Mike McDermott: Listen, here's the thing. If you can't spot the sucker in your first half hour at the table, then you ARE the sucker. – Rounders, 1998
 
In any zero-sum endeavor, it pays to know who you’re playing against.  In a 9 person poker game, who the sucker is becomes clear fairly fast. But in financial markets, figuring out who the sucker is can take quite a bit longer, particularly when the markets all start moving in the same direction. This herding mentality can lead to crowding into trades, whether its Nifty Fifty stocks in the 1970s, internet stocks in 1999, AAA-rated senior CDO notes in 2007, or…passive investing today. 
 
There is lots of data about the saturation of passive today, but being superficial, I like to look at the obvious things that are right in front of me.  Earlier this week the Wall Street Journal ran an article on Jeremy Grantham and his firm, GMO. The short version: investors are doing it again.  $40 billion has been pulled from the firm, just as stocks are at all-time highs.  This is the same guy who warned about the internet bubble in 2000 and the stock market in 2008, and was right. And yet…since he’s been wrong for a little while, out goes the money.  So who’s right?  Grantham, or this guy who just pulled $211 million from him: “GMO is a deep-value investor that takes a really long-term view,” said Dan Gallagher, chief investment officer of the Ventura County Employees’ Retirement Association. “But the board felt it was time for a change.”  Ok.  We’ll see how that works out for them.  Anyone want to place a bet?
 
But it’s not just Grantham.  If it was, then I’d be looking at other factors.  Is the game he’s playing oversaturated with better players now?  Did he lose his edge? Or is it just a bad run of the cards?  Here’s where the other players at the table matter.  Let’s look at who’s down a bit in chips.  Paul Tudor Jones is having a bad run.  David Einhorn at Greenlight can’t catch a break.  Even John Burbank at Passport had a rough year.  What’s really interesting to me is that all 4 of these investors utilize different investment strategies or focus on different markets, but all have excellent long-term records that suddenly went bad.  Did they all get dumb, all at once?  Or is something else going on? 
 
Mike McDermott: [Narrating] In "Confessions of a Winning Poker Player," Jack King said, "Few players recall big pots they have won, strange as it seems, but every player can remember with remarkable accuracy the outstanding tough beats of his career." It seems true to me, ‘cause walking in here, I can hardly remember how I built my bankroll, but I can't stop thinking of how I lost it. – Rounders, 1998
 
So why have the cards suddenly gone so cold for so many of the best investors?  What changed?  Just like in past bubbles, dumb money is on a hot streak, which is running over the better players – in the short term.  But just like you always see the same faces at the final tables of professional poker games, I think we’re about to see a turn in the game of investing, where the sheep start getting sheared again and the dumb money gets flushed out.  I don’t know what the trigger will be, just like no one knew that Yahoo actually reporting a profit in March 2000 would trigger the bursting of the internet bubble, but it will happen.  Probably sooner than later. 
 
I think we are at or near “peak passive” as it’s being called. When everyone knows something to be true, it’s probably not. And right now the one thing that “everyone” knows is “true” is that passive always beats active investing. Instead of folding in the face of that, I think it’s about time to call that bet.  Don’t believe me?  Let’s review some numbers.  According to ICI, since the end of 2006 investors have taken about $1.2 trillion from actively managed mutual funds and given $1.4 trillion to equity index funds and ETFs in the U.S. alone.  That’s a lot of money.  How much is it?  Well, when you consider that the U.S. equity mutual fund industry has grown from just $284 billion in AUM in 1989 to around $6.7 trillion today, it’s a lot.  And look at the growth in Index funds – they were just $3 billion in AUM in 1989 and are about $2 trillion today, or nearly 30% of total assets under management, according to Credit Suisse. 
 
The issue is timing. While it’s usually fairly clear when a bubble is forming, it’s a lot harder to time when it’s going to pop. These processes usually become self-reinforcing, as successful relative performance leads more investors to invest in the same strategies, driving up their assets, with which they buy the same securities they already own, and on and on.  This is the “Madness of Crowds” Charles Mackay wrote about in 1841 that infects markets periodically. (You can see it at the craps table in a casino as well.  They’re always the ones having fun. Until they bust.)  But it’s this same crowding into a narrow asset class that creates future problems, as there are fewer assets on the other side of the trade to buffer the eventual reversal.  See the $211 million that Ventura County took out.  Or the other $1.4 trillion in actively managed assets that were shifted to passive.  Who’s going to be the buyer, when that money turns and runs?  Yeah, I don’t know either.  
​

​I hesitated a few days before sending this note, since just after writing it I was sent Michael Mauboussin of Credit Suisse’s latest piece, titled “Looking for Easy Games.”  Not wanting to look like I mirrored his work, I had to take the time to read it and be sure our ideas weren’t too similar or that I would just be repeating what he said.  They aren’t and I’m not, despite the similarity of theme (using a poker analogy to point investors towards games they can win).  That said, he had some great data. His conclusion: if you’re going to be an active investor, be REALLY active and long-term. Don’t closet index. But that doesn’t really answer the question of what games active investors can win.  And that’s where I want to dig in.    
 
Mike McDermott: [Narrating a quote from a gambling maxim] You can shear a sheep many times, but skin him only once. – Rounders, 1998
 
When markets change, you need to find a way to either change with it, or be able to just fold your cards a lot. Poker pros fold many more hands than they play. Amateurs are in every hand and re-raising pre-flop with Queen-Ten. (No, this is not a good starting hand.)  But professional investors face a problem: if they fold for too long, their investors may leave them, like Ventura leaving GMO.  But many pros aren’t really able to get up from the table and find another game. If you’re known as a deep value investor, and you think most stocks are overvalued, do you change your investing philosophy and become a growth investor, or a GARP aficionado, or something else?  That’s called style drift. Asset allocators don’t like it. I know – I used to be accused of it all the time in my mutual fund days.  (In my defense, my team and I were just buying whatever was cheap, regardless of what bucket Morningstar put the stock in.  Still, it made for some interesting sales meetings.) 
 
With the proliferation of cheap computing power and widely available data, it has become a lot harder to find games you can win. For example, when I started at Keefe, Bruyette & Woods as a bank analyst in 1994, just having the data on the banking industry gave us a huge edge. Every quarter we dutifully collected it from regulatory filings and company releases, entered it into a big database, then printed the “Bank Book.”  It was the bible for bank investors.  With that bank book alone and some time digging around, you could make good money.  Then others starting collecting the same data (damn you SNL), and computers got cheaper, and just having the data wasn’t enough. When I started my hedge fund in 1997, we had an edge – we knew small-cap banks better than 95% of the investors out there.  There were others who did what we did – but there was room for more than one shark at the table.  The market was so inefficient that there were plenty of sheep.   And then our returns sealed our fates.  We compounded at 25% per year net of all fees for 10 years.  Assets swelled.  We closed our fund to new investors, but others who were similar to us, and just as smart, kept getting assets, and suddenly our market got crowded. We killed the sheep. 
 
Worm: [Pretending to be a sore loser at the college fraternity game] Like my uncle Les used to say "When the money is gone, it's time to move on."  – Rounders, 1998
 
We were left playing against other professionals. The game got hard, and returns suffered, so we started looking for other games. Some we were good at, and some we weren’t. It was a painful adjustment, but over time we found more sheep.  That’s the nature of markets – they move in cycles.  I think the professionals, the Einhorns and Burbank’s of the world, will adjust, and active managers will have their due. 
 
So what are the games that can be won today?  Where are there still sheep?  I’m not going to give away all my secrets, but look for where sheep are doing things that they really shouldn’t be doing. Trading weekly options.  Buying yield stocks at any price.  Buying very high-yielding BDCs. Chasing performance in the “Trump Trades.”  If you can, just keep folding, and wait till investors panic and dump something that “everyone knows is a disaster”, like energy and bank stocks a year ago.  Then push in your chips.  In markets that are dominated by passive flows into ETFs, and especially sector ETFs, your edge may well be your ability to do nothing for awhile.
 
Look at these charts from Credit Suisse and tell me if you can spot the bubble.  I’ll wait. 
​

Jo: Mike, I learned it from you. You always told me this was the rule. Rule number one: Throw away your cards the moment you know they can't win. Fold the hand. – Rounders, 1998
 
Right now I’m market neutral, with fairly large bets via options on a SPX decline. I increased these bets in the past few days. 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 waiting for the moment when passive panics, and we can push in our chips again.
 
I was quoted in Barron’s The Trader column, written by Ben Levisohn last weekend. We discussed the trend from big to small and global to local that I wrote about in my last Musings. You can find a link to the PDF here if you don’t get Barron’s (but you should).    
_______________________________________________________________________
This week’s Trading Rules:

• Throw away your cards the moment you know they can't win.
• Only play games you know you can win.
• Sometimes you need to learn a new game.

 
SPY Trading Levels: Our levels have been about spot on.  Maybe time to play smaller.

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, 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 XLU, SPY, and BWX. Long options on SPY, KRE, XLF, HYG.

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.

I am a deeply superficial person. –  Andy Warhol

This past Thursday I took two of my daughters to see the great Andy Warhol retrospective currently on display at the Portland Art Museum.  Most people are familiar with his work, the most famous of which consists of highly colorized sequences of reworked photos of Mao, Marilyn Monroe, and the Campbell’s Soup can series.  We got lucky with our timing, as Jordan Schnitzer, the scion of a local real estate family who also happens to own all the works on display in the show (he owns the largest collection of works on paper in the country), was there to give a talk about the collection.  I’ve heard Jordan speak on a number of occasions, and he always has some interesting insights into the lives and moitvations of the artists he collects, so I was excited for my girls to get a chance to hear him explain the backstory of the most famous of Warhol’s works (included in the show are 10 Maos, 10 Monroes, and a few dozen Campbell’s soup prints).  Instead, I got a lesson in American commerce from the 1950s and 1960s that explains a lot of what we are seeing in today’s economy and global politics, but in reverse.  Stick with me on this.
 
Briefly, Warhol’s works, especially the Coca-Cola and Campbell’s soup can pieces, were a commentary of the commoditization of culture in America that occurred in the late 1950s and early 1960s.  Warhol started his career working in advertising as an illustrator. Before the widespread advent of television advertising, if you wanted to market a product across the whole of the United States, you had to place ads in about 150 local newspapers. There was no national culture in the sense we know it today. There were a series of local cultures, with local products, local tastes, local production, etc.  With the rollout of national television networks during the 1950s, companies could now advertise nationwide. Culture became commoditized, via the Madison Avenue Mad Men.  Now to reach everyone, you just had to sponsor a popular show on one of the big three networks and off you went.  Hence, the growth in national brands like Coca-Cola, which could create a brand image that was consistent nationwide.  It was this commoditization of culture that Warhol was critiquing with his art. 
 
