Yes, and how many years can a mountain exist
Before it's washed to the sea? Bob Dylan, Blowin’ In the Wind There is a mountain of overvalued debt in the world, and folks are beginning to wonder how long it can exist before it washes out to sea. About $8 trillion in debt around the world is currently trading at a negative interest rate, implying that the holders of this debt expect deflation for the foreseeable future. Smart, rational investors around the world are bemoaning the stupidity of this situation in increasing numbers, but central bankers push onward with their quest to drive rates even lower, in the hope (wrongly) that lower rates will spur lending by banks and investing by companies. Yes, you read that right – the geniuses in Brussels think that lower rates will make banks want to lend more. Why? Because that’s what their broken models tell them. Don’t believe me? Watch this video on the inner workings of the ECB’s bond buying operations. Skip ahead to the 2:30 mark for the explanation of why they are doing it, but be sure you’re alone, because if you actually have a brain and think about what he says, you’re going to want to scream. If you want to understand the crazy distortions in bond markets today, take 3 ½ minutes to check it out. In the U.S., the picture is a bit better, but the weak jobs report in early June took down the market’s expectations for near-term Fed rate hikes significantly. This caused financials, which had been acting well of late, to sell off this past week, as they are desperate for higher rates in order to make lending more profitable. Unfortunately, they have hordes of Ph.Ds at the Fed and ECB standing in their way. (Did you know that there are 750 Ph.Ds on the staff of the Federal Reserve alone?) These economists all follow the Keynesian theory that we have a consumption problem – ie, that consumers aren’t buying enough stuff to create scarcity and drive up inflation to their preferred target. For some reason, they think that lower rates will drive consumption, despite the fact that ultra-low rates for the past seven years have failed to do just that. They think that consumption is a borrowing-cost problem, when in reality it’s an income problem. And they are the ones that are creating it. How? By stripping massive amounts of interest income out of the economy. When the Fed buys bonds and artificially lowers interest rates below their natural market-level, they are stripping income from the economy. That 5% in interest payments that the government used to pay to savers, insurance companies and pension plans is now under 2%, and mostly paid to the Fed. What does the Fed do with its interest payments? Nothing. It simply gives it back to the Treasury. All that income is taken out of the system. Sure, some investors move on to other yield investments, which explains the overvaluation of income stocks like utilities and telecoms, but there is more uncertainty in these securities, more volatility in their prices, and therefore a lower propensity to spend the income they generate – so savers hoard their assets instead of spending the income. This explains the really low velocity of money in the U.S. economy, because when savers, like retirees in Florida, can’t earn enough income from bank CDs and Treasuries, but are forced into risky assets they really don’t want to own just to earn enough income to pay the rent and food, they aren’t going to be out there spending on anything but the basics. That new outfit? It can wait. New golf clubs? Last year’s work just fine, thanks. Fancy meals out? I’ll stay home and cook instead. So when these savers fail to spend, the Fed, and its 750 Ph.Ds, decide that well, our models show that lower rates should boost spending (how? they never explain, because it doesn’t work), so we’re going to just lower them more, or put off raising them, despite the evidence (see Japan) that low rates do not create inflation or more spending – they kill it. If you want to create more spending and monetary velocity, you need to increase consumers income. You need to get them more income today than they had yesterday, and they need to feel confident that that increase in income is safe and sustainable. Want to increase spending at restaurants in Florida? Take Fed Funds to 6% again. Want to make pension plans solvent? Take Fed Funds to 6% again. Want see banks falling all over themselves to make loans to small businesses again? Take Fed Funds to 6%. It’s simple. Don’t believe me? Give every saver with $500,000 in investable assets an additional $25,000 a year in income and see what happens. The Fed has the power to increase incomes tomorrow if it wanted, but it doesn’t really understand that. Incomes create spending, which will create the inflation they want. Don’t believe me? Give every person of working age in the U.S. one million dollars tomorrow and see what happens to inflation – there will be lines out the door of every Best Buy and auto dealer in the country. Too simple? Maybe. But directionally, that’s how it works. Unfortunately for the global economy, the inmates running they central banks insane asylums don’t get it. So what’s an investor to do in such an environment? I don’t think the sovereign debt of countries that have their own currency and an accommodative central bank (CB) is much of an issue. So long as the CBs are willing to finance the debt, and continually roll it over, then it never really needs to be repaid and taxes don’t have to be diverted from spending to pay it down. How long can this go on for? Forever. When debt comes due, the CB can just print more money, hand it to the Treasury, who gives it back to the Fed for its bonds, and voila – no more debt. Or, they just issue more debt that the CB buys, and they leave the same nominal amount outstanding. So the U.S., China, U.K., Japan and other countries with their own currencies are fine. The Eurozone countries are in a bit more precarious position, particularly because Germany doesn’t really seem to understand this mechanism and balks at “bailing out” weaker members of the currency union. For now, the ECB seems to be pushing on without them, and rolling their debt, but the restrictions Germany wants to impose on its Eurozone partners could eventually lead to further crisis. For now, however, I think that sovereign debt fears are overblown in the face of an overwhelming cover bid from CBs around the world. Corporate debt is a different animal – while the ECB is now buying corporate bonds in addition to sovereigns, its ability to roll over a bond from a distressed borrower is somewhat in question in my mind. If you have a corporate borrower that runs into issues and doesn’t have the cash flow to pay back its debts, what will the ECB do? Extend and pretend? Foreclose? How will it foreclose – it doesn’t have the systems and people in place to do it? Collecting a debt is not a simple academic exercise of asking nicely – it entails securing collateral, selling that collateral, enforcing guarantees, etc. There’s a reason why distressed debt firms get paid a lot of money – because getting your money back is hard work. Here’s where I see a problem developing. Smart investors are pointing to the 18% non-performing loan levels in Italy (which they claim are understated!) and saying this is where the next banking crisis in Europe will come from. Maybe. I’m not that smart to know. But I do know that when bad corporate debt meets an unsophisticated government buyer, bad things will happen. They always do. Yes, and how many times can a man turn his head And pretend that he just doesn't see? The answer, my friend, is blowin' in the wind Bob Dylan, Blowin’ In the Wind The global hunt for yield has created some really risky securities, which investors would do well to avoid seeing in their portfolios despite the fact that they have been some of the best performing sectors in the U.S. stock market recently. In particular, utilities, telecoms, and consumer durables stocks are trading at ridiculously high valuations, as investors try to hide in “low vol” stocks and yield plays. Unfortunately, those needing safety and income the most are the ones most at risk in this market, as these stocks are pricing in all future returns today. Quoting John Hussman’s latest letter: An extended period of modest interest rates encourages investors to forget what I often call the “Iron Law of Valuation”: the higher the price an investor pays for a given set of future cash flows, the lower the long-term investment return one can expect. With every increase in price, what was “expected future return” only a moment earlier is immediately transformed into “realized past return,” leaving less and less future return on the table. Investors over-adapt to low short-term interest rates by chasing yields and driving up the valuations of much riskier securities (mortgage securities during the housing bubble, equities, corporate debt, and covenant-lite junk securities in the current episode). The rising asset prices also convince investors that risky assets really aren’t actually risky, and a self-reinforcing bubble results. Ultimately, low interest rates aren’t followed by high investment returns at all. Rather, low interest rates encourage concurrent yield-seeking speculation for a while, but after an extended period of yield-seeking, the overvaluation is followed by awful subsequent outcomes over the completion of the market cycle. 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. (For an excellent recap, read Steve Blumenthal’s On My Radar – and sign up to get it every week, for free – it’s a must-read). Unfortunately, their timing can be off, especially for fund managers who are judged on a monthly basis. Investors in stock funds have become so short-term oriented in their view, in particular pension fund investors, that the managers of these funds feel great pressure to do things that they ordinarily wouldn’t do in order to “keep up appearances” for lack of a better phrase. They search for the “least bad” alternative in the hope that they can generate competitive returns in the face of overvalued markets and be able to jump off the moving merry-go-round without getting hurt. For mutual fund managers, the quarterly performance reviews and quick-triggers of fund boards will almost ensure that they maximize the pain of their investors in the next downturn, as managers that have shown conservatism and restraint have mostly been shown the door by the bull market of the past 7 years. On the rare occasions that I discuss markets socially, I feel terrible for those that don’t know any better and continue to blindly index their life savings to overvalued markets. The drumbeat of the financial press about the failings of active managers, and the focus on relative short-term performance instead of absolute performance over a full market cycle by allocators, is going to inflict some serious damage on investor’s portfolios in the next downturn. When will this downturn come? I really don’t know. So many things that could have been the spark that lights the fire have come and gone without a trace over the past 7 years, so why will this time be any different? A prudent investor in this environment will focus on idiosyncratic investments, both long and short, special situations, like spinoffs, takeover candidates, and restructuring stories that can add value without the overall market moving up. But since these investments can be crushed in a broad market decline despite excellent fundamentals, investors looking to preserve capital must hedge in this market, despite the high-cost of doing so, either via options or outright shorts. Yes, the prudent investor will underperform if the market turns and rips higher, but they will also preserve capital and be able to take advantage of the bargains that the eventual selloff will create when it finally occurs. __________________________________________________________________________ This week’s Trading Rules:
