t know when they will have access to their funds. 

Our current expectation is that at a minimum, most depositors at SVB will have access to about 50% of their uninsured deposit balances on Monday. This assumes that no other bank steps in to assume/acquire these deposit accounts this weekend, in which case almost all of their funds should be available. However, we would put the likelihood at about 90% that another bank or consortium of banks does acquire these deposit accounts, which have real value to another bank, by Monday morning. We know that there are bank CEO’s right now hoping they get the call to take over these accounts. So that should happen. We would expect that, given what the regulators did to banks like JP Morgan after the GFC in 2008 (recap: force/encourage strong banks to take over weak ones, then sue/fine them a few years later for the transgressions of the weak banks they rescued), that there will not be a full purchase of SVB. Instead, regulators will break it up and sell off the pieces, with the residual value, if any, going to ensure full depositor repayment (if the deposits aren’t acquired) then to pay off holding company bonds, then finally any remaining funds (we don’t think there will be any) going to shareholders.

Therefore, our opinion is that depositors at SVB will probably be depositors at a different bank on Monday morning, with full or nearly full-access to their funds soon. This is the logical outcome for a number of reasons. Banks want deposits. SVB has them. The FDIC needs to move them. Hence, this should be fairly straightforward to resolve, even though it is a big bank to rescue. We caveat our opinion with this, however: a lot of really illogical things have happened lately. More than once in recent years we’ve debated a situation in markets or the economy and said “well that XYZ outcome doesn’t make any sense, so it won’t happen.” And then it did. So we’re putting that asterisk out there. The FDIC as a government agency is actually pretty good at moving fast and not breaking things, which is a minor miracle when you think about it. But we have an administrative state that is hostile to all-things financial, big, and money making, so weird things could happen.

We expect Monday to be quite volatile again, with maybe more of a decline in the broader market as it catches up to the banks, with a rebound likely on Tuesday as the situation settles down and fear subsides. We were hedged well for the event on Thursday, and as these hedges increased substantially in value we sold them to lock in our gains. On Friday, as the selloff continued, we covered other shorts and bought some banks we like at prices we never expected to see again. We also added a significant broader market hedge near the close on Friday in case things are worse than we expect on Monday to protect our downside. We expect this situation to remain fluid and volatile for a few days, which may provide us with more opportunities to buy strong banks at great prices.

As the Talking Heads would say, “So how did I get here?”  Like all good stories, this one has three Acts. Act I: Silicon Valley Bank was started 40 years ago to bank technology companies. By the 1990s it was public, and two of us at JCSD were bank analysts covering the company on the sell-side. John Dean was  a good conservative banker, and SVB built one of the strongest franchises in the industry. We were fans. But then things changed. New management came in, and success bred hubris. Eventually, management thought that they didn’t need the traditional bank investors that gave them their expansion capital and invested in them when they were small, and instead wanted only growth and tech investors. Management stopped going to investor conferences. Despite attending half a dozen conferences a year, we’ve never met the current CEO in person, only IR and occasionally the CFO. Cultivating relationships with bank investors was not worth the CEO’s time. On roadshows, the company actively avoided meeting with any hedge funds, even those that tend to be biased long bank stocks. But things were good for SVB, and their stock traded at a tech stock like valuation for awhile, so no one cared.

Act II: Covid happens, the Federal government floods the economy with cash, VCs raise record funds, and they invest those funds in startup technology and life-sciences companies at a record pace. Deposits surge in the banking industry as locked-in consumers can’t spend the money they are getting. Between Q4 2019 and the first quarter of 2022, deposits at US banks rise by $5.4 trillion, and due to weak loan demand, only ~15% is lent out; the rest is invested in securities portfolios or kept as cash. SVB’s deposits rise by 300% in three years. That’s a lot! Its stock price soars with the tech stock bubble, as it’s a tech bank. Management gets even more arrogant, as their skyrocketing stock price means they must be geniuses. Questions asked (by us) at a conference to the CFO about capital and asset/liability management are dismissed as irrelevant in this new era of extreme liquidity. And then mistakes are made.

SVB believes its own hype and makes a bet that everything will be awesome forever. In a reach for yield, they invest all this excess cash not in short-duration t-bills or fed funds, but instead in long duration MBS at quite low yields (while we believe it was 8-10 year duration at 1.87%, we have seen other similar but slightly different numbers – the exact number isn’t really important). This was back when interest rates were still low, but inflation was already ripping higher. The Fed was stating that inflation was going to be transient, so some banks took them at their word and went long on the asset side of the balance sheet. This was mistake number one.

Inflation wasn’t transient, and the Fed raised the benchmark, risk-free interest rate banks can receive from 0% to 4.50% in about a year. This caused the value of the long dated bonds SVB purchased to go down in value. (Bonds are priced as the net present value of their future interest payments. The discount rate is basically Fed Funds or T-bills plus a small spread). But this wasn’t the actual problem for SVB, as the bulk of their bonds were in their Held-to-Maturity portfolio, which doesn’t have to be marked to market. The assumption is that while rates go up and down, so long as the bank intends and does hold the loan to maturity it will be “money-good” and therefore not a capital issue. This is generally correct. The actual problem was self-inflicted, a result of management’s hubris and bad advice from Goldman Sachs.

SVB wanted to boost its net interest income on its other bond portfolio, the one that is Available For Sale. This was about $25 billion in size. Because it had bought the bonds in this portfolio when rates were low and now rates were higher, it could sell those lower yielding bonds and buy new, higher yielding ones and earn more interest income, which would increase its earnings and hopefully its stock price. But selling the lower yielding bonds would lock-in a loss on those bonds. It’s just simple bond math – a low yielding bond will trade down in price until its current yield matches that of newer bonds. And worse, while the lower price was reflected in its GAAP book value, it was not in its regulatory capital until it sold them. So despite this transaction (swapping low coupon bonds for higher coupon bonds) being economically a wash (you’d never do this in your own account, it wouldn’t change your returns), and detrimental to regulatory capital, Goldman Sachs convinced SVB to do it. And ego driven SVB management did it. This was mistake number two. At this point SVB was like Schrödinger's cat – both alive and dead at the same time.

“How did you go bankrupt?"

Two ways. Gradually, then suddenly.”

― Ernest Hemingway, The Sun Also Rises

Act III:  They did it wrong. They sold the bonds first, locking in a regulatory capital loss of about $2 billion. In any two-legged trade, you always do the riskier, hard to execute leg first. That’s trading 101. You don’t do the easy leg first, then see if you can execute on the hard one. That’s just dumb. But that’s what they did. Mistake number three. Then, after selling the bonds, Goldman couldn’t raise the capital. Why?  Because Goldman isn’t a well-respected investment bank when it comes to depository institution investment banking. Well, of course there were other investment banks on the deal who are respected in the industry who could help fill out the order book right?  No.  As we’ve noted, SVB’s management is a) arrogant and b) dismissive of bank investors – you know, the kind of investors that can make a decision to inject a few billion dollars into a bank overnight. So SVB only hired Goldman and the investment bank it owns, Leerink, to run the deal. Leerink is a technology investment bank. Goldman doesn’t have deep ties to bank investors. If SVB had instead hired KBW or Sandler O’Neill as deal runners, we believe it’s highly likely this deal gets done. But Goldman didn’t even call us to see if we wanted to put in capital, and that’s all we do. And we weren’t the only ones they didn’t call. Mistake number four. That’s too many.

Dénouement: Silicon Valley Bank can’t raise the capital it needs in a timely manner. Its depositor base, which is tech savvy and therefore reading about these problems on Twitter, immediately opens their banking apps and wires out their money. Some prominent VCs advise their portfolio companies to do the same, a run on the bank ensues, and the bank fails about 36 hours after announcing its intent to sell bonds and raise capital.