What's great about this country is that America started the tradition where the richest consumers buy essentially the same things as the poorest. You can be watching TV and see Coca-Cola, and you can know that the President drinks Coke. Liz Taylor drinks Coke, and just think, you can drink Coke, too.  
​–  Andy Warhol
 
In a bit of a weird coincidence, later that same evening we decided to watch A Charlie Brown Christmas. I hadn’t seen it in awhile, but was immediately struck by its focus on the same themes that Warhol was skewering: the over-commercialization of American culture. (Ironically, the production was commissioned and sponsored by…Coca-Cola).  Warhol’s first exhibition of the Campell’s soup cans was in 1962.  The Charlie Brown Christmas special came out in 1965.  This timing coincided exactly with the mass-adoption of television and the building of the interstate highway system.  In 1946, only 0.5% of U.S. households had a television, in 1954 this was 55%, and in 1962, it reached 90%.  For the first time, everyone in the country could see the same shows, be sold to by the same companies, and get the same products shipped to their stores.  The significance of this for our culture and the nature of business for the next 50 years cannot be overstated – it literally reshaped the way companies were constructed, how products were produced, and the winners and losers in the battle for the consumer.  And I think that era is over. 
 
Today, we are experiencing the dismantling of a national culture. It is occurring not only because we have hundreds of TV channels instead of three, but because we can all choose which news media fits our worldview and only listen to the news we want to hear. Advertisers have a harder and harder time reaching everyone, which is why print advertising is dying and the only television advertising that has retained pricing power is for the Super Bowl, which may be the last truly national experience we share.  While the recent presidential election made the echo chamber problem more visible to more people, it has been occurring for years, as power to influence tastes and desires has shifted away from Madison Avenue to Youtube influencers and organic, authentic marketing campaigns aimed at more subtle associative feelings of good, or bad, will.  Culture is splintering in hundreds of mini-cultures, each insulated from the others. And it’s happening all over the world. The world is becoming more insular, more closed-off from other cultures, and more intolerant.  The Silicon Valley version of the future had the internet at the nexus of a global culture in which everyone would finally love their neighbors, because they finally got to know them.  (This was a lot of the thinking behind the European Union as well). But a funny thing happened along the way – the more people got to know their neighbors, the more intolerant of them they became. Familiarity bred contempt, not compassion.  The vision of Twitter as a distributed information network has devolved into a sort of hellish hate-transmission vehicle for the radically intolerant on both the far-left and far-right, with the middle left wondering what the hell is going on and why are so many people apparently so angry all the time.
 
Now and then, someone would accuse me of being evil - of letting people destroy themselves while I watched, just so I could film them and tape-record them. But I didn't think of myself as evil - just realistic.  –  Andy Warhol
 
The increasing Balkanization of politics in western democracies is manifesting itself in incredibly intolerant micro-cultures on both ends of the political spectrum.  The victimhood culture that relies on extreme reactions to perceived microaggressions only serves to reinforce this phenomenon and further isolate its proponents from mainstream society, while the rise of the “alt-right” for lack of a better term is a mirror-image manifestation of a similar victimhood culture that expouses violence instead of whining as a solution.  Neither is useful for resolving societies problems, and both will continue to eat away at the foundations of western civil societies as the ability to only hear what you want to hear and only read what you want to read becomes increasingly prevalent.  Facebook and Twitter really have ushered in an information revolution, but not the one they were expecting.  The Balkanization of thought has turned out to be a very nasty thing to unleash.
 
I think we’re going to see this same Balkanization in the upcoming European elections.  Brexit wasn’t an outlier, it was a warning shot.  The danger is that Europe has a history of interstate warfare, and a rise of intolerance could quickly spiral into a shooting war if the migrant crisis and the rise of Islamic terrorism isn’t met with more action than words in the future.  The risk is low, as Europe is steadfastly against action of any kind apparently, but a frustrated populace combined with a resurgent right could combine to create a push for military solutions to the problems that Brussels has created.  Is this likely?  I don’t know. But it’s possible.  Especially when the clueless bureaucrats running the ECB and EU are more upset about Italy bailing out its banks than about the complete inability of the German intelligence service to monitor a terrorist suspect because they didn’t have the resources.  Where are their priorities?  Apparently not on public safety, which throughout history has been an extremely costly mistake to make by those in power.  I literally read back to back articles in the FT last week that demonstrate the blindness of those in power to what is happening in the world.  In the first, a German functionary at the Bundesbank was “aghast” and “appalled” that the Italians were considering breaking the EU imposed limit on debt issuance to preemptively backstop a bank in which tens of thousands of depositors stand to lose their savings if it fails.  In the second, Merkel said she was going to “seriously look at” the shortcomings in intelligence that allowed Amri to go unmonitored after he was known to German intelligence to be a terrorism risk because of a lack of resources.  Think about those two statements for a bit and then ponder the Warhol quote above.  Sometimes life does imitate art.
 
I always like to see if the art across the street is better than mine. –  Andy Warhol
 
What does this Balkanization of thought and culture have to do with investing? Everything. The same forces that are making splintering our national culture are making it increasingly harder for big brands to create a connection with their customers.  You can see this in any number of industries, where the concentration of market share is declining.  Look at microbrews taking significant market share from Budweiser (BUD), or the multitude of specialty waters and teas taking share from Coke (KO), or the locally sourced hip restaurants stealing share from McDonalds (MCD) and Applebees (DIN).  Today’s buyers want authenticity, and they think they can find it in local, small-batch products. I think this fracturing of markets is just starting, and it’s going to make sales gains for the large brands difficult. This is a big versus small battle, and while no one small producer will make an impact on a Budweiser or McDonalds, collectively, I think they are going to be quite meaningful.  Just like one red ant is a nuisance, but a swarm can be deadly, I think this continual pecking away at the big brands is going to be an inexorable headwind for years to come.  I think a wave of disaggregation is coming.  It will be like the creation of General Motors (GM) 100 years ago, but in reverse, as smaller becomes better. This will reshape the investing landscape, and management teams that engage in insular thinking will destroy value. I’ve seen it happen over and over, where a management team is so emotionally and financially invested in the status quo that they can’t see the secular decline that is eviscerating their industry.  Sometimes making the best buggy whips isn’t enough. A secular decline is incredibly hard to fight. I met with the CEO of Peabody Energy (BTU) a few years ago.  He was a nice guy. But he was too “inside” the industry to see that coal was done no matter what he did. I kept asking about solar, wind, and natural gas all getting cheaper every year, and how he could fight that, and he said he’d make it up by exporting to China, which was growing demand rapidly. I replied that eventually the shipping costs would kill the cost advantage, they’d dig their own or find cheaper alternatives, and then what?  He just couldn’t see it.  Peabody filed for Chapter 11 in April of 2016. 
 
Being good in business is the most fascinating kind of art. Making money is art and working is art and good business is the best art. –  Andy Warhol
 
At this point you’re probably wondering if I’m going to do the usual New Year predictions thing where a pundit makes a guess where the stock market will be in twelve months.  Well, sorry, I don’t do that, because I don’t know.  Stocks are fully-valued, but shorting on valuation is notoriously difficult to time right. Bonds are the clearer play, with high-yield spreads quite tight to a treasury yield that is still quite low by historical standards.  Yes, U.S. treasuries have fallen sharply since the summer, but with global rates still near 500 year lows, do you think a 10% drop is all that we’re going to get?  Yeah, me neither.  If we ever get a recession again, high-yield will crater, but right now, it’s a painful short.  I’m sticking with it.  How about instead of looking at stock market pundits’ guesses in order to place a big macro bet, we instead make many smaller ones on companies we know well?  That’s what I’m doing.  If you want some specific stock ideas, my StockPicker newsletter is coming out this week and its free to try for awhile.  Just reply to this email and I will send it to you when it’s ready.  The themes I think will move markets in the years ahead are being driven by the increasingly fractured nature of society, and therefore small will beat big, authentic will beat artificial, and craftsmanship will beat mass production.  As people become more and more afraid of each other, I think a search for safety and comfort is taking hold, with a nesting instinct manifesting itself in more cooking at home, less eating out, more Netflix and HBO binging, and a focus on safety and security.   The problem, besides the obviously negative implications for society as a whole, is that most of the beneficiaries of this trend are private and the losers are public.  Good for a long-short portfolio, but bad for the overall market.  Invest accordingly.
 
My positions haven’t changed much since the last letter.  Right now I’m market neutral, with small 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. 
_______________________________________________________________________
This week’s Trading Rules:

• Disruptive technologies often have unforeseen consequences, many of which are bad for the incumbents in both politics and markets. 
• Sometimes the obvious answer is staring us in the face. Being deeply superficial can be profitable.

 
SPY Trading Levels:

In our last letter we said resistance was about 229.  The market stopped at 228.34 before retreating to 225.66 on Friday.  That has created some overhead just above here.  This week’s levels:  

Resistance: With the pullback there is now a lot between 226 and 228.  Then its moved up to 229.50.  Not a lot above that.

Support: 219/220, then a lot at 214/216.  After that it’s 212.50, then a little at 210.

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

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

Mr. Miller has been quoted in financial publications including the Wall Street Journal and New York Times, and he has appeared on Fox Business News, PBS and CNBC.  More information and past articles can be found at www.StockResearch.net.  Sharing and quoting from this letter is permitted with attribution.

Uh uh. I know what you're thinking. "Did he fire six shots or only five?" Well to tell you the truth in all this excitement I kinda lost track myself. But being this is a .44 Magnum, the most powerful handgun in the world and would blow your head clean off, you've gotta ask yourself one question: "Do I feel lucky?" Well, do ya, punk?
            Harry Callahan, Dirty Harry, 1971
 
The Trump Trade has been in full effect since election day, with very few pauses.  Anything domestic and regulated or geared to the economy has been on fire, while the stocks that either had their own growth (FANG) or were “safe” havens have fared poorly. In the U.S., Banks (BKX) are up 23.5% since election day, and Industrials (XLI) are up 12.5%.  Regional banks are up even more than their large cap brethren, with the biggest determinant of performance being whether or not the company was a member of a regional bank ETF.  Those in an ETF are significantly outperforming those that are not.  This has been a massive allocation trade, based, as I wrote in my last note, on expectations for higher interest rates, regulatory reprieves and tax relief.
 