Stocks, especially small caps, pushed higher the past few weeks before the ECB-induced interest rate distortions accelerated on Thursday and pushed stocks lower on Friday. Financials are being hurt by the prospect of “lower for longer” again in the U.S. and weirdness from negative rates abroad. Morgan Stanley is hosting their big financials conference this week, so watch for headlines from that. The Fed meets this week, but don’t expect much action, just more talk, especially as what has come to be called the Shanghai accords continue to make Yellen afraid to act in the U.S.’s best interest. Brexit is becoming an issue for markets (I don’t think it’s as serious long-term as many pundits believe, but what I think doesn’t really matter short-term). Things feel funky out there – the sell-off Friday came on decent volume, and with conviction levels among investors near record lows, don’t expect dip-buyers to materialize right away. When volatility has been this low for this long, it can trigger big selloffs as stops are triggered and complacent investors suddenly panic. Plan for this, stay hedged, and don’t be a hero on the first leg down. SPY Trading Levels: The market is still coloring within the lines. The SPY stopped just under the 213 resistance level we mentioned in our last note after moving through the big level of 209/210. That resistance level is now support, followed by 208 then 204/205, a little at 200 and 195, then 185. Resistance: 213 has held a few times. If the markets punch through, there isn’t much above it. Positions: Long and short U.S. stocks, ETFs and options. Neutral stock exposure, slightly net short down 3%. Don’t worry about a thing, ‘Cause every little thing gonna be all right Bob Marley, Three Little Birds The past few weeks have given us a steady parade of top investors speaking at conferences. From the highly entertaining panel at Milken featuring Steve Cohen, Cliff Asness and Neil Chriss (see the whole discussion here), to the somewhat disappointing Ira Sohn conference to the recently concluded SALT extravaganza, we’ve gotten a hit parade of downbeat hedge fund managers lamenting the fate of their chosen profession (full disclosure: I’m a hedge fund manager too). Apparently, managing money is hard. Especially when you get too big to be flexible. Why this is new news isn’t clear to me, but apparently it’s a bit of a surprise to all those who allocated money to the top 10 or 20 funds. Size is the enemy of performance. Any manager who tells you differently is either a fool or lying. Not sure either is good. But smaller managers who remain flexible in their net exposures and can move in and out of positions without moving the markets should still be able to perform well over a full cycle. And I think we’re getting near the end of the bull run in this one. At SALT, Leon Cooperman said he wasn’t sure it was worthwhile managing outside money anymore. At Sohn, Stanley Druckenmiller said to get out of all equities. I feel like I’m experiencing a weird sense of de ja vu. Because these same guys were saying the same things in late 1999 and early 2000. Also back then, Julian Robertson famously gave up fighting the internet bubble and threw in the towel on managing money (a terrible bet on US Air didn’t help things either). At that time, the market was doing irrational things for longer than the hedge fund community could take it. Sound familiar? It does to me. And then the bubble burst, hedged strategies proved their worth, and hedge funds that were positioned defensively enjoyed a great 5 year run. I know we did – we had great performance in 2000, 2001 and 2002, while the “market” struggled. I think we’re heading for a repeat performance. The overall market is due for a steep fall, but managers positioned properly can make good money both long and short in the next few years. So don’t worry about a thing. Real long-short hedge funds, not the highly-concentrated private-equity-like things that folks like Bill Ackman run, will do well in coming years. Long-short funds have had a tough run, and the press is full of stories about the pension plans run by California and New York City pulling out billions of dollars because the performance hasn’t been good lately. To me, these large pension plans are the perfect contra-indicators. The U.S. stock market is sitting right under its all time high, and now the pension plans want to go bigger in long-only index funds? Wow, it is late 1999 all over again. Hedging doesn’t look so good when the market goes up for 6 years. But how good will indexing look when the market is flat-to-down for 5 years or more? Not so good. And then I bet that these same sheep, ah, pension funds, will come running back to chase performance in hedge funds again. Probably at a market bottom. Rise up this mornin', Smiled with the risin' sun, Three little birds Pitch by my doorstep Singin' sweet songs Of melodies pure and true, Sayin', "This is my message to you-ou-ou " Bob Marley, Three Little Birds Why do I think that the stock market in the U.S. is heading for a fall? There are a number of reasons, none of which on their own will tip it over, but which in combination will make it harder for the market to continue its rise. So here is my message to you: Stock and bond valuations are both very high. On a number of metrics, we’ve almost never been higher. And when were stocks higher? 1929, and early 2000. If growth was strong, earnings were going higher for most sectors, and rates were benign, then we’d have some room to move up in the markets despite the high-valuations. But growth isn’t strong (revenue growth is hard to find – just look at the retailers this past week), earnings are down year-over-year, and rates are just weird. Every time the Fed mentions raising them, the markets throws a fit. Not a good setup when rates are too low for the financial markets to effectively allocate capital and the banking system to function well. Rates should be higher in the U.S. (and around the world), but the Fed is afraid of its own shadow, so it does nothing, as we’ve discussed many times before. Geopolitics are not great. The Middle East is a mess, but this somehow has moved from the front pages despite “issues” in Syria, Iraq, Yemen, Lebanon, Egypt, Libya, etc. Oh, and the refugee crisis -- it’s still ongoing, in case you forgot. Europe is facing a crisis in its banking system, its political union, and its economy, all without the will to jump-start their economies through infrastructure spending and labor reforms. It is a slow motion train wreck, and won’t get better any time soon. And then there is China. Forget about its militarization of the seas around it, and the personality cult that Xi is creating around himself. Now we have The People’s Daily, the mouthpiece paper of the ruling Communist Party, publishing a piece on May 9th quoting a leading party official who is warning of significant problems, including a bubble in real estate, industrial overcapacity, rising debt and non-performing loans, among other issues. We have been harping on these issues in China for a long-time, as have others, such as Kyle Bass and George Soros. So to see the official paper actually admit that these issues are real and a problem for growth there going forward was quite shocking, since up to now the government has resolutely stated that “there is nothing to see here.” Well, apparently now there is. Pay attention. Here in the U.S. things are getting weird too. We have the bizarre story from last week about how the Obama administration played the media for fools in order to get his Iran deal passed. It’s a crazy read. Then we have the ongoing circus around the nominations for both parties. Sanders keeps winning, but Clinton doesn’t seem to notice. So now Sanders is threatening a contested convention on the Democratic side, in addition to the potential for fireworks at the Republican convention (while the other candidates besides Trump have “suspended” their campaigns, there is still the strong likelihood of a failed first ballot and then chaos on the second). This should be interesting. Which would all be fine if stocks were cheap and the biggest companies were doing well. But they aren’t. For example, Apple continues to fall apart. As we wrote back on November 3rd, 2015, when the stock was at $122.57 (self-congratulations: it hasn’t traded higher since then), Apple faces a host of issues, from its declining sales for its iPhones to its lack of a new category killer. Now it will be facing a hostile Chinese government if it doesn’t agree to provide the government with access to the data on its phones. So the company is stuck. By refusing to give the FBI access to data on iPhones in the U.S., it has set itself up for failure with the same policy in China. Refuse and they are out. Capitulate and they lose the “victory” they claimed in the FBI fight. This is myopic strategic thinking and hubris at its worst. After it blows up, Apple might be a buy. But until then, it’s uninvestable, even here at $90, although it is due for a trading bounce. __________________________________________________________________________ This week’s Trading Rules:
Stocks continued to follow our playbook the past 2 weeks in the U.S., as smaller stocks performed better than large cap and the SPY struggled twice at the 208 level. Nothing has really changed. Right-size positions and get ready to play more active defense. Macro issues have been quiet – too quiet. My sense is that the big move since February will continue rolling over. As Art Cashin would say, be wary and very, very nimble (yes, we quoted him last time). Because the crisis can happen faster than you would think is possible. SPY Trading Levels: The market is still coloring within the lines. The SPY stopped right at the 209/210 resistance we mentioned last time as being a tough level to get through. Moving a lot higher will be hard, and I think we’re headed lower near-term, but if we do break 211, expect a sharp spike as shorts rush to cover and cautious investors play catch-up. Support: 204/205, a little at 200 and 195, then 185 Resistance: A lot at 208, 209/210, 213, then not much. Positions: Long and short U.S. stocks, ETFs and options. Very hedged against a large decline. Miller’s Market Musings is a free bi-weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. If you no longer wish to receive this letter, simply hit reply and put “Remove” in the subject line. Prior posts can be found at www.millersmusings.com. Mr. Miller has been quoted in financial publications including the Wall Street Journal and New York Times, and he has appeared on Fox Business News, PBS and CNBC. More information and past articles can be found at www.StockResearch.net. Sharing and quoting from this letter is permitted with attribution. Pay no attention to that man behind the curtain.