So what happens now? There is a lot of chatter on TechTwit about how companies should move their accounts to the largest banks as they are safer than smaller banks. But SVB was a big bank!  Don’t do that! SVB was also uniquely exposed to large deposit accounts. Small banks are not. Smaller banks tend to have well diversified deposit bases across both commercial and retail accounts. SVB had almost no retail accounts. Moving to JP Morgan will not be a good idea for the vast majority of businesses. But as we mentioned above, a lot of illogical things have happened that we didn’t expect, so we need to be open to the possibility that people come to the wrong conclusion and move money from small banks to large banks. We’ll be closely watching for any developments here.
​
What should happen? This was an old fashioned bank run, a liquidity crisis that caused a short term solvency problem. The FDIC was created to prevent exactly this type of liquidity crisis from happening. But the $250,000 FDIC insurance limit only prevents retail investors from doing a bank run, and SVB didn’t really have that type of customer. There is currently no program in place to prevent a bank run by large corporate accounts – the kind that SVB had. Our solution would be that the FDIC insurance limit be raised dramatically, to say $50 million. One person who we suggested it to said that the FDIC can’t afford to do that – we replied that it can’t afford not to. And by raising the cap to $50 million, it dramatically lowers the need to ever have to use it to cover a liquidity run again, as there wouldn’t be a liquidity crisis to avert. Current bank regulations are already really tough on lending in order to prevent a credit crisis, which is really trying to prevent insolvency. By increasing FDIC insurance limits, they can greatly reduce the chances of another SVB type liquidity-driven failure happening again as well.


Best,

Jeff
 
DISCLOSURES

 

DISCLAIMER: The opinions expressed in this quarterly letter are for informational purposes only and should not be construed as investment advice.  The letter is not a recommendation of, or an offer to sell or solicitation of an offer to buy, any particular security, strategy or investment product.  Past performance of any strategies discussed herein is not necessarily indicative of future results.  The research for this letter is based on current public information that we consider reliable, but we do not represent that the research or the letter is accurate or complete, and it should not be relied on as such.  Performance numbers presented herein were prepared by JCSD Capital, LLC, and have not been compiled, reviewed or audited by an independent accountant and are presented for informational purposes only.  All performance estimates are subject to future adjustment and revision.  The information provided herein is historical and is not a guide to future performance, and any potential investors should be aware that a loss of investment is possible.  The views and opinions expressed in this letter are current as of the date of this letter and are subject to change.

​Phil: Do you ever have déjà vu, Mrs. Lancaster?
Mrs. Lancaster: I don't think so, but I could check with the kitchen.
            Groundhog Day, 1993
 
Before we dive into the most recent letter, I have an exciting announcement.  When I started writing Miller’s Musings 6 years ago, the audience was investors in my funds, past colleagues, and some other fund managers with whom I swapped ideas and information.  Since then the readership has grown to include not only some very well-known market professionals, but also a large contingent of non-professional but quite dedicated investors.  I have been asked by both groups for more regular, in-depth research for a long-time, but resisted, as managing my fund is my primary focus (and yes, it is still open to new investors.  If you are interested, please email me directly.)  Frankly, while I love writing, and the process helps me clarify my thinking about markets and stocks, the prospect of managing payment gateways, subscription lists and the attendant hassles was daunting. However, recent advances in technology have made the process of managing multiple distribution lists, and getting paid for the effort, much easier (I hope!). Within a few weeks I expect to launch two new services for investors, which will be released much more regularly and frequently. You can get some pricing information here.  Don’t worry though, Miller’s Market Musings will continue to be free. 
 
Since we have recently added quite a few new readers, it’s probably worth a reminder that all past articles can be found at www.millersmusings.com.  But to save you all some time, here are links to the three most popular and recommended articles of the past year.
 
September 5th, 2017 – The Sun Also Rises
 
January 23rd, 2017 – Snow Crash
 
December 27, 2016 – Being Deeply Superficial
 
And one that is a not-so-humble brag: Are We There Yet, January 20th, 2016, where I said a turn was at hand in the markets, small caps were oversold, and with oil at $28 and energy companies in the tank, they were a buy.  That worked out pretty well…  See, I’m not always bearish – it just seems that way to my recent readers.
 
That said, I am 100% bearish now.  But you probably already knew that, which is why this letter is titled Groundhog Day.  As I sat down to write this letter a few weeks ago, I said to myself I can’t do it again – I’ve already said what needs to be said, so now it’s time to just wait.  But then things got even more nutty, so I’m back.  If you have any comments or if you want to receive my more detailed Miller’s Market Matrix, email me directly at [email protected]. 
 
Phil: What would you do if you were stuck in one place and every day was exactly the same, and nothing that you did mattered?
Ralph: That about sums it up for me.
Groundhog Day, 1993
 
Here’s where we are stuck right now:
 
·         U.S. stock markets are at all-time highs and all-time overvaluations on most metrics. 
 
·         Expected real returns on equities for the next 10-12 years are negative.
 
·         Volatility is at or near all-time lows.  The SPX is about to set a record for stability.
 
·         Assets in vol-targeting and vol-selling vehicles (ETFs, risk-parity, etc.) are exploding.
 
·         Long-Short hedge fund managers (myself included) are posting terrible performance.  Anyone who is trying to be risk-averse is either losing assets, credibility, or their jobs. Just like in 2000 and 2007.  Only now we have Twitter to remind us of it daily. 
 
·         Interest rates in the U.S. are still very low, but are starting to move up on the short-end, flattening the curve. Normally this presages recession, unless “this time is different.”
 
·         Globally, interest rates are still ridiculous, with real rates negative in about a dozen countries, and irrational/idiotic central bankers (Draghi, Kuroda, Yellen) in command.
 
·         Global economic growth is still listless.  If growth prospects were good, we wouldn’t have negative rates and the enormous central bank bond and stock buying programs. The alternative answer is that Europe’s financial systems are too fragile to handle policy normalization.  Either answer is “not good.”  
 
 
 
Phil: Ned, I would love to stay here and talk with you... but I'm not going to.
Groundhog Day, 1993
 
Investors in today’s market have a few choices – they can run with the herd, hoping to escape before going off a cliff.  But I’ve been to the Maasai Mara in Kenya during the great migration, and I’ve yet to see any animal successfully leave the pack without getting picked off by crocodiles, lions, leopards, cheetahs or hyenas.  Watching a pack of hyenas chase a pride of lions off a kill is an amazing sight, but also a stark reminder that charting your own course is fraught with danger.  That said, I’m doing it, as my investors and readers know.  I’d love to still be long for this last push higher in the markets – I’d be making a lot more money for my investors and myself, and not constantly reevaluating my decision-making process.  But I’m not going to. 
 
Why not run with the herd, and use a stop-loss of some sort to get out?   Or, use a technical indicator to try to time the market?  Well, I do use charts, and find them very useful for timing market entry and exits.  But I also believe in mean-reversion, as well as math and studying history – and I’m fairly certain that this market boom will end just like all booms end, with prices reverting to a level that offers an attractive real-rate of return for investors.  Right now, no public financial markets offer that. Yes, there are particular individual stocks that are attractive, and I own them, but I have also fully hedged my broad market exposure. What I am not certain about is when.  There are some technical factors that indicate that the turn may be near, but given how wrong I and others have been over the past 12 months, I’m not willing to say its imminent.  Central banks have been buying U.S. stocks, which has pushed back the day of reckoning, as they are price-agnostic and have seemingly unlimited buying power.  When the history of this market is written, the outsized role of Central Banks and Sovereign Wealth Funds in creating this bubble will make for some fascinating books.  My last Musings goes into detail on the absolute levels of overvaluation we are now faced with in financial markets, and things have only gotten more extreme since, so instead of repeating it, I’d suggest clicking the link above and reading it again if you need a refresher.  The Summary: It’s Bad. 
 
Rita: Do you ever have déjà vu?
Phil: Didn’t you just ask me that?
Groundhog Day, 1993
 
I almost didn’t write this letter, as I can hear you all muttering to yourselves “great, he’s still bearish, yada yada, let me know when something changes.”  Hell, I didn’t want to write this letter again.  It’s not fun.  I’d much rather be saying this market is a buy, here are the sectors that are most attractive, and here are the stocks that are most attractive within those sectors.  But I can’t.  If this feels like déjà vu, it’s because you have seen this movie before.  And like all markets that have been this overpriced in the past, it’s not going to have a happy ending.
 