The KBW Regional Bank Index (KRX) hit a new all-time high on December 9th before pulling back a bit.  Since bottoming out from a six-week free-fall on February 11, 2016, both the BKX and KRX are up about 65%.  That is quite a move. In fact, according to KBW, it is the second-best trough-to-peak move on record for them both.  Only the 164% BKX rally from March 9th, 2009 through October 14th, 2009 beat this year (that was a fun time).  For the KRX, its best year-to-date trough-to-peak return came in 2008 surprisingly, when it advanced 88% from July 17th to September 23rd (inauspicious timing, that).  So after what is pretty close to a historic move in banks, you have to ask yourself:  Do I feel lucky?
 
Well, before we talk luck, maybe we should look at the terms of the bet first.  In an earlier note, May the Odds Be Ever in Your Favor, I wrote “The bond market is, probabilistically speaking, an underdog to perform well over the next 2-3 years.”  Since then, the 10-year US treasury bond yield has risen over 83 basis points from 1.75% to 2.58% as of the close today.  An investor in the 10-year bond has lost nearly 9% of their principal in the 5 months since rates bottomed in July.  Investors in a 60/40 stock/bond portfolio are not doing nearly as well as the headlines on CNBC would suggest.
 
At the same time, U.S. banks have risen on expectations that the Fed is going to keep raising. But remember, they said the same thing last December, before global tummy troubles made them change their mind.  If you recall, the Fed is very afraid of “uncertainty” and is quite enamored of its own power to cause it.  The market has already priced in at least 4 more Fed hikes, along with a healthy dose of tax and regulatory relief.  How much is priced in the banks here?  Well, if your average bank pays a 35% Federal Tax rate, and that goes to 25%, earnings go up 15.4%.  These rate hikes add another say 3% to 8% depending on the bank.  So, after a 23% move, most of this is already the stocks.  What are the odds that we get more than the 4 hikes that are already baked in?  That’s what you are betting on happening from here if you stay long the group.  I don’t think I feel that lucky.  This past week I closed out my long KRE and XLF call positions and am now market-neutral in financials. 
 
So what about the rest of the market?  What can take the overall market higher from here?  Again let’s examine the terms of the bet.  The broader market is moving up on expectations that Trump is going to be able to get a massive infrastructure package through Congress and get tax reform done. Except Mitch McConnell said last week that any package would be “revenue neutral” – which means it’s not a stimulus package, it’s a reallocation package.  Recall, your traditional Republican Senator is not a big Trump fan, so just because he won, doesn’t mean he’s going to get what he wants.  I think the odds of some more gridlock in Congress over taxes and spending are coming.  Everyone wants tax reform, but if you’re cutting taxes and want to increase spending by say a trillion dollars AND the head of the Senate wants it all to be revenue neutral? Good luck with that. 
 
Let’s Play a Little Poker.  The Terms of the Bet, i.e., Your Hole Cards: 
 
U.S. Stocks:  Valuations are near all-time highs.  Only higher on a number of measures in a few times in the past 100 years, including 1929, 2000, and 2007.  See Steve Blumenthal’s excellent piece for the details.  Odds: Not good.  Timing?  Hard to game. 9 of hearts. 
 
U.S. Bonds:  Valuations are also near all-time highs, although they have dropped nearly 9% for the 10-year and about 19% for the 30-year treasury already.  Cheap yet?  I don’t think so. This move can continue.  Rising rates at some point may impact stocks that aren’t banks.  10 of hearts.
 
You have suited connectors. Not the best hand, but not terrible.  I’d play it. 
 
5 cards to come on the flop, turn and the river.
 
The Flop:
China:  Just today China halted trading in “key bond futures” according to the Wall Street Journal.  Its 10-year bond is now at 3.4%, a 16-month high.  After halting trading, do you think yields are poised to go higher or lower?  Me too.  This is after the Chinese government has been doing everything it can to stem the trillion Yuan and counting exodus from its currency.  So far it has cracked down on moving money to Macau, cross-border deals, and companies with operations in China moving their profits out of the country.  That’s right, if you operate in China and make a profit there, it’s become nearly impossible to move the money out.  So, what are profits in China worth if you can’t ever bring them home?  If you said $0, you and I agree.  This is a bad card.  5 of clubs.
 
Italy:  Quick, what is the third-largest issuer of government debt in the world, at $2.5 trillion Euros?  Since this is the Italy card, you guessed right. In case you let your FT subscription lapse, the situation there is “not good,” and not just because the country voted no on a referendum.  It’s not good because most of its banks are insolvent (if your bad loans are 20% of assets while your equity is about 10%, you have a problem – it’s not rocket science).  How can Italy resolve this problem?  If it was back on the Lira and out of the Euro, it could devalue and recap its banks with government cash. If it stays in the Euro, Draghi and the Dreamers (hey, new name for a band?) in Brussels will have to do some form of extend and pretend again – but that just delays the inevitable, while saddling the Italians with a stagnant economy and massive unemployment.  Remember, before the advent of the Euro, Italy was a manufacturing powerhouse with an economy and stock market that outperformed Germany.  Since the joining the Euro, it has badly lagged.  How hard will it be for the “leave” candidate in Italy to make that point?  Another bad card. 4 of spades. 
 
France:  Not too dissimilar to Italy, but it isn’t as acutely aware of its issues yet and its banks are in somewhat better shape than Italy’s. They have elections on April 23rd, 2017, and the incumbent is already out.  Marine Le Pen has a very good chance of doing well in the election, and if she gets significant power, you could easily see a push here for cutting ties to Brussels as well.  This is a neutral card – say the Jack of diamonds.  Now we have 3 to a straight.  Odds of hitting it are 4.4%.
 
Keep betting?  At this point I’d fold.  But say it’s a friendly game, and the company is good.  You call knowing you’re probably going to lose. 
  
The Turn:
U.S. Politics:  Looking out say 6 months, what are the odds that nothing weird, strange or dangerous happens here?  Right now in the U.S. there are high hopes for a Congress that can roll back some of the most harmful regulations stifling business, simplify and streamline the tax code, and get business investing in the U.S. again. A lot of that actually happening is already in stocks.  In addition, there are a lot of unhappy voters making all sorts of noise about being obstructionist, as well as questions about the DNC hack and other issues.  But will they meaningfully impact stocks, enough to derail the momentum it has right now?  I don’t think so.  Queen of hearts.
 
The River:
Geopolitics: Chinese military aggression (South China Sea), Russian military aggression (Baltics) and the likely breakup of the Eurozone. Any of these things would be a negative for stocks. The odds of all of them happening are low, but the odds of at least one of them happening are pretty good, and if any of these happen, stocks will be down 10% fast, if not more.  3 of clubs. We lose.
 
What cards do we need to hit to make a winning hand?   All of these are needed for stocks to go significantly (10% or more) higher:
 
The Eurozone abandons its austerity measures and moves to fiscal stimulus, not just monetary accommodation.  With the Germans running the show, odds are low.  But if it hits, Europe could actually show some growth.  Absent that, continued stagnation.   
 
The U.S. passes a $1 trillion or more infrastructure package without offsetting spending cuts or tax increases, while reducing the top corporate tax rate to 25%. 
 
China doesn’t implode under its massive debt burden.
 
A strengthening dollar doesn’t create another emerging market debt crisis (recall, since most emerging market debt is denominated in US dollars today, a stronger dollar makes it harder for those countries to repay their debts.)
 
Oh please, I scare easy.
            The Killer, Dirty Harry, 1971
 
If all that makes it seem like I scare easily, I guess I’d argue that I like to be aware of my surroundings.  When stocks were at valuations that were extremely attractive in 2009, I was buying hand over fist.  As they have become fairly-valued and then overvalued recently, I have definitely become more cautious.  Right now I’m market neutral, with small 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.  For more specific ideas, please email me for a free trial of my new StockPicker newsletter, where I will be discussing specific stock and sector picks in more detail.  Just reply to this email for more information. The next one comes out this weekend. 
_______________________________________________________________________
This week’s Trading Rules:

• Think through all the potential scenarios and then make an informed, probability-based decision.  Betting big to hit a runner-runner straight is gambling not investing.
• Doing nothing is often the best bet.

 
SPY Trading Levels:

Resistance: The market is just off its highs, so there isn’t much resistance.  The top of the Bollinger Bands is at 229 – look for some resistance there. The market is overbought but can still trend higher in the near-term.

Support: 221/222, then a lot at 219.  After that it’s 216, 212.50, then a little at 210.
 
Positions: Net neutral stocks (both long and short stocks). Short XLU, SPY, and BWX. Long options on SPY, KRE, XLF, HYG.

Sometimes the light's all shinin' on me,
Other times I can barely see
Lately it occurs to me what a long, strange trip it's been
            The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir
 
In my last note, May the Odds Be Ever in Your Favor, I wrote “The bond market is, probabilistically speaking, an underdog to perform well over the next 2-3 years.” Since then, the 10 year US Treasury bond has fallen over 3.5%, and the yield has risen over 58 basis points from 1.75% to 2.33% as of the close yesterday.  For investors who bought the 10-year thinking they were going to earn 1.75% for the next ten years, losing over two years’ worth of income in a month must sting a bit. And if they don’t change, they’re going to get stung again.    
 
Could rates pull back a bit?  Sure. It’s been a big move, fast.  But as another writer I respect wrote recently, “Interest rates go from 15% to 1.3%, then go to 2%, and you think you missed it?” Retail investors who have piled into bond alternatives like Utilities and Staples in an ill-informed yield chase are going to be in for a shock when they get their November statements in a few weeks. Long-time readers know that we have been short both sectors via the XLU and XLP for awhile, and those bets have paid off.  We’re not saying the move is done, but the risk-reward is now more balanced, and we’ve been paring them back. (We’re out of the XLP short completely).  One trade we still like is our short in foreign sovereign debt.  This short is working (down 4.7% since election day) and I think will continue to work. Negative interest rate policies are just dumb, as they eviscerate wide swaths of the economy, from pension plans to insurance companies and regular savers. I like being short stupidity, and being short negative yielding bonds is a way to do it. 
 