The Wizard of Oz in The Wizard of Oz, 1939 So that was neat. I’ve always wondered what the hype is all about regarding the annual pilgrimage to Omaha for Berkshire Hathaway’s annual meeting. Since traveling to Omaha, Nebraska is not on my bucket list, and I can think of better things to do with half a week than wandering around a convention hall looking at booths from companies that have actual stores near home, I’ve never gone. So it was great that this year the meeting was webcast for all to see, because now I realize that I wasn’t really missing anything. Were there some interesting moments? Most definitely. I spent a large portion of my Saturday glued to the webcast. Buffett has created a lot of wealth for a lot of people and built a very stable company. There are worse ways to spend a Saturday. But I was left wondering what all the hype is about, simply because for 99% of the people in attendance, who spent decent money on flights, hotels, restaurants, etc., they have zero chance of replicating, even poorly, what he has done. Especially since the only real investment advice he seemed to dispense was that most investors should simply put their money in an S&P 500 index fund and go home. And he’s probably right. Most people don’t have the time or the ability or the desire to spend most of their waking hours investigating potential investments and then waiting patiently for their thesis to come true (or not). But they flock there anyway to sit in an arena and listen to him talk for a few hours when the real lessons they want to learn are available in his annual letters, books that have been written about him, and myriad other sources that are basically free. Who says people are rational? The most interesting part was when he was asked why Berkshire had changed from investing in companies with high returns on capital and no-or-low capital requirements to those that require massive amounts of capital, like railroads and pipelines. His answer: because Berkshire is too big now to invest in those great low-capital businesses (even though they are superior to what he is buying recently and are what created the track record of which so many are envious). My takeaway: smaller is better in asset management, because it opens up many more opportunities that are unavailable to investors that grow too large – like Berkshire Hathaway. Buffett hesitated before he answered, because the answer revealed an uncomfortable truth – that Berkshire is no longer able to maximize returns for its shareholders, but Buffett is unwilling to return the capital to them to go and find other investments. Ego? Probably. When everyone who you come in contact with is always telling you how great an investor you are, it makes it hard to think that someone else could do a better job than you with shareholder money. But when the alternative is to keep buying large, slow growing, capital intensive and economically cyclical businesses, maybe it’s time to pull back the curtain on the Wizard. Coroner: [singing] As Coroner I must aver, I thoroughly examined her, and she's not only merely dead, she's really most sincerely dead. The Wizard of Oz, 1939 We are about two-thirds of the way through the first quarter’s earnings season, and so far the results have been decidedly mixed. Last year’s darlings, the cohort known as FANG (Facebook, Amazon, Netflix, and Google) have had a poor start to the year, although this week both Facebook and Amazon reported better than expected numbers, sending their stocks soaring. Netflix was fairly bad, and the stock got hit for over 15% as a result, while Google was fine (note: my fund is long Google). But the stock of the week was clearly Apple, which fell nearly 10% after reporting really lackluster earnings on falling iPhone sales. We wrote about the issues facing Apple back in November, detailing how its products were becoming hard to distinguish from its competitors, and how its future reminded us of the once-great company Sony, another consumer electronics manufacturer that was known for great design but missed a few product cycles and fell into a long slow decline. It appears to us that the time when Apple is a “must-own” stock is “really most sincerely dead.” Why? Because Apple has a weakness that most investors aren’t talking about, but which I believe has a significant non-zero chance of happening. What’s the weakness? Its substantial sales in China combined with its unyielding stance on encryption during its clash with the FBI over unlocking the San Bernadino bombers’ iPhone. While CEO Tim Cook’s unyielding position of putting Apple’s customers’ privacy ahead of the government’s interest in protecting its citizens from terrorism may fly (sorta) in the U.S., it definitely won’t in China. And no one is talking about that. So what happens to Tim Cook’s moral outrage when China demands that Apple make its phones accessible to the Chinese government? Does he maintain his “high” ground? Or does he capitulate because he wants the business? And what happens to Apple’s stock when this debate happens? To me, this is not a question of “if”, but “when.” Don’t think it’s gonna happen? From the New York Times: “Last week, the company’s iBooks Store and iTunes Movies services were shut down by a Chinese regulator, just six months after they started operating. The rare about-face by China suggests that Apple could face further pressure as the Chinese government increases its scrutiny of American companies’ operations within its borders.” Don’t say you haven’t been warned… Google already doesn’t operate in China. Neither does Facebook, or a host of other companies. But Apple gets about a third of its iPhone sales from China. So being banned there, or even just getting into a no-win fight with the Chinese government, will leave a mark. And by the way, growth in the overall market for smart phones in China is expected to slow to under 5% this year, down from 50% in 2014. So even if they don’t end up in a battle over privacy, they don’t have the big tailwind from market expansion that they used to have. Maybe that’s what Icahn was referring to when he said he sold his whole Apple stake because he was worried about China. Those still holding should be too. Scarecrow: I haven't got a brain... only straw. Dorothy: How can you talk if you haven't got a brain? Scarecrow: I don't know... But some people without brains do an awful lot of talking... don't they? The Wizard of Oz, 1939 I was fortunate enough to attend a long dinner with Vincent Daniel of The Big Short fame this past week. Besides reminiscing about our days as research analysts at Keefe, Bruyette & Woods, where we both used to work (although at different times), we spent some time discussing our favorite long and short ideas for our respective funds and the craziness that is happening in central bank board rooms around the world. The world’s central bankers like to do a lot of talking, but they don’t seem to have a lot of brains. I suppose this is what happens when you spend your whole career talking only to other career economists and bureaucrats instead of actually doing something – like holding a real job, or building a business. Why our world’s policy makers are uniformly uninformed individuals who all believe more in their models than in rational thinking and problem solving is beyond dumb, but that’s the hand we’ve been dealt. You can’t invest based on “what should be,” only on “what is.” And right now the “what is” is crazy. We both agreed that while the insanity that is negative interest rate policies (NIRP) will end badly, the problem is that neither of us know when or how it will happen. My fear is that NIRP in say, Japan, will cause depositors to flee if they are charged for holding money at the bank. If they do, and the outflow reaches a tipping point, it could easily cause a liquidity crisis. Or will NIRP cause dislocations in overnight lending markets in Europe? In money market funds? Will it create distortions in sovereign bond markets that violently unwind? There are many potential outcomes. I just can’t think of one that ends well for someone holding a negative yielding bond, so the trade is probably to short negative yielding bonds in relatively strong economies if you can, since you are guaranteed a small profit if you can hold the short to maturity and a potentially large one if rates suddenly spike higher on a flight from “safety.” I’d also continue to avoid equities in general where the situation is so dire that central bankers feel the need to engage in negative rates, because when the big unwind happens, stocks are not going to be where you want to be, unless you’re short. __________________________________________________________________________ This week’s Trading Rules:
Stocks continued to follow our playbook the past 2 weeks in the U.S., as smaller stocks performed better than large cap, but now we’re at the high end of the trading range while earnings are coming in so-so at best. Nothing has really changed. Right-size positions and get ready to play a little defense. Macro issues have been quiet – too quiet. My sense is that the big move since February is rolling over. As Art Cashin would say, be wary and very, very nimble. SPY Trading Levels: The market is still coloring within the lines. The SPY stopped right at the 209/210 resistance we mentioned last time as being a tough level to get through. Moving a lot higher will be hard, and I think we’re headed lower near-term, but if we do break 211, expect a sharp spike as shorts rush to cover and cautious investors play catch-up. Support: 204/205, a little at 200 and 195, then 185 Resistance: A lot right here at 209/210, 213, then not much. Positions: Long and short U.S. stocks, ETFs and options. Short XLP, XLU, long CPB puts. Miller’s Market Musings is a free bi-weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here. It's the most wonderful time of the year
It's the hap-happiest season of all With those holiday greetings and gay happy meetings When friends come to call It's the hap- happiest season of all