Below I’ve posted some of the most relevant charts I’ve come across recently.  For many more, and some specific ideas, email me to get Miller’s Market Matrix at [email protected].

Phil: This is one time where television really fails to capture the true excitement of a large squirrel predicting the weather.
Groundhog Day, 1993
 
 
The Next Two Charts are Courtesy of www.hussmanfunds.com
 
Expected nominal returns for the S&P 500 are now negative.

​Public Financial Assets are Expensive Everywhere

​U.S. Stocks are Objectively Expensive – Will This Time End Differently?

How Weird is Our Current Rate Environment?  323 Years of Bank of England Rates
​

VIX Has Become Positively Correlated to the SPX – This Often Signals a Short-term Top
​

​Banks Have Outperformed Since the FOMC, but the Yield Curve is Flattening – Not Good.

If The Economy is So Strong that Long-run Inflation Risks are Increasing, This Chart Would Need to be Flipped Upside Down.  In Other Words, Bonds Don’t Believe the Fed.
 
US Treasury Bond Yields, Spread Between 5 year and 30 year Bonds.
​

This Isn’t How This is Supposed to Work
​

Large % of BB-rated Bonds in Europe Yield Less Than Equivalent Maturity Treasuries
​

Phil: Something is... different.
Rita: Good or bad?
Phil: Anything different is good.
Groundhog Day, 1993
 
_____________________________________________________
This week’s Trading Rules:

• Paul Tudor Jones: “I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”
• Warren Buffett: “Be fearful when others are greedy. Be greedy when others are fearful.”

 
SPY Trading Levels:  

Resistance:  What’s That? We’re in record territory, so there isn’t much.  254 should have been resistance, but the market isn’t play by the old rules.  
   
Support: 254, then a lot at 250 and 247/248.  Below that its 243/244.  Note: these are very tight ranges. In a real correction, next stop is 220 then 212.  

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 market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. 

​“You're not a moron. You're only a case of arrested development.”
― Ernest Hemingway, The Sun Also Rises
 
Conservative investors who think about valuations and prospective future returns (I consider myself to fall into this category) are having a very hard time in this market. We look like morons.  Usually in markets like this, value investors start to look like time has passed them by.  Their investing acumen is questioned, and they lose assets under management.  It’s at these times that I like to start over, asking basic questions about risk, return, growth rates, and valuation.  I pull out my handy chart of implied growth rates and discount rates for various P/E ratios, trying to triangulate what the market is discounting at the current prices. I’ve been wracking my brain trying to understand what I am missing about this market, trying to place myself in the shoes of the marginal buyer of stocks today, at today’s prices. 
 
This started with an examination of the banking sector, my specialty.  I was trying to come up with a model that justified the sector’s current valuations.  I’ve done this exercise periodically over the past 23 years, usually when I’ve been wrong on the market for longer than I, and my investors, feel comfortable with, and I’m trying to come up with a reason to “get involved.”  And usually, this is right before being patient and cautious and trying to be prudent turns out to have been the right call.  Will it once again this time?   Beats me.  Check back in a year.  But I spent some late nights this past week deep in spreadsheets and databases trying to construct a bull case.  I kinda failed.  I do think there are a few sectors and companies that are fairly cheap right now.  The issue I’m having is that if the overall market tanks, it won’t matter – everything will go down.  In a correction, correlations have a habit of going to one fast. 
 
Here are the facts: The S&P 500 is trading at about 22 times trailing earnings, which isn’t so good.  That’s a 4.5% earnings yield.  But wait, I’m using last year’s earnings you say?  Ok, let’s look at forward estimates instead.  On forward earnings, the market is cheaper at about 17 times, but forward earnings have a bad habit of never actually happening. That’s just reality.  As a whole, we analysts are an optimistic bunch (or, more likely, the sell-side doesn’t like making management teams mad by posting estimates that are materially lower than company guidance – that’s a good way to lose access to management and your ability to get paid for it).  So consensus estimates always start off too high then come down during the year.  A more accurate method would probably be to just take last year’s number and add a few percent to it.  But again, that’s not what happens.  Check out the chart at the top of the next page.  Will this year be different? 
 
So what’s the “right” Price/Earnings ratio for stocks?  After a lot of time spent digging into spreadsheets, I came to the same conclusion I always do: I don’t know.  There are too many moving parts to be certain.  Peter Lynch in his classic book One Up on Wall Street always used “the earnings line” in the Value Line tables as his “right” number.  Well, if you look at the charts he put in his books, the earnings line is a P/E of…15x earnings.  If it was good enough for Peter Lynch, it’s good enough for me.  We can try to justify a higher number by doing all sorts of math, but frankly, I spent about 20 hours this week trying to reprove everything I learned in business school and in the years since, and then results are so susceptible to small changes in any of your inputs that I’ve come back to where I started.  A 15 P/E for a non-cyclical company gives you a 6.7% earnings yield, so with 3% growth you can get close to a 10% “cash-on-cash” return.  I’d argue that banks and cyclicals should trade for less, because in recessions they have a nasty habit of losing money, so you need to be compensated for the “lost years” of earnings, and, in a bank, potential dilutive capital raise if things get dire enough.  It turns out, banks are a good way to examine the market, because their balance sheets tie well to their income statements.  Banks are holding about 10% equity these days, and earning 1% on Assets, for a 10% ROE.  Historically banks have traded on a price to book basis of about 1.25 times ROE.  So a bank earning an 8% ROE trades at 1x book, a bank earning 16% trades at 2x book, etc.  That would imply a current price/book of 125% and a PE of 12.5x.  But today, the average bank P/E is closer to 15x, or about 20% overvalued.  How much are the banks (KRE) up since the election?  19%.  There is still a big “Trump Bump” in the market.  But if we don’t get higher growth, lower regulations and most important for valuations, meaningfully lower taxes, this market is very overvalued, not just the banks.

What are analysts thinking?   Lets review. Corporate profit margins are not expanding anymore, but are still near peak all-time highs.  They we’re expanding in recent years because we’ve been in a 30 year period where Software companies dominated SPX growth, and they have very high margins.  For example, if the cost to create a new version of Microsoft Windows is (I’m making this up) $1 billion, then the first copy costs $1 billion, and the 2nd costs basically $0.  Distribution costs (click here, download, run, install) are close to zero.  Microsoft has been succeeded by Facebook and Google, who also have very high margins, but outside of those few companies, margin growth is slowing and is probably going to revert to the mean.  Look at the charts on the below from Yardeni – they are similar to the previous chart, in that they show that forward profit margin estimates are always too high relative to actual reported profits margins for the S&P 500.  Always.  ​

​“How did you go bankrupt?"
“Two ways. Gradually, then suddenly.”
― Ernest Hemingway, The Sun Also Rises
 
Despite what you read in the paper, the economy is not booming right now. A chart similar to this was passed around my finance blogging circles recently.  Not being one to just borrow all my charts, I went searching for the original government data.  Here it is:

That chart is the change in real net value added to the economy adjusted for inflation.  In other words, it’s the corporate P&L for the USA.  When the growth in the overall country’s P&L turns negative, we usually have a recession fairly soon thereafter.  Anyone have some gray ink?
 
Why is this important?  Because pretax profit margins predict business cycles, and we are very far into this one.  If stocks were even just at fair value, the expected drawdown in a recession (as companies report lower earnings or even losses) would be significant.  But coming from our current levels, which some market experts (Hussman, GMO) are calling the most expensive in history, the drawdowns could be incredible (Hussman thinks anywhere from 50-70%).  If corporations had fortress balance sheets, they could weather the recession, whenever it hits, and maybe come out stronger (by buying weak competitors, etc).  But right now, we’re in the opposite situation, as public companies have taken advantage of ultra-low borrowing rates to lever-up their balance sheets and buy back stock.  As discussed in the last Musings, this is actually the right move for a company with slow or negative growth – if you’re company is stagnating, you owe it to your shareholders to shift risk from the equity holders to the debt holders as much as possible.  But this process has made corporate America as a whole very fragile to exogenous shocks today. Again, at a time of record high valuations, this is a nasty combination.  Check out the charts below.  Companies have been increasing Debt vs Equity.  Source: www.thefelderreport.com and GSAM.      
 ​

​Check out this chart from Hussman Funds (www.hussmanfunds.com) – Go read his reports.
 