On the flip side, U.S. banks are on fire. The KBW Regional Bank ETF (KRE) is up 17.1% since election day (full disclosure: I was long XLF and KRE calls before election day and am still long over half the position). Higher rates are only part of the story, and arguably, the least important part. Yes, higher rates are great for most banks, as they can finally earn a spread on their lending. Low rates were terrible for net interest margins (NIM), but with rates moving up, banks can earn a decent return again. This will in turn spur more lending, which will help the economy, particularly small businesses, where funds were tougher to get.  But the big benefit for banks will be in regulatory relief.  Right now, the two big numbers for banks are $10 billion and $50 billion. Not to go into too much detail here, but those are the two asset levels at which onerous fees (particularly at the $10 billion level) and regulations (at the $50 billion level) kick in. There seems to be a general consensus that the Dodd-Frank bill has been overly burdensome on small community banks, with compliance costs through the roof and loan growth to small businesses and individuals (via mortgages) anemic.  A revision or removal of some of the worst of the regulations, particularly for mortgages, will be very beneficial for consumers.  (Bernanke himself had trouble getting a mortgage once he left the Fed – that’s about all you need to know about the state of banking regulations in the U.S.)  Greater mortgage availability will drive home building and construction, which will also benefit the economy overall. (Some will argue that higher rates will crimp mortgage demand due to higher costs. I disagree.  It will crimp refinancing, but whether a mortgage costs 3.5% or 4.0% doesn’t matter much when you can’t get one at either price.  A mortgage you can get at 4.0% is much better than one you can’t get at 3.5%.)  
 
Another big benefit for financial firms? (Arguably the biggest?)  Elizabeth Warren has been sidelined.  The prospect of Senator Warren becoming Treasury Secretary Warren was frightening for financial markets, and was a non-zero probability if Hilary Clinton had won the White House.  The idea of Warren being free to implement her anti-business policies was a frequent topic of conversation among investors I speak with, and now that she is relegated to gadfly instead of policy maker, banks are a much more attractive investment.
 
Not to be overlooked in a Trump presidency is the prospect for lower corporate tax rates. This is more or less important for some sectors than others (pharma companies and some large international tech companies and manufacturers have been pretty good at reducing their tax rates already), but what sector is pretty tax-inefficient?  Regional banks again.  On average, they pay an effective tax rate of over 33%.  A lower corporate tax rate falls right to their bottom line, boosting 2018 earnings estimates by 10-15% or more depending on the company.  Is most of this already baked into their stock prices after this 17% move?  It sure seems that way.  That said, I think banks have room to move a little higher, probably after a short-term pullback, as the combination of better loan growth, lower regulatory costs, higher interest rates and lower corporate taxes is a powerful tailwind to their earnings growth. 
 
 Sittin' and starin' out of the hotel window
Got a tip they're gonna kick the door in again
I'd like to get some sleep before I travel,
But if you got a warrant, I guess you're gonna come in
          The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir
 
This doesn’t mean that the U.S. stock market is just going to go on a tear. There are lots of companies and sectors that are adversely affected by higher rates or a stronger dollar, or have been a haven in a low-growth, low-rate world. Besides the already discussed staples and utilities getting hammered, stocks that were a safe haven, like FANG (Facebook, Amazon, Netflix and Google) have been weak since election day, as they were a source of funds for investors looking to move into financials.  I’m personally a big fan of Google and am a buyer here, and bought a little Amazon last week for a trade. However, I’d be avoiding companies that get a lot of their income from overseas, as foreign markets are still stagnant at best, particularly in Europe, and the prospect of higher rates and stronger growth in the U.S. is making the dollar stronger every day.  I think we are just at the beginning of a strong dollar regime and that investors that try to fight it will be in a losing trade. Interested in companies that are losers in this?  Email me for a free trial of my new StockPicker newsletter, where I will be discussing specific stock and sector picks in more detail.  Just reply to this email for more information. 
 
You may have noticed that I haven’t spent any time talking about Trump’s infrastructure plans. While I do think the U.S. desperately needs to spend money on infrastructure, particularly bridges that need repair and some airports (been to La Guardia or Kansas City airports lately?), I don’t think the impact will be that meaningful in the near-term to the economy (longer-term it’s a net positive), and the stocks that benefit most have already had massive moves, so chasing that play from here is not a good risk-reward.  I’d wait for a market correction to get involved, or look for second and third-level effects for investing ideas. 
 
Truckin', like the do-dah man Once told me "You've got to play your hand"
Sometimes your cards ain't worth a dime, if you don't lay'em down,
          The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir
 
Here’s the hand we’ve been dealt: rates are going higher, which is good for financials but bad for multinationals.  At some point, higher rates may become a self-correcting, circular type of process wherein higher rates start to impact discount rates on equities, limiting how far they can rise, at the same time that they support a stronger dollar, which hurts exporters and those with large overseas sales.  Net-net?  A U.S. stock market that treads water, in my opinion, with a continual rotation among sectors based on money-flows and relative improvements in earnings.  In past letters I have repeated that “currents were shifting beneath the surface of what appeared to be a calm stock market. In particular, I repeatedly stated that banks were a buy and utilities and staples were a sell.”  Well, that trade is getting very stretched.  I’d look for the market overall to trend sideways to down, with the possibility of a 10% or more pullback in the next quarter or two being fairly high.  The market is liking what it’s hearing from Trump so far, but the market shifts have been massive beneath the surface of an S&P 500 that is up just 2.1% since election day, making further progress increasingly difficult on an overall market basis. 
 
Busted, down on Bourbon Street, set up, like a bowlin' pin
Knocked down, it get's to wearin' thin They just won't let you be, oh no
          The Grateful Dead, 1970, by Jerome Garcia, Philip Lesh, Robert Hunter and Robert Weir
 
All of which brings me to this, again – watch your VAR.  The U.S. ten-year bond is off -3.13% since election day, -3.56% since my last letter and down -5.4% since early July.  In the less than two weeks since the election, the international bond ETF (BWX) is down -4.7%, Staples (XLP) are off -4.2% and Utilities (XLU) nearly -6%.  Over the same time frame, Banks (KRE) are up 17%, Financials overall (XLF) are up over 10%, Industrials (XLI) are up over 5%, and Homebuilders (XHB) are up over 6%.  Think everyone got this right?  Me neither.  Volatility has gotten cheap again, with the VIX falling from over 22 on November 4th to 12.85 at the close on Friday.  The pins are set up for a correction.  I’d be prepared before they get knocked down.  Because VAR moves just won’t let you be. 
_______________________________________________________________________
This week’s Trading Rules:

• When everyone is sure they know what’s going to happen, they’re wrong.
• You can’t invest based on what should be, you can only invest based on what is.   

 
SPY Trading Levels:

Resistance: a lot at 219, not a lot above that.

Support: 216, 212.50, then a little at 210, 204/205, and a little at 200.  Not much below until 190.
​
Positions: Net neutral stocks (both long and short stocks). Short XLU, SPY, and BWX. Long options on SPY, KRE, XLF.

May The Odds Be Ever in Your Favor
President Snow:  Seneca... why do you think we have a winner?
Seneca Crane:  What do you mean?
President Snow: I mean, why do we have a winner? I mean, if we just wanted to intimidate the districts, why not round up twenty-four of them at random and execute them all at once? Be a lot faster.
[Seneca just stares, confused]
President Snow:  Hope.
Seneca Crane:  Hope?
President Snow:  Hope. It is the only thing stronger than fear. A little hope is effective. A lot of hope is dangerous. A spark is fine, as long as it's contained.
Seneca Crane:  So...?
President Snow:  So, CONTAIN it.
            The Hunger Games, 2012
 
Just like President Snow, I think Chairwoman Yellen is playing a dangerous game with investors, giving them just a little bit of hope that someday monetary policy will normalize, that Fed Funds rates won’t be stuck right near zero forever. But a lot of hope, a real conviction that the Fed was going to embark on a hiking cycle, would be dangerous for financial markets, in particular bonds of all kinds, which are trading at levels that assume that the Fed never really will follow through. Hope has been contained. For now. 
 
But what would happen to bond markets if that hope turned into conviction that the Fed was really going to raise, or, even more dangerous (and much more likely), that credit spreads were going to widen?  Then we’d see massive losses in bonds, in particular high yield CCC bonds, which are currently performing poorly from a credit perspective but doing very well from a price perspective. 
 
Effie Trinket: Happy Hunger Games, and may the odds be ever in your favor.
          The Hunger Games, 2012
 
Right now, if you are long high yield bonds, the odds of making a decent return going forward are definitely not in your favor.  Credit spreads are tight, and they are tight to an ultra-low risk-free rate. Not a good combination. At the same time, the fundamentals of the companies that issued those bonds are deteriorating, and the market for new issuance of high yield bonds is drying up. If you own a high-yield ETF today, you are making the bet that these spreads will tighten further, which is really a bet that the underlying fundamentals of these companies will get better not worse.  Seven or eight years into a recovery, when corporate earnings have been down for 5 quarters in a row, do you really think the odds are still in your favor?

​
​Effie Trinket: Two hundred miles per hour and you can barely feel a thing. I think it's one of the wonderful things about this opportunity, that even though you're here and even though it's just for a little while, you get to enjoy all of this.
          The Hunger Games, 2012
 
In many past letters I remarked that currents were shifting beneath the surface of what appeared to be a calm stock market. In particular, I repeatedly stated that banks were a buy and utilities and staples were a sell.  That trade has pretty much worked. As a result, I have cut my short position in utilities by 2/3, and have pared back my longs in banks.  Why?  Because those trades have worked on the back of the Federal Reserve providing some small rays of hope that they will raise their target for the Fed Funds rate in December. At the same time, other central banks (Japan in particular) are now indicating that they would like to see their yield curves steepen, which would help bank earnings and hurt the case for owning low-growth, expensive stocks just for the yield.  From July 8th through October 12th, Utilities and Telecoms fell more than 9% while Financials increased nearly 5% and Tech stocks nearly 10%.  The S&P 500 overall?  Up 0.50%.  