No, it’s not Christmas time. It’s earnings season, the most wonderful season of all. When we get most of the major companies reporting earnings all within a few weeks of each other. Conference calls, investor meetings, and the annual meetings are on the agenda for the next few weeks. What makes the first quarter the most wonderful time of the year is that it’s when management teams are full of hope and optimism for the upcoming year. Budgets are still attainable, goals can still be made, and by golly, this year will be the year that the company really hits its stride. (This is in stark contrast to the third quarter’s earnings season, which is when these same companies will finally admit that there is no way they’re are going to hit their goals, and start cutting guidance.) But for now, hope springs eternal that good things are on the way. This is also a good time to be investing, especially in certain sectors where expectations had gotten overly bearish. Large cap banks have reacted very well to their earnings reports so far, as the stocks had sold off into the reports – so when they release just “ok” numbers, the stocks go up anyway, since poor reports were expected. That’s why this time of year is great for stock pickers – if you were patient enough to wait for the stocks to come down, and then chose wisely, you did very well. Conversely, there is a whole cohort of stocks out there that are priced for perfection. These companies have sky-high expectations built into their stock prices, and any shortfalls will be punished. These stocks can be tricky for fund managers – while they are currently performing well, and not owning them makes you look stupid in the short-run versus your less discerning brethren, they are not a good investment long-term, as their stocks reflect not only expectations for strong earnings and dividends in the future, but the expectation that their price-to-earnings multiples will continue to expand over time. If either expectation proves to be too ambitious, the stocks will fall precipitously. We prefer to be early on the improvement in earnings for banks than to own stocks “too late,” like consumer staples and utilities, as the losses in these companies could be significant when they ultimately come back to earth. This notion of being early is often construed with being wrong, as the two are closely correlated. If you buy a stock and it goes down, by definition you have gotten either the story wrong or the timing wrong. But, unless you bottom-tick perfectly every stock you buy, you will, inevitably, be losing money on most of your positions at some point after you buy them. So are you wrong or early? That’s the million dollar question. It’s hard to know which ahead of time. You can think you are right, but until you close the position out, either in a few months or a few years, depending on your time horizon, it is hard to really know. The Big Short movie captured this conundrum really well (I highly recommend the movie as a hedge fund manager myself). A few smart investors did the work and figured out that the synthetic CDOs and CDO2s created from subprime loans were ticking time bombs. But between the time they put on their shorts and the time they paid off, they had to go through a very painful period in which their shorts went against them and the cost of carrying the shorts was high. Were they wrong during the year it took for their positions to pay off? Or just early? Many of their investors thought they were wrong, and tried to pull their money. Others were unable to really tell the difference, but put enormous pressure on the funds to perform “now.” Making the argument for patience doubly tough was the fact that other managers at the time were doing really well, making the relative disparity look even worse. Until, finally, reality took hold and the fundamentals were finally reflected in the market in a dramatic fashion. Fast forward to today: bank stocks have had a very tough start to the year. As a fund that has a significant portion of its assets in financials, this has been painful, especially in January and February. The KBW Bank Index (BKX) touched a low on February 11th, down 23.4% for the year at that point. That is a greater than 23% drop in 6 weeks. That’ll leave a mark. Even after the recent rebound from those levels, as of the close of trading on April 18th, the BKX was still down over 8% for the year. When you wonder why your fund manager is having a tough time keeping up with the overall market, look at the banks for part of your answer. For the rest of your answer, look at the insanity that is happening with “safe” dividend paying stocks. Normally, I’m a fan of “safe” and “dividends,” but the past few years of ZIRP and NIRP (zero interest rate policy and negative interest rate policy) have made people do things they otherwise wouldn’t do. Such as paying well over 20 times forward earnings for slow-growth consumer staples companies like Clorox, Campbell’s Soup, Coca-Cola, and Hormel. (Full disclosure: my fund is long puts on Campbell’s soup and the consumer staples ETF, XLP.) Why are they clearly overpaying for these companies? Because the alternatives are worse if you are “risk-averse.” Now, while it may seem riskier to buy Goldman Sachs or Morgan Stanley than Coca-Cola or Clorox, because the former are in the news all the time, and not for good reasons, as some politicians with bad hair who are running for president berate them constantly in their campaign speeches, while the latter evoke memories of the good old days of strong American brands, the stock market isn’t a popularity contest in the long run – it is a capital allocator. And if the investors who are hiding in consumer staples and, to a lesser extent, utilities, decide one day that the prospect of losing a little money isn’t attractive relative to the ability to lose no money at all by holding cash, I think we’ll see a massive wave of selling in these companies stocks. There'll be parties for hosting Marshmallows for toasting And caroling out in the snow There'll be scary ghost stories And tales of the glories of Christmases long, long ago
So we are in the most wonderful time of the year (for earnings). But keep in mind the coming shifts in the marketplace that can quickly change this happy tune into “scary ghost stories and tales of the glories of (prices) long, long ago.” So where do we go from here? As I said in my last Musings, “I think the S&P 500 is range-bound for now between 1950 and 2100, with a tighter range between 2000 and 2050. As we approach the end the quarter, we could see stocks drift down into earnings, as investors take a wait and see attitude towards new investments. Bond replacement stocks (staples, utilities) are incredibly expensive, while stocks with some issues (energy, financials, international stocks) look attractive.” Not a lot has changed, except the banks have rallied nicely and the S&P 500 is sitting just under 2100. As a result, we’re lightening up just a little, keeping ourselves very well hedged, and putting out some shorts in consumer staples and durables stocks. __________________________________________________________________________ This week’s Trading Rules:
Markets in the U.S. have moved on the prospects for higher oil, a weaker dollar, and a trade into the higher end of the trading range. Nothing has really changed. Right-size positions and get ready to play a little defense if needed. SPY Trading Levels: The market is still coloring within the lines. The SPY has stopped right at the 209/210 resistance we mentioned last time as being a tough level to get through. Moving a lot higher will be tough, but if we do, expect a sharp spike as shorts rush to cover and cautious investors play catch-up. Support: 206/207, 205, 201/202, 195 Resistance: A lot right here at 209/210, 213, then not much. Positions: Long and short U.S. stocks, ETFs and options. Short XLP, XLU, long CPB puts. A singer in a smokey room
The smell of wine and cheap perfume For a smile they can share the night It goes on and on and on and on
The past few weeks have been quite important on the central bank/central planning circuit. On March 16th, China’s National People’s Congress passed its 13th Five Year Plan. It is more a set of goals and policies than a specific plan – individual bureaucracies will come up with precise implementation steps later. But it lays out what is important to the top of the Communist Party and in particular to Xi Jinping (this is the first Five Year Plan created under his watch). Quoting from the Association of Foreign Press, here are some of the main targets of the plan: 1. To grow China's economy, the world's second-largest, by an average of at least 6.5 percent a year over the period. Gross domestic product (GDP) to go from 67.7 trillion yuan (R162.3 trillion) last year to more than 92.7 trillion yuan in 2020. 2. The service sector to account for 56 percent of GDP by 2020, up from 50.5 percent in 2015. 3. To cap total energy consumption under five billion tonnes equivalent of coal by 2020, compared with 4.3 billion tonnes equivalent of coal last year. 4. To cut energy consumption and carbon dioxide emissions per unit of GDP by 15 percent and 18 percent respectively from 2015 levels by 2020. 5. City air quality to be rated "good" or better at least 80 percent of the time by 2020, up from 76.7 percent in 2015. 6. To raise installed nuclear power capacity to 58 gigawatts by 2020, when another 30 gigawatts are scheduled to be under construction. Currently, 28.3 gigawatts are installed, with 26.7 under construction. 7. To expand the high-speed railway network to 30,000 kilometres (around 18,600 miles) by 2020, from 19,000 kilometres last year, and build at least 50 new civilian airports. 8. To boost per capita disposable income by 6.5 percent or higher every year. The figure grew by 7.4 percent in 2015. 9. To create a total of 50 million jobs in urban areas over the five years. 10. Permanent urban residents to make up 60 percent of China's total population by 2020, up from 56.1 percent last year. The proportion of people with urban "hukou", or household registration, is to reach 45 percent of the total population. Can they do it? Beats me. But they will probably get close – at the end of the day, the Chinese Government dictates who gets capital and for what. That goes a long way towards making things happen. The one that stuck out to me was number 7 – increase their already large high-speed rail network by over 50% and add 50 airports. That’s a lot of infrastructure, and will definitely help with the GDP goals, even if the airports are sparsely used.. But I’m not sure where the urban service jobs are going to come from – that is a big shift in just 5 years in a massive economy. Saying it should happen is one thing, but making it happen, in an economy with significant amounts of graft and regulation, is going to be tough. Good luck…I see lots of smokey back room deals over wine. Workin' hard to get my fill Everybody wants a thrill Payin' anything to roll the dice Just one more time Some will win Some will lose Some were born to sing the blues Oh, the movie never ends It goes on and on and on and on