Losses of 50-70% over the next 3 years would be normal.

Hussman has tons of great charts and data.  His analysis shows that we have only been more expensive in the 2000 tech bubble.  It’s hard to argue with his math.  The timing is also hard to get right.  Living in this market is very, very difficult.  You can play along and hope to find a chair when the music stops, or you can decide this game isn’t fun anymore, and leave early.  I’d suggest that is the better course of action today. 
 
“I did not care what it was all about. All I wanted to know was how to live in it. Maybe if you found out how to live in it, you learned from that what it was all about.”
― Ernest Hemingway, The Sun Also Rises

Once again this letter is getting too long, and I have a lot more data and information on rates, negative rates on corporate Euro bonds, the strained consumer in the U.S., low stock market volatility, and other topics.  I go into all of these in the next Miller’s Market Matrix, coming out this week.  If you haven’t subscribed yet to Miller’s Market Matrix, just reply to this email, or email me directly at [email protected] and I will add you to the list.  It’s free, so try it.
 
 
 “You ought to dream. All our biggest businessmen have been dreamers.”
― Ernest Hemingway, The Sun Also Rises
 
_______________________________________________________
This week’s Trading Rules:

• From David Tepper: There are times to make money and times not to lose money.  Know what time it is.
• Cash is an option on future lower prices.

 
SPY Trading Levels:  

Resistance:  Two tops at 248.  Not much above that.    

Support: 245, small at 242, then a decent amount at 239/240, followed by a lot at 233/235.  Long-term support is 210. 
​
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.

Wait, you haven’t subscribed yet to Miller’s Market Matrix?  You don’t like money-making stock ideas?  One of our largest positions, Scripps, just sold itself to Discovery Networks, as we expected.  Content is king.  If you would like to receive it, just reply to this email, or email me directly at [email protected] and I will add you to the list. 
 
Sometimes it’s good to get out and see new things.  Well I recently took that to a bit of an extreme.  There is nothing like a 3,000 mile RV trip with 4 kids, 2 dogs and 1 wife to remind you how big the country is – and how different parts of it are compared to where most of the readers of this letter live.  Wyoming, South Dakota, and Montana are beautiful.  If you haven’t been to Yellowstone, it is worth a trip.  But there is something you should know – there are large areas that are completely devoid of cellular service.  Or services in general.  Driving a large RV with crappy gas mileage through remote parts of the country quickly gets you doing mileage calculations every 30 miles or so – and gets you checking the trucker guidebook we bought that lists all the gas stations at every highway off-ramp in the country to be sure you’ll make it.  Relaxing?  Not really.  Informative?   Most definitely.  ​

Jack McCall: Should we shake hands or something, relieve the atmosphere? I mean how stupid do you think I am?

Wild Bill Hickok: I don't know. I just met you.
     Deadwood, HBO, 2004-2006
 
One of the places we visited was Deadwood, SD.  Deadwood is famous for being where Wild Bill Hickok was shot while playing poker in the Number 10 saloon on August 2nd, 1876 (happy anniversary Bill?).  Apparently, this is still one of the most interesting things that has happened in that town.  In Deadwood today, you can see reenactments of it in the main street about every 2 hours, followed by a trial of his killer, Jack McCall, in the evening at the elks lounge.  As entertainment goes in the towns we were driving through, this qualified as exceptional. 
 
But the trip through Deadwood was educational for another reason.  It made me realize how fleeting “success” is in business.  A little history: in 1868, the U.S. Government signed the Fort Laramie Treaty giving ownership of the Black Hills to the Lakota Sioux nation.  But when gold was discovered in the northern Black hills in the 1870s, the government reneged on the deal.  Deadwood was established in April of 1876 and by summer there were well over 5,000 miners staking claims along Deadwood Gulch.  But just as quickly as it rose up, it fell back, as better gold mines were found in other hills.  By 1890 the population had declined to 2,366 people.  The population today?  1,264 people. 
 
Al Swearengen: Announcin' your plans is a good way to hear God laugh.
     Deadwood, HBO, 2004-2006
 
Another stop on our trip emphasized the theme of impermanence.  After a night in a less-than-memorable RV “park,” we toured Butte, Montana.  Butte is another mining boom town that’s quietly gone bust.  The Anaconda Copper Mining Company was formed in 1881.  Anaconda’s owner, Marcus Daly, had the good fortune to own the largest known copper mine at the same time that electricity was being installed across the country – and electrical wires need copper.  Anaconda was immense, and the wealth it created also immense.  But mining became less profitable, and the mines were eventually shut down.  From a peak population in the 1920s of over 60,000 people, today Butte is a neat little town of 34,000 people with the country’s largest Superfund site as its main tourist attraction. You got it, the country’s most polluted body of water (yeah!) is something people pay money to see.  We skipped that and instead spent a morning at the really interesting World Museum of Mining – which is definitely worth the time for the underground mine tour and its replica of what the town looked like in the early 20th century. 
 
At this point, if you’re still awake, you’re probably wondering what this has to do with investing. Well, it has everything to do with investing, because as this history of boom and bust towns shows us, a “sure thing” in investing can, and most likely will, eventually fade away.  Gold in the late 1800s and copper in the early 1900s proved to be impermanent – just like companies in many other industries.  History is littered with failed once-great companies (Polaroid, Eastman Kodak, and Blockbuster Video as some recent examples).  GM went bankrupt in 2009, but the government bailed them out, so they’re still here for now.  Other iconic companies that are struggling and one day could either quietly fade away or be acquired are P&G, GE, and IBM.  Don’t think that’s possible?     GE traded for well over $100 a share in 1983 – today it closed at $25.50.  IBM traded for over $175 a share in 1987 before falling to almost $40 in 1993.  It recovered to make new highs in 1999 before falling back to $54 in 2008.  Today it closed at $144.45, but hasn’t grown revenue in years, and is at risk of obsolescence. 
 
Al Swearengen: Sometimes I wish we could just hit 'em over the head, rob 'em, and throw their bodies in the creek.

Cy Tolliver: But that would be wrong.
            Deadwood, HBO, 2004-2006
 
This cycle of boom and bust in corporate America may well be why dividends have historically provided so much of the stock market’s total return – because once you’ve been paid the dividend, it’s a permanent part of your total return. In other words, the past yield can’t go to zero. But the stock of the company that paid it can.  In the almost 25 years I’ve been in the investing business, I haven’t been a big dividend investor.  To me, what was important was the free-cash flow generating power of the company.  Many great investments haven’t paid dividends at all (here’s looking at you, Berkshire Hathaway, Google, and Amazon).  But…looking around Butte and Deadwood and other old mining towns, I’m thinking that getting the cash out upfront isn’t such a bad idea.  In other words, hitting a company over the head, robbing it of its distributable cash and dumping the body in the creek maybe isn’t wrong after all.  Because eventually, all good things come to an end.  
 
I know what you’re thinking - surely today’s market darlings won’t disappear.  They’re just too integral a part of the economy, too essential to our everyday lives, and too entrenched to be unseated from their place at the pinnacle of the economy.  You know, just like Sears.  Oh wait…  According to a Crain’s Chicago Business article from 2012:
 
As both Sears and America flourished, the company's goods transformed those dreams into middle-class realities. Sears' best-selling Craftsman tools, Kenmore appliances and DieHard batteries built, furnished and ran the American household. By the 1960s, 1 out of nearly 200 U.S. workers received a Sears paycheck, and 1 out of every 3 carried a Sears credit card. By catering to prosaic daily needs, the retailer grew into a behemoth that defined not only the Chicago economy but American business.
 