​Haymitch Abernathy: Embrace the probability of your imminent death, and know in your heart that there's nothing I can do to save you.
        The Hunger Games, 2012
 
This next part could have easily gone off on many tangents, but in the interest of brevity and clarity I cut about 90% of it.  The short version: prepare your portfolio for some increasing volatility.  Many ill-informed pundits have taken the recent absence of volatility to mean that it is gone for good. But many smart investors, like Tepper and Gundlach and Druckenmiller, who are paid to protect their clients’ money against large drawdowns are forgoing returns today (and incurring hedging costs to boot) in order to protect against an anticipated pickup in extreme events in the future.  Why?  Because they know that a financial market structure that is predicated on the inputs to the valuation models never changing in an adverse way is a market that cannot be saved forever. What the Fed and other central banks have tried to do by keeping rates at zero (or negative) for so long is to postpone the revaluation of risk-assets lower to compensate for the deterioration in the underlying earning power of the assets. That’s it. All they have been trying to do is keep asset prices up so that the owners of those assets (banks, pension plans, investors, etc.) don’t have to realize losses.  They have been playing a game of kick the can down the road.  But what if the game stops?  What if they can no longer delay the repricing?  What if, in other words, you shorten the time frame between repricing events but keep the overall price movement the same, instead of artificially elongating it?  Well then you get massively increased volatility, much beyond what standard Gaussian models would predict.  You get a market that displays characteristics of what Mandelbrot called “fractional Brownian motion in multifractal trading time,” and the more you shorten the time frame over which the market move occurs, the more volatile the market becomes.  And when that happens, you get market crashes.  So you can either embrace the probability of the imminent death of the bond market, or else there is nothing I can do to save you (well, your portfolio anyway). 

​
Seneca Crane: Everyone likes an underdog.
President Snow: I don't.
          The Hunger Games, 2012
 
The bond market is, probabilistically speaking, an underdog to perform well over the next 2-3 years. Unfortunately for primarily stock investors like myself, the stock market has become inextricably tied to the bond market.  As a result, I’m still positioned more defensively than I have been since 2007, with my stock positions net neutral and an overlay of options to take advantage of any sell-offs.  While the Fed may well be able keep a little hope alive that it will only very gradually raise interest rates, if investors begin to hope for more, to hope that the yield curve will normalize and steepen someday, then things may get dangerous. In that scenario, I wouldn’t want to bet on the underdog.
_______________________________________________________________________
This week’s Trading Rules:

• Bet on the underdog in football, not in financial markets.
• Hope is not an investment strategy. 

 
SPY Trading Levels:

Resistance: 214, a lot at 215/216, then 218.  
Support: 212/213, then 210, 205, and a little at 200.  Not much below that.
​
Positions: Net neutral stocks (both long and short stocks). Short XLU, SPY, XLP, and BWX. Long options on SPY, KRE, XLF.
​

​Miller’s Market Musings is a free bi-weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. If you no longer wish to receive this letter, simply hit reply and put “Remove” in the subject line.  Prior posts can be found at www.millersmusings.com. 
​
Mr. Miller has been quoted in financial publications including the Wall Street Journal and New York Times, and he has appeared on Fox Business News, PBS and CNBC.  More information and past articles can be found at www.StockResearch.net.  Sharing and quoting from this letter is permitted with attribution.

Wade Wilson: I had another Liam Neeson nightmare. I kidnapped his daughter and he just wasn't having it. They made three of those movies. At some point you have to wonder if he's just a bad parent.
            Deadpool, 2016
 
What is your goal as a parent?  That’s a trick question because I didn’t give you a time horizon. “What is your long-term goal?” is more precise. An answer might be “provide guidance and life lessons so that your children become good people.”  That seems like a good goal.  What if I asked what are your near-term goals for your children? Then your answer might be for them to be safe, or healthy, or happy. Also a good goal.
 
But you probably wouldn’t answer “My goal is for my children to always be happy, to never experience pain, or sadness, or disappointment. To always get what they want, and to never have to hear the word ‘No.’”  That sounds like a recipe for disaster, right?  It would mean giving them unlimited ice cream, access to Netflix, and no boundaries. What would you think of that parent?  Clearly, you would say that they were spoiling their kids and that they are probably going to turn out badly. Like a Hilton or Kardashian-kid-badly.  
 
And yet…central bankers around the world are those parents. The bad ones. The one’s you don’t let your kids play with. Because eventually, bad things happen there. Those spoiled kids take greater and greater risks, do dumber and dumber things, because there are never any consequences for their actions. Our Federal Reserve is encouraging people to do riskier and riskier things because they fear upsetting them with a few rate hikes and a fall in asset prices. They want markets to always be happy. They want markets to never go down, to have no volatility. They never want to tell the markets “No.” And like Wade Wilson, at some point you have to wonder if they’re just bad parents.
 
We all know what risky behavior looks like in children, but for some reason, when it comes to financial markets, lots of investors act like risk is something you can’t control, so why bother trying. That’s like saying a kid is just going to do whatever they want even if I say no, so I’m not even going to try to set boundaries. Investors in bonds with a negative yield are engaging in risky behavior because their bad central bank parents aren’t home. They’ve lost all sense of right and wrong, because they’ve never experienced the consequences of their actions. Is it the Fed’s fault? It is for bond investors. But there are lots of bad parents out there.
 
Deadpool: Did I say this was a love story? It's a horror movie.
          Deadpool, 2016
 
Maybe I’m just a mean dad, but I think kids benefit from knowing that someone is setting limits, providing guidance on right and wrong behavior, and trying to inculcate a sense of responsibility in them. What is risk in investing? Missing out on a potential return, or losing money – maybe for decades or even permanently?  How long is permanently for a saver?  For a retiree? 

Millions of investors have been seduced by a famous mutual fund company founder, who shall remain nameless to protect the guilty, into thinking that managing risk is pointless, that markets are inherently unpredictable, and that everything will always be fine “in the end” so long as you remain fully invested. (Ok, its Jack Bogle of Vanguard.)  But when is “the end.”  What if it is soon, or now, because you are already in retirement?

People like Bogle say that even when markets break, they eventually recover, so there is no need to worry about market crashes. Just ride them out and everything will be ok.  Except this ignores the fact that many times in history, markets have crashed and taken much longer than a decade to recover.  Especially when “safety stocks” are trading at 25 times earnings. Got a spare decade or two?  Ok then, you can ignore the current risks. The rest of you need to think about a backup plan.

Time horizon and need should drive risk/reward choices. Currently monetary policies around the world have converted savings into non-assets. They are effectively worth nothing. In Europe and Japan, they are worth less than nothing. As Bill Gross wrote recently, negative yielding debt is not an asset, it’s a liability. There literally is a line you can cross to convert an asset into a liability.  It’s zero. Multiply your asset by a negative number. Your positive income becomes a negative. You owe someone money. Negative rates work like that. It’s middle school math. Zero is the line. Except no one at the ECB apparently remembers their middle school math.

This is why so many smart investors seem so angry with central bankers both in the U.S. and abroad. They have callously eviscerated the value of retirees’ savings. Remember when CDs paid interest you could live on?  The old paradigm of work hard, save a lot, buy safe bank CDs and have enough money to pay your mortgage, food, and transportation expenses is gone. But the bad parents at the Fed don’t realize that if they take away someone’s “safe” income, they aren’t going to have any money to spend, or that forcing them to buy dividend stocks, or MLPs, or some other yield producing but-not-100% safe asset, is not going to make them comfortable enough to spend, and that really, those are the only two outcomes that a rational person will come up with. Reducing the security of someone’s income stream will make them want to protect what remaining income and assets they have, and save more, because they will probably have to live off of more principal and less income. It’s just math. That’s it. And like in middle school, when you multiply by a negative number, you get a negative. That’s all you need to know.

Recruiter: You're looking very alive.
Deadpool: Ha! Only on the outside!
Recruiter: This is not going to end well for me, is it?
Deadpool: This is not gonna end well for you, no.
         Deadpool, 2016
 
Stock markets are also engaging in some risky behaviors. There are many ways to measure riskiness in stocks, but Steve Blumenthal does an excellent job in covering most of the good ones, and he does it every week for free. Go and read his latest “On My Radar” here.  But the cliff notes: stocks are really expensive based on actual earnings when compared to history. Like 28.7% above median fair value if you go back to 1964. Or using another metric, the Shiller P/E ratio, stocks have only been more expensive in the late 1920s (just before the crash) and in the very late 1990s (just before the crash). From this level, the subsequent 10-year annualized real return has averaged about 3%. Better than 10-year treasuries at 1.6%, but probably not what most people are expecting.  And in the past, when stocks are this expensive, the subsequent 10-year return has been as low as negative 6% per year when starting at these valuations. Not exactly risk-less.

Colossus: [Deadpool is about to shoot Ajax.] Wade! Four or five moments.
Deadpool: Sorry?
Colossus: Four or five moments - that's all it takes to become a hero. Everyone thinks it's a full-time job. Wake up a hero. Brush your teeth a hero. Go to work a hero. Not true. Over a lifetime there are only four or five moments that really matter. Moments when you're offered a choice to make a sacrifice, conquer a flaw, save a friend - spare an enemy. In these moments everything else falls away...  [Deadpool gets bored and shoots Ajax in the head, killing him.]
Colossus: Really? Was that necessary?
Deadpool: You were droning on.
         Deadpool, 2016

Janet Yellen gave a speech recently at the big Federal Reserve boondoggle in Jackson Hole. From Yellen’s speech:
As noted in the minutes of last month's Federal Open Market Committee (FOMC) meeting, we are studying many issues related to policy implementation, research which ultimately will inform the FOMC's views on how to most effectively conduct monetary policy in the years ahead. I expect that the work discussed at this conference will make valuable contributions to the understanding of many of these important issues. 
​
This is not science. You don’t do research in a “lab”, apply some formulas, do some math, and then play god with the largest financial markets in the world. Unless you’re the Fed.  Then you do just that.  Even when your own charts show just how wildly you are guessing in your predictions. From her speech: 

Like Colossus, I feel like I’ve been droning on about this issue forever. A year ago I was pounding the table and telling anyone who would listen (since I work with just one other person, it wasn’t a big audience) that the Fed should be raising rates because we had a small window to get them in before things went bad, because eventually, things always go bad. And once they do, you really don’t want to be raising rates.  Markets will go nuts if you do. But…here we are. They didn’t do it, the economy is at stall speed, and the Fed is out of options. Maybe we can get some fiscal deficit spending going that will give a boost to the economy, but think through the timing. Nothing will happen until we have a new president, because this one is brain-dead when it comes to economics. So we’re into early 2017. Say whoever it is makes a massive infrastructure bill a part of their first 100 days agenda. Further say it actually makes it through Congress. How long for the rules of implementation to be written, then for contracts to be awarded, funds dispersed, workers hired, and so on. My point is, it’s not happening soon. The Fed missed their moment to be a hero, as did Congress and the President. Everyone just stood around doing nothing. And our economy, like Ajax, is about to get shot.