A headline from US News and World Report on March 10th exclaimed: "The European Central Bank has cut all its main interest rates, expanded its bond-buying stimulus program, and offered new cheap loans to banks, an unexpectedly aggressive move to boost inflation and economic growth in the 19 countries that share the euro… ECB President Mario Draghi said the bank's decisions at the meeting of its 25-member governing council were the best answer to recent questions about whether central banks were reaching the limits of what they can do. 'We don't give up in our fight to bring inflation back to our objective,' Draghi said. He added that the steps to increase bank lending would 'reinforce the momentum of the euro area's economic recovery and accelerate the return of inflation to levels below, but close to, 2 percent.' " What I find funny is that at the same time these steps he’s taking will “reinforce the momentum of the euro area’s economic recovery,” he finds it necessary to further cut interest rates and increase stimulus. I guess he meant to reinforce the downward direction of the recovery – he just forgot to mention that part. Because his prior actions haven’t done anything to boost the economy of Europe, which is on the brink of disaster due to the ECB’s ruinous policies. The ECB keeps wrecking the profitability of banks with low and negative rates, with crazy regulations, and with odd asset risk-weightings, and yet, they wonder why the banks won’t lend more. Gee, I don’t know, because the banks don’t get paid to do it and even if they did get paid to do it, the economy is so tenuous there that their credit costs are likely to be so high that any profits would be quickly erased. So they sit on their funds, try to manage their capital ratios, and hope that things will eventually get better. Hoping isn’t a strategy, which is why Italian banks are sitting on 20% non-performing loan ratios. Worries are that, absent a significant turnaround in their economies, other countries in the Eurozone aren’t far behind, if not to quite that extent. Things are still bad. Don’t let the “momentum of the recovery” fool you…Some will win, and some will lose. I’m guessing the winners are going to be those who stay far away from European credits. ISIS struck Belgium last week, and unfortunately it doesn’t appear like this will be the last time Europe will be victimized by these barbarians. At some point the political leadership in Europe (and America) needs to stop being apologists and accommodators for radical Islam and realize that they are playing a zero-sum game – us or them. They want to rid the world of western values and return it to a barbaric Middle Ages-like existence. The West is at war, only we don’t want to admit it. Peggy Noonan wrote a great article in the Weekend Wall Street Journal – I have linked it here via a different site so you can read it free. It’s worth the time. We need to attack ISIS and eradicate it, not try to appease or contain it. Evil isn’t appeasable. In the meantime, this is also a terrible blow to the tourist economy of Europe – first Paris, now Belgium, with terrorists freely operating under the nose of Belgian intelligence services. I traveled to Africa 2 weeks after 9/11, but I’d have to think long and hard about a trip to Paris or Belgium or Berlin right now. I don’t think I’m alone in that. Against this lovely backdrop of global banking problems, central planning, and terrorism worries, I’m actually bullish on a quite a few stocks here in the U.S. I’m trying hard not to let the macro worries scare me out of the good solid companies I like. As I’ve mentioned in the past few Musings, I am bullish on community banks. A few weeks ago I attended a sell-side conference for regional and community banks, and came away with the following observations:
Just a small town girl Livin' in a lonely world She took the midnight train Goin' anywhere
Janet Yellen is in a lonely world, as the only central banker talking sensibly about the fact that rates should be higher. If you want lending to drive GDP growth, maybe let the banks make a little money on the loans? Just a thought. Some at the Fed even seem to be beginning to understand that low rates may be creating low inflation due to the lack of income being earned by savers. After not moving at their March meeting, Fed governors have recently made it clear that moving at the April meeting is a possibility, and that two hikes are definitely on the table for 2016. Given that in February the Street was thinking one or none, two sounds pretty good. They’re slow, but eventually they might get there… So where do we go from here? I think the S&P 500 is range-bound for now between 1950 and 2100, with a tighter range between 2000 and 2050. As we approach the end the quarter, we could see stocks drift down into earnings, as investors take a wait and see attitude towards new investments. Bond replacement stocks (staples, utilities) are incredibly expensive, while stocks with some issues (energy, financials, international stocks) look attractive. Terrorism and geopolitics continue to be the overhang. China worries cast a shadow as well – can the bureaucrats monetize their debts and assume their banking system’s bad loans without triggering a run on the Yuan? We’ll find out. European financials continue to be in a lose-lose situation, with capital and credit problems in a no-growth economy run by clueless technocrats. As a result, we’re sticking with the US market, but keeping ourselves very well hedged. __________________________________________________________________________ This week’s Trading Rules:
Markets in the U.S. have moved on higher oil, a weaker dollar, and a trade into the higher end of the trading range. Nothing has really changed, and now we head into the quiet period ahead of earnings. Expect lower volume and watch for exogenous shocks, which can have an outsized influence during these times. Right-size positions and get ready to play a little defense if needed. SPY Trading Levels: Last Musings’ levels worked out really well. The market is coloring within the lines. The SPY stopped right at the 205 resistance we mentioned before backing off a bit. Support: 201/202, 200, 195, 191/192, then 183/185. Resistance: 204.5/205, then a lot at 209/210. Positions: Long and short U.S. stocks, ETFs and options. Short XLP, XLU. 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. Fly me to the moon
Let me play among the stars Let me see what spring is like On a-Jupiter and Mars In other words, hold my hand
In the last Miller’s Market Musings written 2 weeks ago, I closed with the following: Markets have bounced very nicely in the past week and a half. Will it continue? I think the S&P 500 could easily move up to 1950 or even 2000. After that, I expect it to bounce between 1850 and 1930 for a while, i.e., until China comes apart. Then it will be time to play defense and wait for the next down leg to occur. But in the meantime, I’m going to repeat what I said at the end of the last letter: what’s really interesting is what is happening beneath the surface. I think a wave of M&A is coming to community banks, and that companies that have been crushed on the back of oil’s decline and aren’t actual oil drillers are, for the most part, interesting investments down here. Leadership in the markets will shift from growth to value and large-cap to small. Blatant self-congratulations alert: that’s basically what happened. The SPX closed at 1999.99 (I’ll call that 2000) on Friday, while in the past two weeks the SPX is up 4.3%, the small-cap Russell 2000 is up 7%, and the KRE (regional bank ETF) is up 9.2%. This game is easy. So what drove this big move? I think it was a combination of oil prices going up lessening the need for Sovereign Wealth Funds to sell stocks to meet funding needs, selling pressure easing by macro funds, Chinese economic officials making noise about not devaluing the Yuan “for competitive reasons,” and high-yield bond spreads tightening (although they are still fairly wide). There are a number of other, less important factors, but I think those are the main ones. So where do we go from here? I think the overall market will probably churn around 2000 for a little while, but the sub-sectors will have fairly divergent performance. Banks probably have another 3-5% upside, while high-quality energy stocks could also continue to move higher. The sectors that have been the “safe” havens for stock investors will probably become less safe. Consumer Staples companies like Campbells Soup (CPB), Clorox (CLX) and Kelloggs (K) are trading for incredibly high valuation multiples, mainly because they were being used as a hiding place. Similarly, investors that have been searching for yield anywhere it can be found have driven yields on Utilities to about 3.5% overall, which, to me, is a too low to make a safe investment, especially given the massive changes occurring in how we generate and distribute energy. With the XLU utility ETF trading right at its highs for the past year, I’d be a seller of safety and a buyer of the beaten down sectors. What’s keeping me from being more bullish? A number of things. In no particular order: We’ve had a big move from very oversold levels. The fear trade has worked. From here, there will be a bit more covering and performance chasing, especially in sectors where credit issues were feared to be fatal, but the easy money has been made. China is still a mess. The powers that be are going to be setting some 5 year plans this weekend, so there may be some soothing headlines coming out soon, but overall, their growth is slowing, their debt is growing, and the combination will eventually end badly for them. Now, given that it’s a closed economy and the government can just print Yuan to recap its banks, I don’t expect to see bank failures like you would see here – they will just infuse equity where it’s needed. Some will argue that all this money printing will cause the Yuan to depreciate, but since the Yuan doesn’t really free float, this isn’t guaranteed. Besides, all the other major economies except the U.S. are also printing massively, so on a relative basis to the Euro or Yen they aren’t doing anything that different. That said, the crackdown on dissent, and fear of a more oppressive regime to come, has driven up capital flight, and I only expect that to continue. Eventually, they will have to either let the Yuan depreciate or institute stronger capital controls. When will this happen? Probably further in the future than the China bears think possible, but a lot depends on how fearful the rich in China become about their ability to get money out at all. Europe is still a mess. Draghi thinks that the Euro economies are so bad that he keeps pledging to “do whatever it takes” to