Been to a Sears lately?  Yeah, me neither.  Today, Sears is being stripped-mined for parts by Eddie Lampert’s hedge fund.  Will it be a going concern in say, 10 years?  Probably not.  Again, a company that once employed 1 out of every 200 U.S. workers probably won’t be here in a decade, and today has a market cap of just $873 million.


Francis Wolcott: On my order, Mr. Tolliver, Lee will burn this building, mutilating you before, during or after, as I specify, or when he chooses unless I forbid.

Cy Tolliver: Oh, my full attention is at your disposal.
            Deadwood, HBO, 2004-2006
 
So what does the likelihood that today’s winners will be tomorrows losers mean for investors?  And how do you balance the needs of current shareholders versus those that want to be “long-term” shareholders and future shareholders?  There are a few choices.  If you’re small enough, you can sell outright for cash.  This probably should be option A, especially if you see the prospects for your business starting to fade.  But too many management teams think they are the exception, not the rule, and want to build a larger and larger company – probably because that’s how they’ll make more money.   Boards should be the shareholders representatives, but often they are just there to rubber stamp what management wants to do.  But if they faced the facts, that the odds are against them over the very long-term, I bet they would think differently. This may sound heretical, but I think boards should be focused on maximizing distributable cash and actually distributing it to shareholders as soon as possible.  Continually reinvesting in what is likely to be an eventual failure is effectively burning money.  If the company is at an optimal size, the board should be distributing all excess earnings, not holding and reinvesting it – or worse, just holding cash (yes, I’m looking at you Apple).  If there are projects that show a clear path to a strong IRR, then by all means invest.  But just sitting on shareholder’s money for some future, non-existent capital expenditure is just wrecking investors’ potential rate of return.  Some have criticized IBM for issuing billions in debt to buyback stock at a time when its experiencing declining revenue, but when you think about it, that is exactly what it should be doing for its current shareholders.  Will it eventually become so debt heavy that it is unable to service the debt, and will have to go into liquidation mode and close?  Maybe.  But that’s a problem for future shareholders, and the board represents the shareholders who own it today.  If that means that some future, theoretical shareholders get left holding the proverbial bag, well, maybe that’s the right call.  Corporate governance is tricky that way – is the proper role to preserve value for as long as possible, to create value for a future shareholder that doesn’t even own the stock today, or to maximize return for those that currently own it?  I’d argue it is the last one, and I’d like to see the argument against it.  Just like Butte was strip-mined for its copper and other assets, sometimes strip-mining a company is the best course of action.  I bet Sears’ shareholders wish they had done just that when they had the chance. 
 
Which companies are paying out most of their excess cash to investors today?  Well, there is a sector that as a whole is doing it – banking.  Want to learn which ones are the most attractive investments today?  Sign up for Miller’s Market Matrix, and I’ll tell you.  If you would like to receive it, just reply to this email, or email me directly at [email protected] and I will add you to the list.  The next issue comes out this week.  (Don’t miss it!)   Also, if you would like to receive this newsletter directly in your inbox, simply subscribe by clicking here. 
_______________________________________
This week’s Trading Rules:

• A bird in the hand…
• Even the “greatest” companies eventually lose their edge.  Be realistic and sell before it happens.
• “On a long enough time line, the survival rate for everyone drops to zero.” ― Chuck Palahniuk, Fight Club

 
We ended our last few letters with, “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.” 

Since then, U.S. equities have continued to set new records, volatility has fallen to all-time lows, and Treasuries are signaling that inflation will remain low for the long-term.  Peace and quiet prevails.  U.S. retail investors are now more fully invested than at any time in over a decade.  FAANG continues to do no wrong.  Etcetera, etcetera.  Investors I respect are extremely cautious and raising cash, while friends outside the business regal me with stories of how much money they are making in Apple and Tesla.  I am thinking of taking an Uber just to see if the driver has any tips for me.  I’m not saying a crash is imminent, I’m saying that all the preconditions for a sharp pullback are in place.  As I look out my window at a downtown Portland that is engulfed in smoke from forest fires in British Columbia, I’m reminded that just a like a dry, tinder-laden forest that gets hit by a random lightning strike, it won’t take much of a sell-off to set the U.S. markets on fire.  
 
SPY Trading Levels:  

Resistance: We’re right in it at 247/248.  Not much above here.   
 
Support: 245, small at 242, then a decent amount at 239/240, followed by a lot at 233/235.  Long-term support is 210. 

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

​First, apologies for skipping an edition of the Musings.  Life has been hectic, with traveling to visit company management teams.  And really, there wasn’t a lot to say – markets have been calm and quiet lately.  If you don’t have anything important to say…you know the rest. 
 
“There is nothing more deceptive than an obvious fact.”
Arthur Conan Doyle, The Boscombe Valley Mystery
 
There are some obvious facts about the U.S. stock market that are fairly deceptive.  Maybe the most deceptive of them is that recent low volatility does not portend future low volatility – in other words, if the recent past has been calm, the near future may not also be calm.  And yet, that is precisely what multiple market indicators of future volatility are pricing in.  What is deceptive about this market is that while the overall S&P 500 continues to move in a very narrow, low-vol range, the underlying sectors are swirling around fairly rapidly.  This is leading funds and strategies that aspire to control the volatility of their own returns to become overly comfortable with the market.  If these strategies were small relative to the size of the stock market, it really wouldn’t matter.  But according to the Wall Street Journal, “volatility control” funds that use the VIX to decide whether or not to buy stocks now have $200 billion in assets.  That is in addition to the trend following strategies being used by pension funds and risk-parity funds that increase their leverage during periods of expected low volatility. 
 
“’Is there any point to which you would wish to draw my attention?'
 
'To the curious incident of the dog in the night-time.'
 
'The dog did nothing in the night-time.'
 
'That was the curious incident,' remarked Sherlock Holmes.”
Arthur Conan Doyle, Silver Blaze
 
This crowding into the low-vol trade will only be problematic when volatility spikes and remains high for a significant period of time (i.e., more than a few days).  When will that happen?  I have no idea.  The sell-off in the ever-evolving cohort of FANG/FAAMG (Facebook, Amazon, Netflix and Google, or Facebook, Amazon, Apple, Microsoft and Google, depending on who is using the acronym) on Friday was sharp and, relative to recent trading, deep.  But a rally in financial and energy stocks, which have been the two worst performing sectors year-to-date in the SPX, offset the tech declines – keeping overall SPX vol low.   So the low vol trade continues to work, until it doesn’t.  Put another way, the dog did nothing in the night time, which is a curious thing.   

​The concern I have is that when the low-vol trade eventually doesn’t work, it’s going to blow up spectacularly, as, compared to past market downturns, there is a lot of money betting on stability.  What that means is that, past a certain point, the selloff will accelerate, as put sellers either hedge or get margin calls.  Some would argue that the recent surge in “passive” investing via index funds and ETFs will acerbate that eventual selloff, but I’m not so sure – we have had spectacular crashes in the past, well before Vanguard created an index fund.  What may be different this time is the speed with which it occurs – think Black Monday, 1987, not the relatively more gradual declines of 2000.
 
So why am I so sure that eventually we’ll have a severe decline?  Mainly because there aren’t many cheap stocks anymore.  Value investors (and I think of myself as one of those) prefer to invest when the math on an IRR basis is easy, and right now that math is hard to make work.  At current prices, value investors are having a difficult time finding stocks that they feel confident in buying and holding.  Many value mutual fund managers I talk to are just putting money to work because they have to, not because they want to. Growth has massively outperformed value recently, exacerbating the relative performance problem and driving the aforementioned FAAMG cohort to spectacular year-to-date returns. Unfortunately, what this means is that in a sell-off, value investors aren’t going to be interested until stocks fall a large amount.  When stocks are cheap, value investors are in there picking away at their favorites, and are probably getting money flows to boot if they have recently had good performance (which they tend to do when stocks are cheap).  But in the current market, stocks aren’t cheap, value funds are bleeding cash, and the funds that invest using momentum factors and other trend following systems will all get sell signals at the same time – creating a self-reinforcing negative feedback loop.  The market may well then become reflexive, where stocks going down makes them less attractive to the investors that have been getting money, while the investors that normally step in as prices go lower are already fully invested or don’t have the firepower to stem a decline.  The flow of funds out of active managers and into passive investments is one risk factor that will create this negative feedback loop (index funds don’t hold cash, for example), while the amount of money in “vol control” and vol selling strategies is another.  The combination could create some breathtakingly fast declines.  Buckle up. 
 