Don’t believe me? Hanjin of South Korea filed for bankruptcy this past week. It didn’t even make the front page of the WSJ. Which I find odd, because when one of the world’s largest shipping companies goes belly up, it’s something you should notice. Apparently, they handle about 7.8% of the total volume of goods shipped across the Pacific to the U.S. West Coast. As Joanie McCullough used to say, “that’s a numba.”  Things break. They just do. Prepare for it.
 
Deadpool: Don't worry. I'm totally on top of this.
            Deadpool, 2016

In case you’re wondering why I keep picking on the Fed, well, it’s because it’s so easy to do. The following is taken directly from the Wall Street Journal’s transcript of an interview between WSJ reporters Jon Hilsenrath and Harriet Tory, and James Bullard, president of the St. Louis Federal Reserve Bank. The whole thing is worth reading to understand how we got here.

MR. HILSENRATH: What kind of compromise would it take to get the FOMC to move in September? I mean, so the tradition is there’s some kind of – like you say, some kind of agreement. What would it take to get them there?

MR. BULLARD: Well, I have no idea, so – and it’s really – it’s really the chair’s job to fashion that. But I will say that – I’ll talk historically about the FOMC, the kinds of things that the FOMC would do. You would trade off. You would say, OK, we could hike today, but then we’ll not plan to do anything in the future. That would be one way to – one way to go about a consensus. So that often happens on the FOMC. Or vice versa. If you read the Greenspan-era transcripts, he’ll do things like, OK, we won’t go today, but we’ll kind of hint that we’re pretty sure we’re going to go next time.

MR. HILSENRATH: Right.

MR. BULLARD: And so you get this inter-tempo kind of trade-off, and that often – that often is enough to get people to sign up.

MR. HILSENRATH: So, hike today and then delay.

MR. BULLARD: Yeah. (Laughs.)

MR. HILSENRATH: Or, no hike today and then no more delay.

MR. BULLARD: Yeah, yeah.

MR. HILSENRATH: Something like that.

MR. BULLARD: Yeah, those kinds of trade-offs are, historically speaking – I’m not saying I know what Janet’s doing, because I don’t. But, historically speaking, those are the kinds of things that the FOMC has done.

MR. HILSENRATH: I came up with my catchphrase for the – for the month. (Laughter.)

MR. BULLARD: Those are great. That’s worthy of a T-shirt. (Laughs, laughter.) You could have one on the front and one on the back.

MS. TORRY: Or a headline.

MR. HILSENRATH: Well, that’s the St. Louis framework now, right?

MR. BULLARD: Yeah.

MR. HILSENRATH: Hike today and then delay.

MR. BULLARD: Yeah. That’s what it would be, yeah.
 
​
Weasel: I would go with you, but... I don't want to.
            Deadpool, 2016
 
I’m still being cautious here. Maybe I’m just risk-averse. But continuing the parenting analogy, think back to a big college homecoming party. At some point most people realize they should leave a party. Some have been ingrained with enough common sense and self-worth to leave early – like when people start to get drunk and obnoxious. Some leave only when they are drunk and obnoxious, and their friends have to take them home. Others don’t leave until the cops show up. And then there are those folks who just hide and hope the cops don’t find them. Those idiots are the ones that get arrested. Don’t be an idiot. Protect your portfolio. I don’t want to go to this party anymore.
_______________________________________________________________________
This week’s Trading Rules:

• Everyone always thinks they can leave the party before the cops show up.
• The cops always show up eventually. 

 
SPY Trading Levels:

Resistance is the same as before, 219/219.50. Not much above that.

Support: 217/217.25, small at 216, a decent amount at 210/210/50, then 205 and 185.

Positions: Net neutral long/short. Long U.S. Stocks, short U.S. stocks, short XLU, SPY, XLP, and BWX.

Miller’s Market Musings is a free bi-weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. 

All this time I was wasting,
Hoping you would come around
I've been giving out chances every time
And all you do is let me down
And it's taken me this long
Baby but I figured you out
And you're thinking we'll be fine again,
But not this time around
            Taylor Swift, You’re Not Sorry
 
This letter is going to be full of weird mismatched analogies. I’m sure you’ll be ok. It goes with this weird, mismatched market we are forced to navigate. Some weirdness we’ve discussed at length: trillions of dollars of negative yielding sovereign debt, a Swiss yield curve negative out to 30 years, corporates issuing debt at 0% interest, and a Federal Reserve Board that is clearly lost and afraid of its own shadow. While central banks around the world are doing really inane things, the Fed is caught in a vicious feedback loop that it doesn’t even seem to understand it created. It gets spooked by every little downturn in the market, every reaction to a speech or meeting minutes release. In short, it’s a Hawthorne effect experiment gone bad.  The Hawthorne effect (also known as the observer effect), is when individuals modify their behavior once they become aware they are being observed. 
 
When the Fed was (or at least, said they were) focused on data points from the real economy in making their rate decisions, then the market could watch those same data points and make its own determination about whether or not the macro environment favored one type of investment or another. However, ever since Greenspan started playing God with the markets and focused on asset prices in securities markets as a means to create a wealth effect and increase economic activity, the Fed has been sliding down a slippery slope of reflexivity and feedback loops. By trying to cajole markets to do its bidding without actually moving rates or following through on its statements, the Fed has become a Frankenstein’s monster of the boy who cried wolf and Schrodinger’s cat.  No one believes anything a Fed official says anymore, and the Fed is both alive and dead at the same time.

The annual Jackson hole retreat for Federal Reserve officials is this week, and Janet Yellen is giving a much anticipated speech.  Market pundits keep writing that the speech will be eagerly parsed for signs that the Fed will raise rates sometime later this year. My view is that no matter what Chairwoman Yellen says, no one will believe her. She could stand at the podium and say “I fully believe that rate hikes are going to happen this year” and the market likely will do nothing. Why? Because Fed officials like Yellen and Dudley have lost all credibility. They’re like the little boy that cries wolf. Six months ago, the situation was different. But after so many contradictory speeches since then, the market now knows that if Yellen says she’s raising rates, and the market sells off, then they won’t raise rates, so the market will rise again. But not this time around. After wasting all this time, markets are done hoping the Fed will come around. That’s what happens when all you do is let someone down.  Eventually, they figure you out.
 
Looking so innocent,
I might believe you if I didn't know
Could've loved you all my life
If you hadn't left me waiting in the cold
And you got your share of secrets
And I'm tired of being last to know
And now you're asking me to listen
Cause it's worked each time before
            Taylor Swift, You’re Not Sorry

I think markets are getting tired of being left out in the cold by central banks around the world manipulating securities prices to engineer economic growth. It appears to me that this acceleration into negative rates in the past few months has been driven by a capitulation on the part of income investors who never believed that rates could get this low, so they held back, afraid of locking in (at the time) historically low rates. Then they watched with shock and horror as NIRP replaced ZIRP – and FMO (fear of missing out) kicked in. But at some point, you reach that last marginal buyer. When will that happen? Nobody knows. Central banks keep reloading and doing dumber and dumber things, and since their stupidity seems to know no bounds, I’m willing to say that I don’t know how dumb things will get before they stop.  What I do know is that locking in a guaranteed loss on bonds that are held to maturity is not a good way for investors to meet their long-term liabilities. Think pension plans and insurance companies for example.  Central banks are eviscerating them. How insolvent pension systems and life insurance companies can be good for the global economy is beyond my pay grade, but then again, I don’t have a Ph.D. in economics.  (As an aside, I did take quite a lot of economics, including in graduate school, but quickly figured out that logic and reason had no place in the discipline. When I pointed out an obvious flaw in a professor’s work (outside of class, privately) he admitted that I was correct but that the flaw was needed to make the math work. That’s when I decided to be a history major instead.)  

The Fed wants markets to believe that every meeting is “live” for a rate hike, but markets know that that is simply not true. But the Fed doesn’t know that yet. Like Schrodinger’s cat, the Fed exists in a state of quantum uncertainty in which it is both alive and dead at the same time. It thinks it can move, but it can’t. And now that it knows it’s being observed, it’s stuck.  Ironically, Einstein’s letter to Schrodinger in 1950 could easily be describing the state of monetary policy today. Simply replace “physicist” with “Federal Reserve Board Member”:

“You are the only contemporary physicist, besides Laue, who sees that one cannot get around the assumption of reality, if only one is honest. Most of them simply do not see what sort of risky game they are playing with reality—reality as something independent of what is experimentally established. Their interpretation is, however, refuted most elegantly by your system of radioactive atom + amplifier + charge of gunpowder + cat in a box, in which the psi-function of the system contains both the cat alive and blown to bits. Nobody really doubts that the presence or absence of the cat is something independent of the act of observation.”

So what’s an investor to do? I suggest building a robust portfolio. What’s a robust portfolio?  A portfolio that can survive exogenous shocks to the market systems and survive. Think Jason Bourne. All sorts of bad things happen to him, and he survives. He can get shot, thrown off a bridge, chased across continents, and he survives. He’s robust. He’s the opposite of an effete central banker sipping wine in Jackson Hole this week. For the central banker, even a hint of something amiss, a tremor of market volatility, and they run away, hiding behind “uncertain market conditions” or some other such excuse. They panic. They make a bad situation worse, and they don’t know how to protect against unforeseen outcomes. They are, in the words of Nassim Taleb, fragile. Don’t be fragile.

Am I saying a market crash is imminent? No. I’m saying that all the conditions for a market crash are in place. Volatility selling has pushed down implied vols to a level that will exacerbate any market downturn of about 3% or more, by my estimation. Investors desperate to generate return have taken to selling calls against their portfolios to create income, but they aren’t hedging their downside to protect against a market decline (a very low equity put-call ratio shows this). In the near-term this can work to create a false sense of calm, as investors who have sold calls can’t really sell the underlying without being left naked short, something that mutual funds are usually restricted from doing. But this low-vol environment can entice traders reaching for return to short puts as well, which can quickly become problematic and cause a cascade of selling if and when they rush to hedge their downside exposure.

Even more troubling, is that this recent period of extremely low volatility is setting us up for another VAR shock, reminiscent of last summer.  I wrote about this almost exactly a year ago in response to the S&P 500 diving 6% in a week. We could be in for another round of VAR shocks creating feedback loops that take markets by surprise. The conditions are all set for it. All it would take is a misinterpretation of a Fed speech, a comment from a Chinese finance ministry official about exchange rates, anything really.  With 33% of the market invested in passive vehicles and ETFs viewed as a ready source of liquidity, a small market dislocation has the potential to create flash crashes in various asset classes.  I’m only short ETFs, not long them, and running a market-neutral book. In short, I want my portfolio to perform like Jason Bourne. We may get beaten up, but in the end, we’ll survive. 