stem the decline every time he speaks. He’s giving a big speech this week, so we’ll get to hear more about his easing plans, but at the end of the day, massive QE isn’t working, hasn’t worked, and won’t work. So Europe will continue to muddle along with economic growth right around zero. Japan is still a mess. While we’re speaking of massive QE that hasn’t worked, Japan is still unable to produce any real economic growth despite 20 years of near zero rates and now, negative rates. I’m always amazed at the stupidity of the central bankers who think that they can “create” demand by raising and lowering rates that no one borrows at anyway. As I’ve said in prior posts, if you want to get lending up and spending up, let rates be higher. Savers will have more money to spend and banks will be incented to lend because they will actually get paid to do it. With rates where they are, savers are being crushed since they have no current income, and banks aren’t willing to lend long-term at really low rates because frankly, it doesn’t make any sense to do so. But in the la-la land of central bankers, their models all show that lower rates mean more economic growth. The fact that the evidence from economies around the world shows just the opposite seems to not matter. The U.S. stock market, as represented by the S&P 500, isn’t really cheap. Consensus estimates range from 115 to 125 in earnings for it for this year, so it’s trading at around 16-17 times earnings. Not crazy expensive, but not super-cheap. So we muddle along. Fill my heart with song And let me sing for ever more You are all I long for All I worship and adore In other words, please be true In other words, I love you
I do think some individual stocks look really attractive, and we are long a number of solid community banks as well as some of the largest banks, which look very cheap here. Bill Gross put out his monthly letter on March 2nd and said to get out of the banks, but I think he’s wrong. Mike Mayo, who was bearish on the big U.S. banks for 20 years, is out pounding the table to buy the big 4 at these levels, and I agree with him (full disclosure: I used to share a cab to work with Mike most days about 20 years ago, and I think he’s a good guy). We’re also long some energy stocks, a few solid healthcare companies, and a few retailers trading at 4-5x EV/EBITDA with no debt. Some have recently been knocking the long-term prospects for banks, saying that they are never going to trade at a decent multiple of book or earnings, because they will be unable to earn a decent ROE. This argument usually says that the banks are now like utilities, over-regulated, over-capitalized, and unable to generate much above a 10% or so ROE. My thought is that if banks are like utilities, that’s not necessarily a bad thing. The average utility in the U.S. is yielding just 3.5% with very high payout ratios and sky-high P/E ratios. Once upon a time, banks actually were traded like utilities (this was back in the 1950s and 1960s), where their dividend yields were what mattered. Over time, the metric shifted to P/E ratios and earnings growth. But if we go back to the way things were, and banks are viewed as a stable source of dividend income again, I’d argue that their valuations would go up about 50%. I’ll take that. __________________________________________________________________________ This week’s Trading Rules:
Markets have ripped as the fear and panic that gripped markets in mid-February diminishes. I think this rally is about done. We probably just muddle along here around 2000 as market leadership continues to shift, but I think S&P 500 could fall back to 1950 fairly easily. If it breaks 1940, I’d expect it to retest the recent support around 1850, then to bounce between 1850 and 1930 until some exogenous, macro situation causes another round of selling. Then it will be time to play defense again. SPY Trading Levels: Support: 195, 191/192, then 183/185. Resistance: 200, 204.5/205, then a lot at 209/210. Positions: Long and short U.S. stocks and options. Short stock or long puts on CPB, CLX and K. 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. ‘Cause we’re young and we’re reckless
We’ll take this way too far It’ll leave you breathless Or with a nasty scar
The selling has been relentless. Almost every day from January 1st through January 25th the XLF financial ETF went straight down. Pull up the chart. Why? Why did the largest financial stocks in the U.S. go on a forced march from over $34 to under $28 so fast? Oil and sovereign wealth funds (SWFs). Oil dropped about 23% during the same time frame. As oil dropped, sovereign wealth funds of countries that are used to operating large social programs funded by oil revenues were tapped to meet cash needs. Saudi Arabia, Qatar, Norway, and others all went from swimming in cash to needing to tap their savings to pay their large bills. And what is, by far, the largest holding of SWFs? Financials. Financial stocks make up 46% of the holdings of sovereign wealth funds according to Piper Jaffray. In a distant second are consumer durables at 16%. So why are U.S. financials down? Coming recession? Fear of credit costs going up? Weak earnings? I say none of the above. It is liquidations by sellers who need cash. Add to this list a few other potential sellers, like hedge funds (last week it was reported that Citadel was liquidating its large (the Wall Street Journal said $50 billion with leverage) Surveyor Capital division) along with a number of financially focused trading books due to poor performance. Anecdotally, the mood at last week’s KBW Financial Conference in Miami was notably dour. “Unbelievable”, “Makes no Sense”, and “This is Ridiculous” were phrases thrown around quite freely by bank fund managers. The nadir of negative sentiment was reached on February 11th, right in the middle of the conference, even though management teams presenting were quite sanguine about their own companies. We were decent-sized buyers for our fund that day, and are sitting on some nice short-term gains, but the bigger question is, where do we go from here? Will this move higher continue, or leave us with a nasty scar? So it’s gonna be forever Or it’s gonna go down in flames You can tell me when it’s over If the high was worth the pain
While we’re on the topic of banks, let’s take a look at where global banks stand today. U.S. banks are in pretty solid shape. Strong capital, but subpar returns due to low interest rates, fairly manageable oil and gas exposure, increasing M&A activity, and very reasonable valuations. European banks are cooked. Italian banks are a mess, and four recently were seized. Big banks have more energy exposure than many thought, and the game of kick the can down the road hit the wall recently. Coco’s (contingent convertible bonds) are the issue du jour, with fears of those bonds being forced to convert to equity driving down large German banks in particular. Adding to the pain is the fact that European leveraged loans have recently traded down from 97% to 95.25% of par according to Bloomberg, or 1.8%. This isn’t good. Leveraged loans are held in CLOs and on large bank balance sheets. Let’s assume a conservative leverage ratio of 8 to 1 at a CLO and 10 to 1 at a big bank (I’m being generous). At 10 to 1 leverage, a 1.8% decline becomes 18% of your capital allocated to the portfolio. Surprised European banks are off nearly 30% from their highs? Me neither. Chinese banks are even more cooked. How cooked? Burnt to a crisp, makes 2008 here look like sushi cooked. Kyle Bass, in his latest partner letter, details the problems facing China in detail. Instead of rehashing them here, I will just quote a small part of it. From Hayman Capital’s letter: As the renminbi appreciated over the last decade, China undertook a massive infrastructure spending program in order to maintain politically-determined GDP growth targets in the face of these headwinds. This policy action created a system of distorted incentives (not to mention a dramatic misallocation of capital) whereby local officials were promoted to higher office by exceeding those targets without regard to the return on investment of the projects they supported. In 2005, exports and investment constituted 34% and 42% of China’s GDP, respectively. By 2014, exports had fallen to 23% and investment had grown to 46%. This growth in investment was funded by rapid credit expansion in China’s banking system, which grew from $3 trillion in 2006 to $34 trillion in 2015. You read that right – assets in the Chinese banking system grew by 10x, or $31 trillion, in the past 10 years. Now, you don’t need to be a genius to figure out that not all of that is going to be paid back, especially when you consider that those loans were made in a country with poor corporate governance, managed centrally by a small committee of communist dictators, who have no experience running businesses or allocating capital. China is mixing a retail investor base with a gambling mindset towards capital markets with loss aversion at the senior government level and a state mythology of infallibility of its government leaders. But they are Young and Reckless when it comes to capital markets. They don’t deal with uncertainty well. (Last month, in The Emperor’s New Clothes, I wrote that “If I was able to, I’d short Mr. Xiao’s career at the top of the Securities Commission.” Well, Mr. Xiao Gang “resigned” from his post this week. I’m still betting on prison for him sometime in 2016.) The U.S. doesn’t like uncertainty either, but at least it has a higher hurdle for when it intervenes directly in markets. For that reason, we are expressing our views via shorting U.S. companies with high China exposure instead of its currency, like Bass at Hayman is, as we believe that China can easily change the rules of the game to suit their needs, and the short Yuan trade feels crowded. The reverberations from China’s banking problems, even though China represents a fairly insignificant part of overall U.S. exports (kinda happy about those closed markets now, aren’t we?), will be felt in global markets not because of direct exposures, but because of de-risking by macro funds and other investors like SWFs that will sell what they can (U.S. stocks) to raise cash to backstop their own problems. So while bounces like we had this week are nice, and I do think U.S. banks in particular are attractive, it’s not quite time to tell you it’s over. When China goes down in flames, the high won’t have been worth the pain. Screaming, crying, perfect storms I can make all the tables turn Rose garden filled with thorns Keep you second guessing like "Oh my God, who is she?"