 
“How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?”
Arthur Conan Doyle, The Sign of Four
 
 
At this point you can probably tell that I think it is impossible that volatility will remain near record lows forever.  So what is left that, while being improbable, must be the truth?  Having spent a lot of time lately thinking about the current state of financial markets, I think the risk that most (but not all) market observers view as improbable is that Central Bankers around the world will lose control of their bond markets.  Put another way, I think that most market participants are paying extremely high prices for credit of all types, from Sovereign bonds with negative yields to Investment Grade Corporates (IG) yielding 1% over equivalent sovereigns to High Yield (HY) bonds near (but not quite at) all-time tights, because they think that central banks are infallible.  Long-time readers know I have been pointing at these markets as incredibly overvalued (I think the next “big short” will turn out to be European Sovereign bonds with negative yields and High Yield), but so far have been wrong, mainly because the bond market continues to believe, as a whole, that the central bank “put” will always be there.  The market is pricing in the fact that it is extremely improbable that rates will ever rise meaningfully again. However, when thinking through the various likely future outcomes for financial markets, one scenario continues to strike me as the most likely: that financial markets swiftly, synchronously sell off – a flash crash across global markets that central bankers are unable to stop before bonds are off 15% and stocks are off more than 20%. When will this happen?  Probably not until the ECB or Fed start to meaningfully unwind their $14 trillion in bond holdings.  If they never do, but continue to “buy buy buy,” literally forever, then maybe the bond market will be able to avoid this scenario.  But stocks are a different story.  Something (and no, I don’t know what it will be) will trigger a selloff that lasts more than a few days, and put sellers will have to hedge, and no one will be there to take the other side – and then we’ll get a flash crash that morphs into something a little bigger and longer.  If stocks have to sell down to levels that make them attractive again to value buyers to find a bid, that could be ugly – see the valuation charts below. 
 
 
Yes, we are 99% above the Exponential Regression Trend Line.  We’ve only been higher in 2000, and that was a different type of market.  

​So what’s an investor to do?  Cash should be your first option.  Too many investors view cash as a cost – the lost return on assets you could have been holding that continued to go up.  That “cost” always looks highest near the end of a bull market.  However, it’s a cost that investors should be willing to bear in order to have the ability to buy stocks at attractive prices.  Look at the likely forward 12 year returns on the Hussman chart above.  Do stocks returning 2% per year look like something you really can’t afford to miss? 
 
“The game is afoot.”
Arthur Conan Doyle, Adventure of the Abbey Grange
 
If your fear of missing out on a blow-off stock rally is too great to allow you to sell, then the next best thing to do is take advantage of all the vol sellers out there to take the other side of the trade – be a vol buyer.  This has been costly of late – all the smug owners of vol selling funds are looking pretty smart lately, while those who hedge have just been racking up expired premium. But…that’s when you want to buy hedges – when they are cheap, and before you clearly need them.  This will allow you to stay long if you have to, but protect your downside.  I’m not doing the following trade (I’m not capping my gains by selling the lower strike), but the following chart from the FT is indicative of how cheap hedging has become.   Take advantage of it.

Quite a few of you have signed up for the more in-depth Miller’s Market Matrix, where I delve in-depth into markets and provide specific investment ideas.  This week it will be jam packed with many more charts I couldn’t fit in this letter.  If you would like to receive it, just reply to this email, or email me directly at [email protected] and I will add you to the list.  The next issue comes out this week.  Don’t miss it!   Also, if you would like to receive this newsletter directly in your inbox, simply subscribe by clicking here. 
_____________________________________________________
This week’s Trading Rules:

• Sometimes facts can be deceiving.
• Beware of the dog that doesn’t bark.

 
We ended our last letter with, “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.”  I wouldn’t change a word.   
 
SPY Trading Levels:   
Resistance: A little at 245, then not much. 

Support: Small at 242, then a decent amount at 239/240, followed by a lot at 235/236.  Below that its 232, 229.  Long-term support is 210. 

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.

​Right now we are solidly in the “Most Expensive Quintile” bucket of the above chart, with the most recent reading for the Shiller PE (admittedly, not my favorite measure, but its decent for broad views) at 28.94.  The cutoff to be in the 5th quintile in the chart above for most expensive is 19.6x.  The cheapest quintile ranges from 6.8x to 12.8x.  So to get there, we’d have to fall over 55% to be just inside the band.  To get to 6.8x, we’d need to fall over 76%.  That’s just the truth of the math.  The Shiller ratio was only higher than today in 1929 and 2000.  But wait!  Shiller uses backward looking, smoothed earnings, and earnings were terrible in the Great Recession. It’s also a terrible timing indicator, as it often continues to get more overvalued for years.  Surely things will be better going forward, obviating the usefulness of all this history.  Well, yes and no. Yes, Shiller includes some horrible earning years.  But forward estimates are nearly as horrible at being accurate.  Check out the following chart:

​Over in the Matrix, we’re going to take a deeper look at flaws in ETF construction, what’s happening with consumer loans (hint: it’s not just auto loans that are in trouble), and many more stock specific ideas.  Just reply to this email to be added to the list, or email me directly at [email protected] and I will add you.  Also, if you would like to receive this newsletter directly in your inbox, simply subscribe by clicking here. 
____________________________________________________________________
This week’s Trading Rules:

• Sometimes the truth hurts. That doesn’t mean you should ignore it.
• The only kind of danger is grave danger.

 
Money flows and interest rates drive the macro environment, which moves stocks in the short run.  Long-term, valuation matters as well.  Today, both are unfavorable for strong future returns.  We ended our last letter with, “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.”  I wouldn’t change a word.   

SPY Trading Levels:   Last time we wrote that “This little selloff has created some resistance just above the current price, with a lot more at 236 and then 238.”  Since then, the market spent a lot of time struggling with the 236 level before breaking down recently.  Overhead resistance is even stronger now, while support is weaker. 

This week’s levels: 

Resistance: A whole lot from 235 to 238, as the choppiness just under the 236 level has now become even more resistance.    

Support: Same as before.  228/229 is the first level.  Then a 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 as leveraged players get out. 

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.

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.

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.
 
___________________________________________________________________
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

Gotta Have Faith
Baby
I know you're asking me to stay
Say please, please, please, don't go away
You say I'm giving you the blues
Maybe
You mean every word you say
Can't help but think of yesterday
And another who tied me down to lover boy rules
George Michael, Faith, 1987
 
Before we jump in, many of you have been asking for more information about these markets. If you would like more frequent letters, just email me at [email protected] and I will add you to my newsletter. 
 
There are quite a few markets in which you gotta have a lot of faith in everything going right in order to make decent returns from here.  In short, most financial markets are priced if not for perfection, then for not a lot of bad stuff to ever happen again. But as we all know, bad stuff does happen, and often, not in isolation.  Bad things happening when valuations are inexpensive is survivable.  Bad things happening when valuations are near all-time highs is not.  At least not if you’re in a passive, long-only, market-cap or “smart-beta” weighted index fund or ETF.  If you’re in one of those when bad things happen, you’re going to be praying that if God (or the deity of your choice) just lets you get back to even, you’ll never blindly invest in unhedged vehicles again.  At least until the end of the next cycle...
 