So you don't have to call anymore
I won't pick up the phone
This is the last straw
There's nothing left to beg for
And you can tell me that you're sorry
But I don't believe you baby
Like I did before
You're not sorry, no no oh
            Taylor Swift, You’re Not Sorry
 
In my last letter I laid out some charts and said that I thought there was a lot of churning going on beneath the surface of an unusually calm market. In particular, I said that I thought banks could move higher and that utilities and staples were rolling over.  Well, since then, the KBE (KBW Bank ETF) is up about 5%, the XLU (Utilities ETF) is down over 3%, and the SPY (S&P 500 ETF) is up about 1%.  Rising LIBOR (also discussed in the last letter) was flagged as a reason for optimism about U.S. banks (Japanese banks are cooked if this continues, but that’s a story for another day) and pessimism about bond proxies.  There’s no sign that this LIBOR squeeze will abate before the October change in money market fund regulations, so don’t fight it. 

That said, I think it’s time to play some defense again. I’d sell half the bank position from a few weeks ago and go to cash with it. I’d stay short the utilities and staples, and pare back your tech bets. I’m still long some stocks, but fully hedged. Keep some dry powder so you can take advantage of any severe market dislocations.  
__________________________________________________________________________
This week’s Trading Rules:

• Once everyone knows what the game is, it’s over.
• Being able to suspend disbelief and play along with the market consensus works really well until it doesn’t. 

 
SPY Trading Levels:

Resistance has moved up a little, to 219/219.50. Not much above that.

Support: 217, 216, small at 212, a decent amount at 210, then 205 and 185. On a selloff of more than 1.5%, first stop will be 212.
​
Positions: Net neutral long/short. Long U.S. Stocks, short U.S. stocks, short XLU, SPY, XLP, and BWX. 

​Looking at a chart of the S&P 500 today is like looking at the ocean at low tide – it appears calm, but beneath the surface there is a lot of churning going on. If this churning continues, we could see a leadership change in the U.S. stock market, from defensive sectors to those that benefit from economic growth and higher rates. I think we are on the cusp of such a change. So sprinkle on a little pixie dust and get long select banks, technology, and media stocks, and short, or at the very least avoid, bond proxies like staples and utilities.  My fund has net zero stock exposure and is short international sovereign bonds via ETFs, so I’m not saying go crazy long here, just saying that even if the overall indices don’t move much, there is opportunity to pick some winners and losers for those that like me are free.

I don’t usually put a lot of charts in my letters, mainly because they make it hard to read on a phone, but here a few that I think are important right now. In particular, take a look at how while the SPY is flat, the XLU and XLP are rolling over, and the KBE and XLK are moving higher. The KBE in particular has room to run, as it’s still well below its level of late last year.  In addition, I have put in a chart of the Japanese 10 year bond yield today versus 2003 (when the bond crashed on a VAR delivering) and versus the German Bund a year ago. Danger ahead?  If you’re long negative yielding sovereign bonds, I’d say you’re pretty lost right now. 
​
S&P 500 (SPY)

​Finally done going up? Utilities (XLU)

​Rolling over? Consumer Staples (XLP)

​Room to run? U.S. Regional Banks (KRE)

​Japanese 10 year Bond Crash: 2003 vs Today:

​Japanese 10 year Bonds vs. German 10 year Bonds: Will History Repeat Itself? 

​Tech Breaking Out?  SPDR Tech ETF (XLK):

Charts courtesy of Interactive Brokers, LLC and Bloomberg
__________________________________________________________________________
This week’s Trading Rules:

• When there is a clear consensus about a financial market, it’s probably time to look at going the other way. Consensus thinking can be expensive.
• “If you don’t know what is going to happen, don’t structure your portfolio as though you do.” – James Montier, GMO

 
In my June 24th, 2016 letter, I wrote: “The broader market has been performing worse than the S&P 500, as utilities and staples hold up the index. Tech and financials have been especially weak lately. I’d go shopping there for bargains if you have a time frame longer than a week.  Financials are being hurt by the prospect of “lower for longer” again in the U.S. and weirdness from negative rates abroad. Tech is being hurt by weak global growth outlooks, but the best businesses will be fine, especially those with a U.S. focus.”

Since then, tech and financials have done well, and utilities and staples have stalled out. I’d stick with the trade.  

SPY Trading Levels:

Resistance has been set by the top end of the tight trading range of the past 2 weeks. Lots of resistance at 216.50/217.  Not a lot above that.

Support: small at 214/214/50, a decent amount at 210, then 205, 200, and 185.

Positions: Net neutral long/short. Long U.S. Stocks, short U.S. stocks, XLU, SPY, XLP, BWX.
​
Miller’s Market Musings is a free bi-weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. If you no longer wish to receive this letter, simply hit reply and put “Remove” in the subject line.  Prior posts can be found at www.millersmusings.com.  

Note: This week’s note was written on July 17th. I am traveling in Alaska with very limited internet access, and am just able to send it today. In addition, due to a lack of internet access, there will not be the usual quotes from popular music or movies. I’m sure you’ll all survive.

The Paradox of No Choice

The Paradox of Choice is a well-known psychological phenomenon in which a consumer, faced with too many choices, experiences anxiety about making the wrong choice and therefore makes no choice at all.  Famously, emigrants from the Soviet Union, where they had few if any choices about their food in grocery stores, would come to America, with its seemingly limitless choices, and be paralyzed with indecision. Their lack of prior information and inability to anchor their choices on any prior experience made the situation, instead of an amazing one (“look at all this food!”) an ultimately stress-inducing nightmare. Eventually they would adjust and be able to function, but there is something about too many choices that makes the average consumer freeze. A similar condition is paralysis by analysis – faced with too much information and no good way to organize and process it, many people simply choose to do nothing – they make no decision at all.  

Good stock pickers, on the other hand, often thrive when faced with many choices – in the U.S. alone, there are well over 4,000 individual companies to choose from. Investment managers thrive when they have a good system to sort through the choices and find those with the best chances of producing outsized returns over time. Over time, the best practices become rules, and by following their carefully crafted rules, the top stock pickers create enviable long-term track records of investment success.

But what happens when the market changes the rules?  What does an investor do then?  Well, this has happened before. Warren Buffett famously closed his hedge fund and returned capital to his investors when “he no longer understood the market.”   That was in 1969.   Then, in the mid-1970s, the market suddenly switched back to following the rules again, and he did quite well.  Many investors with enviable long-term track records think we’re going through a similar phase today, where the old rules are being thrown out and replaced with, well, no one is really sure what. As a few market observers have written lately, in the 5,000 year history of interest rates, we had never seen negative rates – until now.  So the rules of the game have changed, but it’s hard to suddenly switch your investment style every time the wind shifts direction, especially if you’ve built your reputation as a “long-term value investor.” (Full disclosure: I like to think of myself as a value investor, just not long-term. But that’s the topic for a future newsletter.)

Negative interest rates are making some well-established rules look obsolete. When I got into the investing business in the early 1990s, I was really sure that there was a “right” hurdle rate of return and that I could simply matrix my investment choices based on those that met it and those that didn’t, and invest accordingly.  This worked really well until it didn’t (see internet bubble, late 1990s).  When that bubble burst, value investing worked really well again, with 2000-2003 producing great returns for my fund.  But this year the rules aren’t working, and investors like me have to decide a few things: a) are we wrong and b) if so, how long are we going to be wrong before things reverse and the rules start working again. As Joel Greenblatt likes to say, if value investing worked all the time, then it wouldn’t work at all. It’s the times that it doesn’t work that makes it work over time. Got that?

Intellectual Purity versus Intellectual Honesty: Which is the right mindset for investing?  

I’m firmly in the Intellectual Honesty camp. I got there by losing lots of money being in the Intellectual Purity camp. I find that the best of my peers with whom I regularly speak have few fixed beliefs about valuation, trading levels, what makes a good company versus a bad one. Instead, investing for them is all about asking lots of questions and trying to figure out what works now. Lately, I find myself asking more questions than ever. What’s the right price for “the market?”  Are historical averages really “right?”  Or were they just a statistical quirk? What if in the past U.S. stock prices were being set at a time of low foreign investment in our markets, and now U.S. stock prices are being set by the marginal global investor with the lowest hurdle rate of return? How long with that continue, and what will happen when it ends?  Will it end slowly, or all at once?

“The Market” is a weird term to begin with. Before ETFs, you could argue that there really was no such thing per se, that it was just the sum total of the individual companies, but the ability to cheaply and easily invest in a myriad of different permutations of asset classes has changed that dynamic. Today, often it is the asset allocation trade that drives the moves of the individual stocks, not the other way around. Look at the components of the KRE or KBE – they often move together. Then look at a similar stock that isn’t in the ETF.  It may not move at all or even in the opposite direction. That isn’t the effect of new information about the individual companies, but the effect of asset allocation shifts.  

So now if you’re an investor looking to generate returns that beat your benchmark and do it in a prudent manner, you’re facing a dilemma.  Is the right price whatever someone else is willing to pay for it?  Today it is. Or is the “right” price the price that is low enough to generate a return based on the company’s expected future cash flows that beats your hurdle rate?  What if your hurdle rate is not only materially higher than the current market hurdle rate, but the poor global economic outlook makes it likely that the lower rate will persist for the foreseeable future.  Then what?  You have 2 choices: do nothing, and sit in cash waiting for a correction that gets prices down to your buy level, but in a low return world, that correction may not occur. Or you can invest despite the likelihood of generating lower returns than needed to satisfy your hurdle rate or target rate of return, and justify it by saying you have no other choice. 

