Retrenchment

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

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

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

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

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

Countries are becoming more divided:

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

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

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

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

Bank Stocks have gone from uninvestable to beloved in a year.  Think this keeps going up

A year-ago everyone loved “safe” defensive stocks.  Today they love cyclicals.  Overdone?
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Macro Funds are leaning very long.  I don’t mean to be mean but…their timing can be off.
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Does this mean we are about to crash?  No.  Markets like this can keep going up.
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​However, almost all financial valuations are overvalued.  Look at US High Yield Spreads:

However, hedging costs are very low.  So why not hedge your equity exposure now? 
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​Portfolio Review and New Ideas:  This is only available to those who have asked to be on the Miller’s Market Matrix distribution list.  Please email me at [email protected] to be added.  
 
The market is fully-valued and is priced for Trump to get what he wants.  We’re holding cash in case he, and the market, are disappointed.  Our portfolio recommendations returned a net 1.10% with a 10% net long stock and 15% net short macro position over the past 2 months. 
Best,

Jeff