So which asset classes are most at risk right now?  I’d start with credit, in particular US High Yield and European Corporate credit.  On Thursday February 16, 2017, the BofA Merrill Lynch US High Yield spread was 3.83% over the spot Treasury curve.  This measures pure credit risk.  So the High Yield market today is only asking for 383 bps of credit spread 8 years into a recovery and with the benchmark bonds to which it is pegged at nearly 140 year lows (or 5000 year lows depending on which bond you use).  So you’ll have big losses if spreads widen, along with pure basis risk if rates rise.  Your probability of making a lot of money is low, while your probability of incurring large losses is high.  Who would buy this crap at this point in the cycle?  Oh right, those institutions that don’t have a choice.  Insurance companies, pension plans, and other large investors with a mandate to own a somewhat fixed mix of stocks and bonds are forced buyers no matter the risk.  They will blindly follow their asset allocation models right off a cliff.  Credit markets are very complacent, despite the fact that we have the following happening right now:

• The Italian Banking Crisis is getting worse not better.
• France has an election in the spring that may not go well for the establishment.
• China is fighting to keep its currency from devaluing quickly while fighting a looming credit crisis.
• The U.S. Congress is seriously considering a border adjustment tax that has the potential to upend global trade flows and disrupt the ability of emerging markets to service their $10 trillion in dollar debt when the dollar strengthens significantly. 

 
Now think about the first 4 weeks of the new Trump Administration.  Has it gone well?  Or, maybe, no matter your political leanings, has it been a little different than normal?  And now do the math.  4 weeks is less than 2% of Trump’s first term.  Think everything will be low vol for the next 4 years?  Ok, now look at these next hree charts and tell me what looks off. 
 

​Well the rally in the U.S. is different you may say.  The U.S. is about to get tax cuts and regulatory relief.  Banks in particular have driven the recent rally, as they are expected to benefit from the above 2 factors along with rising interest rates to boot.  So banks have been on fire, with financials contributing 62 of the 208 point gain in the S&P 500 since election day. Of this gain, nearly all was from forward P/E multiple expansion on the expectation that the above will become a reality.  But in essence, if you are long banks here, you are making the mother of all geopolitical bets – you are assuming that a Congress that doesn’t particularly like the President very much (this goes for Republicans and Democrats alike) will align behind him to pass his agenda.  This may happen.  But stocks are already pricing that in now.  So basic common sense would tell you that the prudent thing to do would be to trim back your exposures and hold cash, right?   Well that’s not what the market is doing…

​Now, what about all the coming tailwinds I mentioned above?   Those aren’t in the numbers yet.  But you know what else isn’t in the numbers?  The inevitable revisions downward as the year progresses.  Basically, analysts always start the year off too bullish and then revise downward as the year goes on.  This is not anecdotal.  It’s reality.  Check out the following chart:

See how all the lines slope downward?  That’s analysts cutting estimates over time. So don’t expect this year to be any different.
 
Before this river
Becomes an ocean
Before you throw my heart back on the floor
Oh baby I reconsider
My foolish notion
Well I need someone to hold me
But I wait for something more
George Michael, Faith, 1987
 
So let’s recap:  bond yields are still near all-time lows, with some exogenous shock potential clearly on the horizon.  An investor in bonds today is  hoping that the Fed and other central bankers know what they are doing and can somehow save them from themselves when credit inevitably blows up and there’s an ocean of sellers. But the Fed and ECB are full of fools that are insulated from reality.  They operate in bubble world of their own creation that is filled with academics and syncophants, and when the next crisis comes, they will be as surprised as anyone and clueless as to how to react. 
 
Seems harsh?  I think I’m being realistic.  Don’t believe me?  Read Danielle DiMartino Booth’s excellent new book, Fed Up.  She was inside the Fed as Richard Fishers right-hand woman, and she’s written an eye-opening expose’ of just how insular and myopic (her words) the Fed really is.  You can buy a copy here (I don’t get paid for this recommendation, I’m just providing a link).  I got my copy on Friday night and finished it Sunday morning.  Here are some eye-opening quotes for those who still think the Fed has a clue about what’s happening and how to handle markets.
 
“Assuming that the FRB/US model does a good job of capturing the macroeconomic implications of declining house prices, such an event does not pose a particularly difficult challenge for monetary policy,” said John Williams, a top analyst at the San Francisco Fed, during the debate. (He would later become the bank’s president.)  “The model showed the economy could weather a 20% drop in home prices with small increases in unemployment and modest cuts in interest rates.”  FOMC meeting, June 2005
 
When I read that I almost screamed out loud.  They had a @#$#& model that showed that the economy could weather a 20% drop in home prices with small increases in unemployment?   In 2005?  Why didn’t anyone say “That makes no sense whatsoever.  The model is clearly broken?”  And yet…every few months we trot out these morons with their models to tell us all is ok.  I call B.S.  They don’t have a clue.  Don’t believe me?   Another interesting fact in the book is that despite having over 1,000 economists with PhDs at the Fed, their studies, most of which are written for academic journals, are no more accurate than a coin flip and many cannot even be replicated.  When asked why they used a measure of inflation that removes food and energy (the core PCE), the answer is that their mathematical models of the economy don’t work unless they do.  When told this in a meeting, James Bullard exclaimed, “Crap in, crap out?  That’s how we make policy?”
 
There are many more quotes like these.  But after the crisis, the institutional myopia (DiMartino Booth’s word) that plagued the Fed must have been rectified, right?  Wrong. Apparently nothing has changed.  We’re going to head into the next crisis with the same academics applying the same mathematical models to problems they don’t see coming and don’t understand.            
 
There is a lot more to discuss about these markets, but this letter is already too long.  If you want to get the rest of my thoughts, just email me at [email protected] and I will send you the latest Miller’s Market Matrix with more analysis. 
_______________________________________________________________________
This week’s Trading Rules:

• Beware of academics bearing models.
• Knowing prices are wrong and knowing when they are going to correct are two very different things.  Being able to survive until and through the correction is vital.

 
Ok, ok, one more:  “The risk of an outright downturn has receded along with the early signs of stabilization of housing markets. In summary, I believe that a soft landing is the most likely outcome over the next year or two.”  Janet Yellen, February 2007.  From Fed Up by Danielle DiMartino Booth

SPY Trading Levels: Once the SPY broke above our resistance at 228 its been straight up.  There aren’t a lot of headwinds.  Volatility remains exceptionally low.  Be careful out there.

This week’s levels: 

Resistance: Not a lot.  It will take macro/geopolitical issues to turn the market down right now.

Support: Old resistance is now new support.  228/229 is the new first level.  Then a little at 221/222, then 218/219, then a lot at 213/215.  After that it’s 209.

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

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.

​We are all susceptible to the pull of viral ideas. Like mass hysteria. Or a tune that gets into your head that you keep on humming all day until you spread it to someone else. Jokes. Urban legends. Crackpot religions. Marxism. No matter how smart we get, there is always this deep irrational part that makes us potential hosts for self-replicating information. 
Neil Stephenson, Snow Crash, 1992, Chapter 56.
 
Markets go through phases, shifting from one regime to another. Its participants succumb to an idea about the “right” way to invest.  In the early 1970s it was go-go growth stocks.  For a while in the 1990s it was all about Buffett and value.  There are times, like the late 1990s, when it’s all about momentum.  But these are all just ideas that the market is telling itself are true at any given time, instead of viewing the markets as systems that move and evolve over time. Investors like the story of being a value investor or growth investor, because everyone needs an origin story - people like to have something to anchor them. Value versus growth versus momentum were the stories investors told themselves from about 1935 through 2009.  And then something changed.  The stories stopped being told by investors, and started being told by government entities.  Central Banks, Presidents and Prime Ministers became more important to markets than the underlying fundamentals of markets themselves, particularly in fixed income. But many investors are having a hard time adjusting to this new reality.
 
It’s uncomfortable to admit that what you do for a living can be driven for years, maybe decades, by a collective story over which you have no control.  But that may well be the only true reality we’re left with these days.  I think we’re going to look back with fondness to when the market’s origin story was told by investors arguing about growth versus value instead of central bankers and politicians. Morningstar and Lipper will be viewed with nostalgia as a quaint way of categorizing the players in a game that became unplayable.  
 