In today’s market, where capital can flow fairly easily from country to country, and where the prospects look fairly bleak in many countries outside the U.S., this phenomenon is called TINA: There Is No Alternative.  In a world where nearly $13 trillion in debt has a negative yield, where economies struggle to avoid completely stalling out, where terrorism continues to strike innocent people in western democracies, what is the “right” price for financial assets in the U.S. that provide a fairly stable income stream?  I have no idea. While I think the valuations that consumer staples stocks trade at are crazy, why can’t they continue to go higher?  Just because I think 25 times earnings for a company growing revenue at 4-5% a year makes no sense from a mathematical return standpoint (I calculate an investor buying those stocks today can expect to earn between 4-6% annually at best before inflation), why can’t investors with no better alternatives continue to buy them until that return becomes 3-5%, then 2-4%, then 0%?  In a world where 0% is a better return than you can get from a large portion of the global sovereign bond market, weird things can happen.
I could take the easy route and just say that this is all nutty and will end badly, as many commentators do, but unfortunately for me, I don’t usually take the easy route, so we need to consider the possibility that even though prices today make no sense to those of us who have been investing professionally for the past 10, 20, 30 years, they don’t have to make sense to us: they just have to make sense to that mysterious marginal buyer who’s hurdle rate of return appears to be at best 0% and may well be negative. In that world, trying to be “rational” means anger, angst, underperformance, and eventually, unemployment.  Unfortunately, the other choice, to just reverse course and “buy buy buy” is probably a bad one and definitely not “prudent” if you’re managing money professionally. Missed the 25% year-to-date move in Utilities and then you bought them?  Good luck writing that investor letter. Unfortunately, maintaining intellectual consistency, while fine in areas like academia and politics, isn’t always a the best choice in investing, but the alternative, having no firm beliefs about valuation, “correct” hurdle rates of return, and risk management just feels wrong.  Even though in today’s market, it may well be the only way to beat the market.
____________________________________________________________________
This week’s Trading Rules:

• You can’t trade on what should be, you can only trade on what is.
  
• First you have to learn the rules of the game, and then you have to learn to play the game better than anyone else. Albert Einstein
   
  

In our last letter, written the weekend after Brexit, we said ignore the pundits who were predicting doom for the markets because of Brexit. Since then the S&P 500 has reached a few new all-time highs. I don’t see why this can’t continue. Market leadership is shifting from yield plays to other sectors, which is healthy overall. Valuations are expensive by historical standards, but that doesn’t mean they can’t get more expensive in the near-term. Long-term, returns will likely be muted, but stocks can go higher first. Stay hedged and be alert for sparks that could set the markets on fire.  Chinese Yuan and emerging market currencies are my guess as to where the next fire for the markets will start.   

SPY Trading Levels:  

Support: 213/214, 210, then 205.

Resistance: Not much. Stocks will be short-term over-bought if we get to 221 quickly.  

Positions: Long and short U.S. stocks, ETFs and options. Short XLP, XLU, SPY. 

​Boys, I got myself a pretty good bullshit detector, and I can tell when somebody's peeing on my boots and telling me it's a rainstorm.
            Ed Earl, The Best Little Whorehouse in Texas
 
As you may have heard, the British decided to have their own Independence Day on Thursday. “Leave” voters are being derided by the press and the losing side as ignorant, foolish, intolerant, xenophobic – and those are the nice things. I call B.S. The Leave voters are none of these things.  They are just tired of being told that the EU is going to save them, when in reality most of the issues in the EU economies can be chalked up to an over-reaching regulatory state. The EU isn’t working.  The economies in it have been eviscerated over the past decade by the very institutions that the Remain people are now saying Britain needs.  Needs why?  As I heard one hardworking gentlemen state on BBC World News today (I know he’s hard working because he was interviewed while literally unloading a truck – how many of the posh bureaucrats in Brussels have ever worked a truck you think?) – “Great Britain has been around for a very, very long time, and we’ll be just fine.”  Good for him – he’s right.
​
Am I saying that Brexit won’t have an impact on the British economy?  No.  I’m saying I don’t know what the impact will be, but staying in the EU wasn’t going to be good. So after a long period of being tied to stagnating, at best, economies on the Continent, leaving to give it a go on their own isn’t so crazy. Think about it. The EU is a morass of poor performing economies – some of the worst in the world – led by career bureaucrats who think that the answer to every problem is more regulation, more government, more centralization of power, more Central Bank meddling in the economy.  And despite the fact that it has produced absolutely horrible growth (if there is any real growth at all), despite the fact that innovation outside of a few Nordic countries is basically non-existent in the EU (can someone point me to their Silicon Valley?  No?  Didn’t think so), despite the fact that the ECB has had to push rates negative across Europe in a blind leap of faith that maybe that will work where nothing else has, despite all this, it’s just crazy for Britain to say, eh, screw it, we’ll give this a try on our own. Who’s the crazy one? I’d say all those folks crying wolf that the EU is the only alternative. Because piss ain’t rain.  
 
Don't feel sorry for me. I started out poor, and I worked my way up to outcast.
            Miss Mona, The Best Little Whorehouse in Texas
 
Oh, by the way, did you notice that the “uneducated masses” who voted for Leave managed to do what the “genius” PH.D.s running the central banks in Japan and Brussels have been trying to do for years without success?  They devalued their currency, and didn’t tank their stock market.  That’s right, the “crash” in the Sterling (and Sterling is just back to where it was on February 26, 2016 by the way) is exactly what Draghi and Aso have been trying without success to do to the Euro and the Yen. When they do it, it’s called monetary policy. When the Leave campaign does it, it’s called a disaster. Okey dokey.  Want to know which major stock market performed the best on Friday? (Asian markets closed before Leave vote was confirmed.) Great Britain’s. And it was up on the week. Nice trick, that.  So despite all the wailing about how this will be a disaster for Britain, the people who actually have to bet with their money disagree. I’d follow the money.

​They want me to close her down, run her out of town. How can I ask her to leave when all I want her to do is stay?
​          Ed Earl, The Best Little Whorehouse in Texas
 
In fact, if you follow the money, Brexit isn’t bad for Britain – it’s bad for the EU. Check out those Italian and Spanish returns – they are the worst one day returns in the history of their markets. Apparently, some folks were expecting the British to take on some of the problems of Italy and Spain. Quoting Spiro Agnew, the “nattering nabobs of negativism” are talking their book – which is long all the bad loans on the Continent. Economically speaking, outside of losing some, but nowhere near all, finance jobs that must be done within the EU per regulation, this will prove to be a net benefit in the long run for Britain. It’s getting rid of the dead weight that is dragging down all the economies of the EU. It’s putting behind it the stagnation and regulation that’s killing innovation. One of the arguments for Remain was that leaving will require the unanimous agreement of the other 27 countries to any of the terms. I’d say that’s a great argument for Leave…  What are three of the strongest countries in Europe? Norway, Iceland, and Switzerland (you can throw in Liechtenstein if you want as well). None are in the EU. 

Now I’m not saying there won’t be some issues to work out. Visa-free travel and the freedom to work anywhere in the EU were nice – but also part of the problem. At the end of the day, more than half of the British people decided that you know what, I don’t travel that much, and I want to stay and work in the town where I live now, so those things aren’t that important to me. They are important to the two groups that mainly voted to Remain – the young, and the international set in London. If you’re used to hopping over to Paris for a quick meeting, going through customs will be a bit of a drag. Welcome to the rest of the world. If you’re young and were hoping to spend a few years just roaming around the continent, working a bit here, loafing a bit there, well, you can’t anymore, and that sucks. But that’s the way democracy works sometimes, and lots of folks decided that unrestrained immigration from the Middle East wasn’t a thing they wanted to support.  Besides, Britain never really wanted to be a part of the EU in the first place. Just watch this video for (funny) proof.
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The border between Ireland and Northern Ireland will be an issue. Right now, it’s open border, but not long ago it was a militarized flash point that cost many, many lives. Going back to that won’t be good, and solving the Irish issue won’t be easy. To me, this is the biggest looming problem from a societal standpoint, and I’m not sure what the right solution will be. Belfast is still a divided place, and could quickly devolve into violence. Hope isn’t a strategy, but it’s all we have there at the moment.

Ed Earl, I think the best thing to do is to put this behind us, just as quick as we can. I've made a little money, I've laughed some, I've danced to the music…it's just time to pay the fiddler, that's all.
            Miss Mona, The Best Little Whorehouse in Texas
 
So back to the markets, which is the focus of this letter. In the U.S., the SPX closed right on its lows (it traded lower Thursday night, but not during the daytime session), but the session was fairly devoid of panic until the closing minutes. Trader lore is that markets never bottom on a Friday, as investors have all weekend to read the worried cognoscenti’s dire predictions (tip: ignore them). Markets usually start to put in a bottom on the morning of day 3 after a shock, as that’s when forced sellers (aka, those with margin calls) and those who invest via model portfolios get out. Technically, stocks behaved as expected – the SPY bounced right off the support we noted in our last letter at 204/205, before breaking down at the end of the day and settling at 202. There is a little support about 1% lower at 200, but if we follow the risk-off playbook from January we could be heading back to 190 over the next week and 185 if things get ugly. For now, I’d continue to play defense and stay well hedged. In the last letter, I said “Lots of smart investors are saying markets are at unsustainably high levels and are preparing for a selloff.  Bill Gross warned of a bond market “supernova”.  Soros is taking down his firm’s equity exposure and buying gold. Same for Druckenmiller. At John Mauldin’s recent Strategic Investor Conference, the speakers were almost all uniformly bearish.”  Turns out they might be right. This selloff is pretty minor so far for the overall market – we’re just back to where we were in mid-May. But I don’t think it’s over just yet.   
 
If you’re inclined to go shopping, I’d look at the U.S. regional banks, which have been just crushed – some were down over 10% on Friday alone, despite having zero exposure to Europe. The ones down the most suffer from a combination of asset sensitivity (they make more money when rates are higher) and exposure to oil. The outlook for both is now lower for longer, as the strong dollar makes raising rates difficult for the Fed, and the strong dollar makes oil cheaper here in the U.S. So the flight to safety trade by macro funds has hit the smaller regional banks in the Western United States. Welcome to investing, circa 2016. We’re all connected. And we’re not even in the EU.
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This week’s Trading Rules are repeats, since they are appropriate in this environment:

• It isn’t what you worry about that hurts your portfolio.  It’s what you know for sure.
• Managing risk, chaos, and probability is what separates the successful traders from the losing ones. Take baby steps.

 
The broader market has been performing worse than the S&P 500, as utilities and staples hold up the index. Tech and financials have been especially weak lately. I’d go shopping there for bargains if you have a time frame longer than a week.  Financials are being hurt by the prospect of “lower for longer” again in the U.S. and weirdness from negative rates abroad. Tech is being hurt by weak global growth outlooks, but the best businesses will be fine, especially those with a U.S. focus.

SPY Trading Levels: The market was coloring within the lines until Friday. The SPY stopped just at the big resistance level of 209/210 before the Friday fall.

Resistance is now 206, 208, 210 and 212. Lots of overhead. 

Support: small at 202 and 200, a decent amount at 194/195, then 188/190.  After that 184/185.

Positions: Long and short U.S. stocks, ETFs and options. Neutral stock exposure, net short down 1%.