This week’s Trading Rules:
Markets have bounced very nicely in the past week and a half. Will it continue? I think the S&P 500 could easily move up to 1950 or even 2000. After that, I expect it to bounce between 1850 and 1930 for a while, i.e., until China comes apart. Then it will be time to play defense and wait for the next down leg to occur. But in the meantime, I’m going to repeat what I said at the end of the last letter: what’s really interesting is what is happening beneath the surface. I think a wave of M&A is coming to community banks, and that companies that have been crushed on the back of oil’s decline and aren’t actual oil drillers are, for the most part, interesting investments down here. Leadership in the markets will shift from growth to value and large-cap to small. SPY Trading Levels: Support: 187/188, then 181/182, then a little at 175. Resistance: 193/194, 200, 204.5/205, then it’s not going above 209/210 soon. Positions: Long and short U.S. stocks and options. 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. Well, I talk about it, talk about it
Talk about it, talk about it Talk about, talk about Talk about movin’
On Friday the Bank of Japan (aka, the Japanese Fed) cut the rate on current accounts that commercial banks hold with it to minus 0.1%, adding that it will push the rate even lower if needed. Effectively, this means that banks will be charged to keep excess assets with the central bank. This move sparked a big jump in stock markets around the world. Some mistook the rise as being predicated on the assumption that negative rates would work to spur growth and therefore earnings and therefore stocks. This is wrong. Stocks moved because as a financial asset they became slightly more attractive than they were the day before, especially when having cash has a tangible cost, and when the same people that just took rates negative said they will take them more negative if they have to. So asset allocators did the logical thing and decided that the prospect of losing money in stocks was more attractive than the guaranty of losing it in bonds. So stocks went up. The common explanation for negative rates in countries that have implemented them is that negative rates will encourage banks to lend and consumers to spend rather than save. It’s the same argument for keeping rates low all over the world – low rates drive lending which drives consumption by individuals. But this isn’t happening. Japan has had ultra-low rates for years and its economy has been terrible. Trillions of debt in Europe now trades at negative interest rates and its economy isn’t exactly booming. Denmark, Sweden and Switzerland all have negative interest rates, but consumer spending isn’t going up there. In fact, savings rates have been going up in lockstep with the decrease in interest rates, exactly the opposite of what the geniuses at the various central banks expected. Welcome to Funkytown. Why is this happening? Simply, savers are scared. Lower rates have wrecked their retirement plans. Say you were doing some financial planning 10 years ago and plugged in 3% from your savings account. Now its 0%. You still have to plan for your retirement. Plug in 0%. What happens to your planning now? 0% compounded for X years is 0%. The math is simple. So in order to have your target savings at retirement, you need to save more, not spend more. But for some reason, the economists that run central banks around the world can’t see this. They are all stuck in their offices talking to one another and self-reinforcing this myth that they can drive spending up by reducing the rate of return on investments. Want to see consumer spending go up? Don’t wreck their savings plans so that they are too scared to spend. But that’s too simple. Instead, central banks use a chain of causation that doesn’t exist to try to create change 3 or 4 steps down the line. It hasn’t worked, and it won’t work. It isn’t in an individual’s self-interest to go out and spend their money on more “stuff” in order to spur economic growth. Won’t you take me to Funkytown?
So how do you get people to do collectively what isn’t in their own best interest to do individually? Put another way, how to you get people to take the savings they think they will need in the future to ensure some basic level of survival, and instead spend it today? I think governments need to be very explicit in what they are doing. Right now, they use terms that the average person doesn’t really understand, or, put differently, people don’t understand how the policies being tried over and over are supposed to affect them. So they ignore them. Why do central banks want higher inflation (of about 2%)? Because they think that this is the optimal level that will make people spend today instead of waiting for something to be cheaper tomorrow. At 0% inflation, there is no incentive to spend today versus a year from today, as prices will be the same. The Fed targets 2% because it believes that is the “right” level that will make consumers move to spend sooner. They are wrong. Consumers don’t think that way. They think in terms of what do I need, what do I want, and what am I willing to pay for it. Needs are bought somewhat irregardless of price. Think food, and homes. Most people in the U.S. actually like it when home prices appreciate at a level that they can see – like 4-6%. I’d hazard to guess that this is the level of interest that would make them feel comfortable spending a bit of their savings too. The Fed is literally “too cute” by half. No one cares about 2%. It’s meaningless. People don’t shop their credit cards, or even call the issuer of the ones they have, for 2%. It’s seen as not worth their time. So all this talk about quarter point moves, half point moves, negative rates, is just that – talk. The people the message is intended for aren’t listening. So again, how do you get people to do collectively (spend now) what isn’t in their best interest to do as individuals (if the prices of goods are going down or are flat, then saving and waiting for the better quality TV, or car, or clothes, makes perfect sense). Insuring against disaster – like losing your home altogether because you didn't save enough for retirement – carries a lot more weight in people’s minds than losing 2% in purchasing power through some unseen inflation that doesn’t even exist at the moment anyway. Central bankers are so divorced from reality that they really think (or at least act like they think this way) that these small moves in borrowing rates, even to negative rates, will scare people enough about their future purchasing power that they will throw caution to the wind and go buy stuff they don’t really need now. Because if they really needed it now, I mean, needed it to survive, they probably already bought it, don’t you think? Gotta make a move to a town That’s right for me Town to keep me movin Keep me groovin’ with some energy
I think the only way to get people to spend their savings now, especially in stagnant economies like Japan’s, is to skip all the intermediate, opaque steps and just tax their financial assets. Just do it directly. Reduce their purchasing power today. That’s all inflation is – a reduction in purchasing power in the future. So pull it forward, and make it crystal clear to the masses that aren’t reading central bank pronouncements what they are doing. Do it in size. And do it monthly. Charge 25 basis points a month on all financial assets – stocks, bonds, banks accounts. Every month that goes by, savers will see less money in their accounts. This is no different than inflation running at 2% or 4% or whatever the target is, but it is a lot more visible to the people you’re trying to affect. So pull a Nike and Just Do It. I’d bet that after about a year, you’d see consumer spending up, inflation up, growth in the economy, and businesses expanding, at which point you could rescind the tax and go back to normal. But you need to shock the system to get there. Incrementalism hasn’t worked yet and won’t work in the future. Hiding what they are doing – trying to boost the rate at which consumers’ purchasing power decreases – isn’t working either. Sometimes you need to use a defibrillator to shock a stopped heart to restore its normal rhythm. Apparently you need to do the same to a whole economy. So do it. __________________________________________________________________________ This week’s Trading Rules:
Markets have bounced very nicely in the past week and a half. Will it continue? I think the S&P 500 could easily move up to 2000. After that, I expect it to bounce between 1900 and 2000 for a while. What’s really interesting is what is happening beneath the surface. I think a wave of M&A is coming to community banks, and that companies that have been crushed on the back of oil’s decline and aren’t actual oil drillers are, for the most part, interesting investments down here. Leadership in the markets will shift from growth to value and large-cap to small. When? Soon… SPY Trading Levels Support: 188/189, then 181/182, then a little at 175. Resistance: A ton at 200, 204.5/205, then it’s not going above 209/210 soon. Positions: Long and short U.S. stocks and options, long SPY and IWM options. Are We There Yet?
I’ve been getting (and asking) that question a lot in recent days. Not only from other market professionals but from people that normally don’t follow the markets. I noticed that in the past few days one of the channels at the gym that is usually tuned to Ellen or some other dreck was now set to CNBC in the afternoons. My answer until today has been consistent – not yet. Today something changed in the market however. Small caps, which had been getting hit for months, and are down significantly more than large cap stocks, turned up at midday day and rocketed higher. The Russell 2000 ETF, or IWM, shot from $95.12 at 12:30 to over $100 before closing at $99.79. This is a huge intraday move. In addition, many of the small and midcap stocks that I watch closely also moved strongly higher in the afternoon. This is a significant short-term trading turn. As of yesterday’s close, the Russell 2000 was down 13.1% over the trailing 12 months and was off a whopping 22.4% from its 52 week high. The average stock in the index was off even more. When you wonder why so many funds are having a rough time, this is a main reason. Only the largest stocks in the benchmarks have been doing well, making it very hard for those managers that don’t want to take on the concentration risk inherent in large index positions to outperform in this environment. But eventually, I think there will be a serious reversion – and it may have just started. For comparison, the S&P 500 was off just 4.6% for the past 12 months, and the S&P 100 even less, at a 3.3% decline. Put another way, the top 100 stocks by market cap beat the smallest by over 10% in the past 12 months, and the performance versus the 52 week high is similar. Since the selloff started in June, large caps have beaten small caps by over 11%. Where do active managers shop for bargains? Not usually at the top of the food chain. Hence the recent pain. How Did We Get Here?