 
"Y'know, watching government regulators trying to keep up with the world is my favorite sport."
Neil Stephenson, Snow Crash, 1992.  L. Bob Rife, television interview, Chapter 14.
 
I think we’re nearing the time when regulators finally realize that their storytelling won’t save the world.  For the past seven years we have been on the receiving end of a constant stream of fairy tales from the Federal Reserve, European Central Bank, China, and Europe’s political leaders. The Fed’s “strategic communications policy” that involved “forward guidance” to “manage market expectations” about the course of future Fed policy became a self-reinforcing narrative that drove a globally connected economic system to push interest rates into negative territory and equity market valuations to levels not seen except at the market peaks in 1929 and 2000.  Merkel and Draghi continually talk about the importance of “unity” while also initiating massive ECB bond buying programs and simultaneously leaving Greece and Italy to suffer massive unemployment and stagnation without fiscal stimulus. Abe has the BOJ pegging Japan’s 10 year yield at zero.  And China just fakes its economic data while trying everything it can think of to cushion the fall in the Yuan.  And yet…everything is great! 
 
But the problem is this narrative relies on all the market participants believing it despite the fact that the narrative makes no objective sense – that at the same time “everything is fine” yet, “we need rates at zero to stimulate growth” – they both can’t be true at the same time.  And yet...the best investment decision you could have made in the past seven years was to believe them both and not fight the central banks. In policy driven markets, you need to play a “common knowledge game.” The key to exiting safely from a policy driven market, like the one we are in now, is knowing when the government regulators are no longer able to keep up with the world.
 
Hiro: "Wait a minute, Juanita. Make up your mind. This Snow Crash thing—is it a virus, a drug, or a religion?"
 
Juanita shrugs. "What's the difference?"
 
Neil Stephenson, Snow Crash, 1992.  Hiro and Juanita, Chapter 26.
 
If you’re able to play along with the new religion, and then, when it cracks, immediately liquidate and go to cash or short, then ride along. But this is tricky. It requires you to, all at once, both be acutely aware of the narrative you are being told, how it is being perceived by other market participants, and when it suddenly isn’t being heard in the way that the storytellers meant it to be. At some point, the narrative cracks, people realize they are being played, and all hell breaks loose. We may well be seeing the start of it now. You can’t tell from financial markets, but I think we’re seeing the dawning realization that the stories we’ve been told just aren’t true, that the ECB and Fed can’t magically create a world of never ending prosperity and zero volatility. Sometimes a new narrative can take over: the recent Trump Trade was one of those times. It was investor driven not CB driven. But it was built on top of the false narrative that Europe is stable and functional, so it's a temporary, albeit powerful, move. And once a critical mass realizes that the narrative is false, we’ll have a Snow Crash – a systemwide shutdown.  And that’s when you’ll want to step back in and buy. 
 
When we can watch something on TV, and then be told right afterwards that what we saw was something else (and yes, I’m referring to the surreal press conference (is it a press conference when the press isn’t allowed to ask questions, or just a speech? But I digress…) held on Saturday by the new Trump Administration)), we’ve stepped across the line from where we knew we were being lied to by central banks and their accomplices in government but at least they pretended to be telling the truth, into a world in which the alteration of truth is upfront.  And you can choose to go along with it, or not – but it’s now hyper clear what they want you to hear.
 
When you’re having debates about facts, you’ve stepped fully into what Ben Hunt has termed the narrative machine (his writings are excellent).  Below is a chart from Hunt’s August 17, 2016 report of how news stories on Bloomberg coalesced around a common account of Brexit after it happened.  The charts show what words and phrases the stories have in common before an event (on the left) and what they share after the event.  It’s a visual way to show the self-reinforcing echo chamber in which the modern media operates. 
 

​Why are we letting this narrative happen?  Because there really isn’t anything an investor can do about it anyway. Fighting it doesn’t work. You just lose money.  And capital.  So you play along, aware that you’re in a metaverse but unable to extricate yourself.   Smart investors – and who’s to say what one really is until after the reversal – will play along too. But smart investors will also spend lots of time obsessing over alternative universes in which things do not work out so well.  They play one game while learning another.  Others…well they just barely figure out the first game before it changes.  Then they blow up.
 
When it gets down to it — talking trade balances here — once we've brain-drained all our technology into other countries, once things have evened out, they're making cars in Bolivia and microwave ovens in Tadzhikistan and selling them here — once our edge in natural resources has been made irrelevant by giant Hong Kong ships and dirigibles that can ship North Dakota all the way to New Zealand for a nickel — once the Invisible Hand has taken away all those historical inequities and smeared them out into a broad global layer of what a Pakistani brickmaker would consider to be prosperity — y'know what? There's only four things we do better than anyone else:
music
movies
microcode (software)
high-speed pizza delivery
 
Neil Stephenson, Snow Crash, 1992.  Introduction to Hiro Protagonist, Chapter 1.
 
This was written 25 years ago. And it manifested itself in our reality this past November.  The hollowing out of our middle class was not only completely forseeable, but it was written about in a popular book.  And yet, here we are, with the political establishment acting surprised it happened and not knowing what to do next.  Well, I don’t know what’s going to happen in politics, but in terms of markets, if we were just sitting here at 8 or 9 or 10 times earnings, getting a 10-12% earnings yield and a little bit of growth to boot, would I really care?  No.  Because it wouldn’t matter.  Yes, maybe the market would get worse, and stocks would go to 5 or 6 times earnings, and I’d be down 35% and wanting to puke, but then my earnings would accrete into book and I’d earn my way out of it in 3 or 4 years.  At a median S&P 500 P/E of 22.9x earnings at 12/31/16, earning your way out of it will take nearly a decade.  That’s not good.  Plan accordingly. 
 

"You don't respect those people very much, Y.T., because you're young and arrogant. But I don't respect them much either, because I'm old and wise."
 
Neil Stephenson, Snow Crash, 1992.  Uncle Enzo, Chapter 21.
 
Not respecting the markets can be a dangerous game.  But there’s a difference between not respecting their correctness, because they’ve been manipulated globally by central banks for the past 7 years, and not respecting their power.  Many smart investors have been run over in the past 2 years by not respecting the power of the markets to do irrational things for longer than they “should.”  That’s what makes this market so difficult, and I think, will make it so dangerous to the passive, indexed, long-only investor in coming years.  After the Snow Crash, we'll invent new stories and narratives to tell ourselves, and the cycle will repeat, only with new narrators and new characters. 
 
Right now I’m market neutral, with fairly large bets via options on a SPX decline. I am still short international sovereign debt, along with small shorts on the Italian and Chinese stock markets.  I’m leaning long in some tech companies, consumer discretionary stocks, and defense in the U.S., with a number of shorts in other sectors offsetting that. And I’m still waiting for the time when market participants realize they’re part of a story that doesn’t end well.
 
I was quoted in Barron’s The Trader column, written by Ben Levisohn a few weeks ago. You can find a link to the PDF here if you don’t get Barron’s (but you should).    
 
If you would like more specific ideas on how to navigate these markets, just reply and let me know and I will sign you up for a free trial of my newsletter.  By the way, we changed the name to Miller’s Market Matrix.  Stockpicker was too similar to some others out there.
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This week’s Trading Rules: (all from Neil Stephenson’s Snow Crash, 1992)

• The world is full of power and energy and a person can go far by just skimming off a tiny bit of it.
• When you are wrestling for possession of a sword, the man with the handle always wins.

 
SPY Trading Levels: Our levels have been about spot on.  The S&P 500 has gone 99 days without a decline of more than 1%.  That's very rare.  It can lead to higher VAR positions than normal.  Be prepared.  
This week’s levels: 

Resistance: Same as before, there is a lot between 226 and 228.  Not a lot above that.
Support: A little at 221/222, then 218/219, then a lot at 213/215.  After that it’s a little at 209.

Positions: Net neutral stocks (both long and short stocks). Short FXI, SPY, and BWX. Long put options on SPY, KRE, HYG and FXI.

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. 
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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.