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Kass: Risk vs. Reward Improves, But Problems Lie Ahead

Written by Doug Kass | Mar 27, 2018

  • The dark week in February, described in The Day Liquidity Died was likely the tremor ahead of a quake to occur later in the year
  • The market may have already seen a 2018 high
  • On Friday we might have completed the similar six week pattern of sharp drop, rally, retest, rally, retest that we saw in November-December, 1987 (in the last liquidity-driven event caused by Portfolio Insurance)
  • Though market risk has recently declined relative to reward, more volatility and a widening trading band likely lies ahead

The key points I want to make this morning:

History Rhymes! The February, 2018 liquidity-driven sell off (as risk parity and the global short vol trade was initially unwound) continues to follow almost the exact pattern of the last important liquidity-driven market selloff (caused by Portfolio Insurance) back in late 1987. The chart below (1987) shows a sharp rally off the initial low (of about +13%), a retest (towards a higher low), an explosive recovery back to the initial rally level and then a slow move lower (early November to early December) into the final retest, right back near to the initial sharp drop (we almost got there at Friday’s close):

On Friday, with the S&P Index touching 2580, we may have fulfilled and completed the six week pattern this year that we witnessed in 1987. So, that chapter (and analog) might now be closed – and we move on to a series of different fundamentals and relationships.

Renewed Volatility The lack of volatility in 2017 is being replaced by a totally different climate of heightened volatility and a much wider trading range. This could be a signpost of a market that has moved from Bull to Bear.

No Man or Company is Above the Law – A Country and FANG in Crisis? There are two important factors contributing to greater market volatility and weakness.

First is the pivot point in how the market now evaluates and begins to pay attention to the downside associated with the President’s dysfunctional White House and policy being made “on the fly” (“Presidency of One?).

As well as the growing existential threat of legislation and regulation towards the leading market sector (social media stocks) is now center stage. FANG has been the center piece of the decade old Bull Market. For one year I have been fearful of their increased market dominance and horizontal acquisition strategy which is disrupting industry after industry – and having a consequential impact on those industries, their employees, and even the real estate markets. More costly monitoring and supervision lies ahead – and with it will likely be newly minted threats to earnings growth coupled with the possibility of lower valuations. (“Are Facebook, Google, and Amazon Too Big Too Fail?”) as more than one company will be face planted in the future.

  • A Market Peak? There is a rising probability that stocks have already made a 2018 high and that January, 2018 was a classic capitulation top.
  • The Outcome of the Mueller Investigation Could Be Market Unfriendly
  • A Blue Wave in the Mid-Term Elections Could Also Be Disruptive to the Markets and the Trump Agenda
  • The Expectations of a Synchronized Global Economic Recovery May Be Wrong: Though many are focused on the big upside reported in the recent Friday’s jobs market — I would emphasize that employment data is a notoriously rear view or lagging economic indicator. Recently the Atlanta Fed said its GDP model sees 1Q2018 Real GDP at only +1.9% (and JPMorgan (JPM) has moved down their estimate to +2%) — that’s fairly disappointing considering we have been in a respend and rebuilding period following the hurricanes and we are now nearly three months past the passage of meaningful corporate tax cuts. Numerous high frequency economic data points now suggest that the much anticipated acceleration in the rate of US economic growth may disappoint investors. And, even in the EU, several economic prints have stumbled recently.
  • Global Central Bankers are Pivoting Towards Tighter Money: In marked contrast to the last nine years, the Fed is no longer our friend.
  • The US Lacks Fiscal Discipline: The recently enacted tax bill will exacerbate risks associated with a rising debt load and expanding fiscal deficit. The Fed’s $4 trillion balance sheet is problematic and $2 to $3 trillion of newly issued Treasuries will likely place pressure on interest rates.
  • Inflation Pressures Are Building and Interest Rates are Heading Higher On rates, few appreciate that it took only a thirty basis points increase in the ten year US note to blow up a trillion dollar global short volatility trade. And, from Peter Boockvar: “Another 2.4 bps rise in 3 month LIBOR on Friday to 2.20% brings the year to date gain to 50 bps. It is now up 105 bps over the past 12 months which of course is greater than the pace of Fed rate hikes and thus the LIBOR/OIS spread keeps widening. It’s been a topic of discussion for the past month but regardless of what’s causing it, the impact grows on the trillions of dollars of LIBOR based loans.”
  • The Rise in Libor Poses a Broader Economic and Credit Threat Than Many Recognize I would be closely watching the plight of European banks (particularly Deutsche Bank (DB) ) which remain highly levered with a toxic book of loans and investments.
  • Trade Wars Seem More Likely – Threatening World Trade: Recent policy moves force us to unfavorably answer question, “Am I a Clever Man (Westley) or a Fool (Vizzini)?”
  • Expanding Individual Investor Optimism: Recent fund flows are at record levels – often seen as a contrarian and bearish signpost. From Barron’s over the past weekend (H/T Randy Forsyth): “Following the stock market’s brief but violent drop in February, investors came roaring back with record purchases of equity funds in the most recent week ended on Wednesday. According to EPFR data cited by Bank of America Merrill Lynch, some $38.3 billion was poured into mutual funds, including the exchange-traded variety.” 