While the recent divergence between large and small cap stocks is fairly well known, what hasn’t been discussed much is why this happened. The stocks that have been performing the best are not those with the most cash flow or the cheapest valuations. They are the ones that have the best revenue growth and perceived ability to sustain that growth for the next few years. But I think there is something more pernicious at work. This has been a terrible year for fund flows into actively managed investment funds and a great year for fund flows into index funds and ETFs. How do most index funds and ETFs invest? By buying the largest stocks. Even funds that supposedly invest in large numbers of stocks, like the S&P 500 index funds that are so popular, have the bulk of their assets in the top 50 companies. The bottom 50 are essentially meaningless. So what you have seen this year, and in prior years, is that as more investors move into index funds, they are all buying more and more of only the largest stocks, and their redemptions from active funds that invest in smaller companies are forcing those managers to sell. The result is not only the large disparity in performance we’ve seen recently, but an increasing concentration of market risk in fewer and fewer stocks. Put another way, breadth stinks, and when breadth stinks, its hard for the market indices to continue to move higher. This has happened over and over again in the history of markets, as investors get into crowded trades at the top of the market. Vanguard and its mouthpiece Jack Bogle perpetuate this myth that indexing is always better than actually selecting stocks based on objective measures of value, when the facts prove otherwise, because it is good for business. Their (misleading) sales pitch has made them the largest mutual fund manager in the world. This concentration risk is also inherent in many index-based ETFs (the dangers of which have been extensively discussed here previously). Despite this obvious structural problem, their sponsors are some of the fastest growing asset gatherers in the industry. Despite these issues, I think we are at a short-term inflection point. Long-term, there are some real bargains out there, but some serious issues in China and the Middle East may make a sustained rally hard to maintain. Many high-quality companies are off 15-20% year-to-date in 2016, and are now trading at attractive prices. Our fund has been buying well-run community banks in strong markets this week, and will continue to do so on further weakness. M&A is coming to this sector, and the market gyrations based on money-flows we’ve seen are giving investors a great chance to buy these companies at good prices. We also like some defense stocks and gaming companies at their current valuations, and are increasingly interested in a few companies that have been unfairly tainted with the specter of oil-related business declines. Speaking of oil – Are We There Yet? I think we are. In August of 2014 my partner (who’s also my wife and our resident oil expert) and I attended an MLP conference at the Wynn Hotel in Las Vegas. Two-hundred and fifty different companies were there presenting their growth plans for new drilling, refining, storing and moving of oil and gas products. Some were bullish on fracking, others on LNG exports, still others on building new pipes from Colorado and West Texas to refineries on the Gulf Coast. Capital was cheap and easy to get, and no one was worried about over-capacity or the fact that everyone there was saying the same things. As the non-energy expert who was there to see what all the fuss was about, to see why there were IPOs and follow-on offerings coming every week that were many-times oversubscribed, I kept thinking that this reminded me, and not favorably, of the similar conferences I attended for sub-prime mortgage originators, REITs, and servicing companies in 2005 and 2006, and how back then I didn’t understand how companies could make loans to people that couldn’t pay them back and expect it all to work out well in the end. Well, just like with subprime, it didn’t’ work out well. Many of these same energy CEOs we met with who were bullish on the way up are now uniformly bearish at the bottom. I chuckle when I see them on CNBC proclaiming that oil at $28 isn’t near a bottom and that $20 is a possibility, when they didn’t have a clue that this selloff was coming when oil was over a $100 and they were growing like a weed less than 2 years ago. Is oil done going down? I don’t know. But I do know that the exuberance is gone, that the CEOs are scared, and that capital spending in the industry is off nearly 75% from its peak. I know that the Saudis are losing money, the Brazilians are losing money, the Venezuelans are cooked, and the Russians are withering on the vine. Canadian oil sands? Done. Artic drilling? Done. Deep water in tough locales? Done. Lots of future production has been cut and isn’t coming back unless oil is back over $70 and stays there. That’s a long way from here. And lets not forget that the quoted price for WTI or Brent is for the best quality crude. Most crude trades at a big discount to that price. I read yesterday that some crude in the Midwest is being bid at $1.50 a barrel. Think that works long-term? Me neither. So what are we doing? We’re picking away at the best midstream MLPs, the best tank car maker, and the best refiners and field services company. Are we early? Yep. Are we losing money so far? As of today we are. But we think that, just like the best banks were a screaming buy in 2009, the best oil companies are a buy today. So that’s what we’re doing. ______________________________________________________________________________ This week’s first two Trading Rules:
China continues to come unraveled, and the central government’s attempts to rescue its markets are failing. The suspicion on desks is that sovereign wealth funds have been dumping stocks to cover budget shortfalls. If so, we may be in for some unusual month-end trading going forward. ETFs and index funds are creating a herding effect in the largest of the large caps. This concentration will end badly, as it has every time in the past. Be wary of expensive “safe” stocks and buy some cheap SMID names instead. Value always wins in the end. SPY Trading Levels: Support: The market broke support at 188 today. Next is very little at 181/182, then 175. Resistance: A ton at 195, 200, 204.5/205, then it’s not going above 209/210 soon. Positions: Long and short U.S. stocks and options, long SPY and IWM options. So off went the Emperor in procession under his splendid canopy. Everyone in the streets and the windows said, "Oh, how fine are the Emperor's new clothes! Don't they fit him to perfection? And see his long train!" Nobody would confess that he couldn't see anything, for that would prove him either unfit for his position, or a fool. No costume the Emperor had worn before was ever such a complete success.
Hans Christian Andersen – The Emperor’s New Clothes Long-time readers will know that we have been skeptical of China for many years. A corrupt, insular government run by men solely focused on maintaining their power and privileges at the expense of the people they govern is not a suitable manager of an economy. And yet, they try. And fail. Over and over. The “Chinese Miracle” that sycophants like to gush over while they hold their hands out for contracts from the state-run enterprises is a mirage. Chinese companies have issued $21 trillion in debt in recent years, much of it to finance inefficient, uncompetitive businesses that wouldn’t be able to survive without regular, large doses of new debt. The economy of China is walking around without any clothes, and yet they think they are a great success. For some reason, the IMF recently admitted China’s currency to the top echelon of global reserve currencies. They stated that China was making moves towards an open economic system in which the renminbi would be freely exchangeable into other currencies. Ah, no they aren’t. A recent article in the Wall Street Journal noted that immediately after receiving this designation, the inner circle of the finance ministry congratulated themselves for a job well done, and turned their attention to weakening the renminbi against a basket of 13 currencies in order to boost their export economy. Free markets? Hardly. But, once again, the IMF and others don’t want to admit the obvious – that China is still a manipulated economy controlled by a statist, Communist government and large, state-run enterprises. It is not a free economy on par with those of Europe, the US, or Japan. The government basically borrowed its way into its current position, and so long as it pegged its currency to the dollar, it could control that debt and its economy. But when you open your currency to the world, and allow it to be valued based on fundamentals, a funny thing happens – you lose control. Either your debts go bad, or you continue to print more money to pay them, which in turn makes your currency less valuable. It is this dynamic that the central planners missed. They would be better off remaining a closed system in order to continue to fund their debts internally by simply printing more money. By then controlling their exchange rates, they could manage inflation and export balances. However, the prideful rulers decided that they wanted the status of a world power, and in order to be admitted to the club of first-world economies they were willing to sacrifice some control over exchange rates. This vanity is now coming home to roost. The ruling party has limited choices. They maintain power by creating an aura of invincibility and infallibility. Criticism of the government is prosecuted and repressed (I’m guessing I’m not going to China anytime soon now). When the market is going up, it’s because the government is doing an amazing job of managing the economy and generating growth. When it goes back down, this same government accuses brokers and fund managers of manipulation and fraud. Numerous heads of companies and brokerages have gone missing recently – not week goes by now when the Financial Times doesn’t have a story on a CEO who is suddenly “unreachable”, and no one knows where they went. Sometimes they reappear a few days or weeks later, without commenting on their disappearance. Sometimes they don’t reappear at all. Want to do business in China still? I don’t. See this article I wrote back in 2011 on the issues in the Chinese economy and tell me if you do. But he hasn't got anything on," a little child said. "Did you ever hear such innocent prattle?" said its father. And one person whispered to another what the child had said, "He hasn't anything on. A child says he hasn't anything on." "But he hasn't got anything on!" the whole town cried out at last. The Emperor shivered, for he suspected they were right. But he thought, "This procession has got to go on." So he walked more proudly than ever, as his noblemen held high the train that wasn't there at all. Hans Christian Andersen – The Emperor’s New Clothes On Thursday China’s cabinet held an emergency meeting about the failed circuit breaker system that the Chinese stock market implemented on Monday and canceled Thursday night, after it clearly didn’t work. At the meeting, held “in the walled Zhongnanhai compound where China’s top leaders live and where few ordinary Chinese have ever set foot” (Wall Street Journal), Xiao Gang, Chairman of the China Securities Regulatory Commission was grilled about the failure of the system he had championed. For a government that needs to appear infallible, the fast fall from grace is unacceptable. The Chinese markets have been revealed to the world as the farce that they are. They have quickly gone from an economy held in awe to one viewed with derision. Social media in China, to the extent the posts are allowed to remain online, has been filled with mocking references to the government. If I was able to, I’d short Mr. Xiao’s career at the top of the Securities Commission, and will not at all be surprised to find him the subject of “corruption” charges or the victim of an untimely accident before the end of 2016. The Emperors are beginning to shiver in China. ______________________________________________________________________________ This week’s first two Trading Rules are a repeat from last time, because they are very timely given that trading in China’s stock market is 85% retail investors, and they appear to be panicking...:
China is coming unraveled, and the central government’s attempts to rescue its markets over and over will eventually fail. At some point, it will either own most of the outstanding shares available on its stock exchanges, or have to abandon its strategy of propping up its markets. Eventually, if it wants to have open markets, prices will move to where investors again become interested in buying. I suspect this level is so far below where the markets are trading today, especially given that no one trusts the government anymore, that either the government will have to close trading for an extended period of time, or allow both the stock and currency markets to reset lower in a large, fast move. I’d bet on the latter. SPY Trading Levels: Support: 188/189. That’s it. Resistance: 195, 200, 204.5/205, 209/210, 213 Positions: Long and short U.S. stocks and options, long CEFs, long SPY and IWM Puts. |
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