Bottom Line

The S&P Index closed at Friday at about 2590.

I continue to expect a 2018 trading range of 2200-2850 – with a “fair market value” of approximately 2400.

Though this has changed with the sharp rise in S&P futures this morning, the good news is that against my “fair market value” (based on my probability distribution of a host of independent variables – interest rates, inflation, corporate profits, economic growth, valuations, etc.) the upside reward, at Friday’s close, had flipped to slightly favorable against the downside risk (about 200 S&P handles of risk and 250 points of reward).

Given the abrupt change in reward vs risk and the emergence of fear and hyperbole late last week, I actually purchased some Spyders (as I disclosed on the golf course to my RMP Investment Conference III pals) at the close on Friday- some of which I have sold out in premarket trading at above $262 this morning). I plan to sell out the balance of my (SPY) long on any further strength this week.

Despite the above, against my downside target of 2200, the S&P still has an unfavorable risk (of about 400 points) relative to reward (250 points). Though the ratio is still a negative 1.5x, that’s a lot better than the 4x downside to upside that has existed for weeks.

Bottom Line, 2

The abrupt market decline in the first week of February, rally, retest, rally, retest (where we might be entering now) pattern of October, 1987, seems to have almost perfectly repeated itself in February-March, 2018. I had expected a sawtooth pattern lower over the near term (much like November-December, 1987 configuration) and a possible test of the early February, 2018 low – which we effectively saw on Friday.

That chapter (and analog) might now be closed – and we must now move on to a series of different fundamentals and relationships.

Though a rally off of Thursday and Friday’s schmeissing seems possible, I see February as a tremor to be replaced by a quake later in the year – given the numerous fundamental headwinds I have delineated in my Diary over the last few months and the substantive head winds to FANG, the market’s leading and heavily weighted sector.

Update

I continue to expect a 2018 trading range of 2200-2850 – with a “fair market value” of approximately 2400.

Though this has changed with the sharp rise in S&P futures this morning, the good news is that against my “fair market value” (based on my probability distribution of a host of independent variables – interest rates, inflation, corporate profits, economic growth, valuations, etc.) the upside reward, at Friday’s close, had flipped to slightly favorable against the downside risk (about 200 S&P handles of risk and 250 points of reward).

Despite the above, against my downside target of 2200, the S&P still has an unfavorable risk (of about 400 points) relative to reward (250 points). Though the ratio is still a negative 1.5x, that’s a lot better than the 4x downside to upside that has existed for weeks.

The abrupt market decline in the first week of February, rally, retest, rally, retest (where we might be entering now) pattern of October, 1987, seems to have almost perfectly repeated itself in February-March, 2018. I had expected a sawtooth pattern lower over the near term (much like November-December, 1987 configuration) and a possible test of the early February, 2018 low – which we effectively saw on Friday.

That chapter (and analog) might now be closed – and we must now move on to a series of different fundamentals and relationships.

Though a rally off of Thursday and Friday’s schmeissing seems possible, I see February as a tremor to be replaced by a quake later in the year – given the numerous fundamental headwinds I have delineated in my Diary over the last few months and the substantive head winds to FANG, the market’s leading and heavily weighted sector.

Yesterday’s point gain was the third largest daily point gain in history – following one of the largest declines a day ago, in a market without memory from day to day.

The proximate causes of Monday’s sharp market move was the absence of any substantive and new revelations in the 60 Minutes interview with Stormy Daniels and a less hawkish trade bark from the Treasury Secretary (over the weekend).

Monday’s advance, when coupled with this morning’s futures rise, brings us back into an overvalued zone – but not meaningfully so.

Monday’s sharp rise looked more like a rally within the context of a changing market complexion (and possible larger correction ahead) rather than the start of a new and bullish market upleg.

My conclusion that volatility is on the rise and that a widening trading range is likely has been solidified.

The new 10 VIX is a 20-25 VIX – good for opportunistic traders but not good for the buy/hold crowd. As I write, the 2018 market, unlike 2017, has more moves than a shortstop batting 110.

Tactically I would be a seller on Monday’s s strength as I continue to believe that a capitulation top was likely formed in late January, 2018 – and that price level is unlikely to be eclipsed in 2018.

Recognizing the dominance of passive and quant strategies and the nature in which they exaggerate short term market moves (as well as rising volatility), I am giving the market a wider berth than usual before I move into a meaningfully net short exposure.


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Doug Kass

Doug Kass, since 2004 Doug Kass has served as President of Seabreeze Partners Management, Inc. He runs a hedge fund and individual managed accounts, co-authored “Citibank: The Ralph Nader Report” with Ralph Nader and the Center for the Study of Responsive Law in the 1970s and wrote "Doug Kass: A Life on the Street" two years ago (John Wiley). Since 2003 Mr. Kass served as a guest host on CNBC's "Squawk Box" and has guest hosted Bloomberg's "Market Surveillance" for the last five years. Along with Jim Cramer, Doug is the principal contributor to Real Money Pro.

2018/03/27
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