Tag Archives: bond

Kass: Bull Market Complacency Is Back

  • The Bull Market in complacency has reappeared as the markets (again) disassociate from the real economy.
  • An earnings recession appears increasingly likely
  • (Always) listen to Warren Buffett

“I didn’t come this far to only come this far, so we’ve still got further to go.”- Tom Brady

“You sure that’s the question you want to ask?”- Bill Belichick

Like the dynastic rule of the New England Patriots football team, Mr. Market continued its assault higher yesterday – making it six weeks of consecutive pass completiions .

Borrowing from Monday’s column, at the core of my market concerns is the diminished outlook for economic and profit growth in 2019-2020…. and there was nothing in the recent high-frequency data or earnings reports that changes this outlook.

Indeed as noted last week, for every Facebook (FB) there is an Amazon (AMZN) or a DowDuPont (DWDP) with regard to fourth-quarter earnings

With political turmoil continuing and our thesis regarding private — and public-sector debt loads unchanged (its a governor to growth!), the market — much like in previous periods such as January and September, 2018 — has detached itself from the real economy.

One must look to the economic message of the bond market, and with a 10-year yield down to 2.638 this morning, that message is loud and clear. Meanwhile a negative (0.01%) Japanese ten year and a near negative yield on the German 10 year bund (at only sixteen basis points).

As reported in Zero Hedge last last week, 1Q2019 earnings are peaking and are expected to post an annual decline — the first such since 2016:

We have learned that this widening gap between economic and profit reality and fantasy can continue for a while, particularly with the Fed at the market’s side, as the market over the short term is a voting machine.

But, as The Oracle teaches us, in the long run, the markets are a weighing machine.

Bottom Line

  • Sellers live lower and buyers live higher
  • “Investors should remember that excitement is their enemy.” – Warren Buffett

Warren Buffett famously said that higher stock prices are the enemy of the rational investor.

Price has a way of changing sentiment. (h/t The Divine Ms M) but we should not lose sight that upside reward v. downside risk is a dynamic and quickly changing calculus.

Reward doesn’t get better with higher stock prices, it deteriorates when stocks are advancing. Often, as might be the case, sharp and unrelenting advances lull us into a false sense of security, particularly when global economic growth is so fragile and beginning to show signs of deteriorating (from a rate of change standpoint).

As I mentioned in yesterday’s Bloomberg interview, we are not quite back to the euphoria of late January, 2018 or mid September, 2018 – but we are definitely back into the Bull Market in Complacency.

It can be argued (and I do), that the market has been materially fueled, in no small measure, by the dominance and impact of the machines and algos – that worship at the altar of price momentum. More than ever, our markets have become a one-way trip (up or down) – difficult to navigate (as suggested by all the long/short hedge fund closures in the last 18 months) – and hard to interpret and trade.

As I look into February, we should remind ourselves that February may make us shiver…

And, like the first half of Sunday’s Super Bowl between the Rams and Patriots, the players may fail to make a forward pass in the months ahead.
The movie is now in reverse as the horror story of October- December has become a love story in January. The machines and algos which sold in November/December are buying in January/February, we have made up a significant portion of the post September 2018 losses.

Perhaps, like my pal Tom Lee (and the other Bulls) believe, the S&P may be headed to new highs and the New England Patriots, led by an aging Tom Brady and with coach Bill Belichick going back to his tapes, plots and schemes — are going to win their seventh Super Bowl ring in 2020.

But I doubt it.

Kass: The Death Of Supply-Side Economics

  • It Now Appears the Trump Tax Cut Is Having Little Impact on Business Fixed Investment and on Domestic GDP
  • The Tax Cut Has Had A Negative Impact on the U.S. Deficit and on Our National Debt
  • The Likely Failure of Supply-Side Economics Will Likely Weigh on 2019-20 Economic and Profit Growth and on the 2020 Elections

“The Trump administration’s $1.5 trillion cut tax package appeared to have no major impact on businesses’ capital investment or hiring plans, according to a survey released a year after the biggest overhaul of the U.S. tax code in more than 30 years.

The National Association of Business Economics’ (NABE) quarterly business conditions poll published on Monday found that while some companies reported accelerating investments because of lower corporate taxes, 84 percent of respondents said they had not changed plans. That compares to 81 percent in the previous survey published in October.

The White House had predicted that the massive fiscal stimulus package, marked by the reduction in the corporate tax rate to 21 percent from 35 percent, would boost business spending and job growth. The tax cuts came into effect in January 2018. “Reuters, $1.5 Trillion U.S. Tax Cut Has No Major Impact on Business Capex Plans: Survey” 

Despite a massive $1.5 trillion tax cut for corporations implemented at the beginning of 2018, Monday’s release of the latest NABE survey in which 84% of the participants said they have made no changes to their capital spending intentions or hiring plans, when combined with the recent evidence of slowing domestic economic growth, should question the belief and highlight the shortcomings of supply-side economics.

  1. After robust growth in business fixed investment in the first half of 2018, capital spending turned flat in the third quarter of 2018, and it appears to have continued to weaken.
  2. Following the January 2018 tax cut, real U.S. GDP surged in the second quarter of 2018 but moderated in the following quarter; the rate of change continues to decelerate

Here are some of the investment, economic and political ramifications of the possible death and growing ineptness of supply-side economics.

* Slowing domestic economic and corporate profit growth. The deceleration in the rate of Real GDP growth in 2018-2019 appears to be eerily reminiscent of 2007-2008. As noted in my 15 Surprises for 2019:

“We learn, in 2019, the extent to which economic activity was pulled forward by the protracted period of historically low interest rates, as capital spending, retail sales, housing and autos founder further.

With U.S. Real GDP growth falling to 1% to 2% in the first half of 2019, inflation remaining stubbornly high (especially of a wage-kind as the labor market remains tight) and with cost pressures unable to be passed on, the threat of recession intensifies.

By the third quarter of 2019 U.S. Real GDP turns negative. Tax collections collapse as government spending continues to rise. The budget deficit forecasts are lifted to over $2 trillion.

The U.S. falls into a recession in the last half of 2019, followed by a lengthy period of stagnating economic growth and higher inflation (stagflation).
A dysfunctional, non-unified and discombobulated Europe also falls into a recession in 2019, with significant ramifications for U.S. multinationals that populate the S&P Index.

U.S./Chinese trade tensions push the global economy down the hill as the year progresses and GDP growth in China comes in below 5.0%. The IMF reduces its global economic growth forecast three times next year.
S&P per share earnings fall by over 10% in 2019.”

* Larger deficits and a higher level of national debt. From Monday’s Political Turmoil, Huge Debt and Slowing Global Growth Underlie the Bear Case(hat tip to John Mauldin):

“For a long time, politics have had a short-term significance to the market, but the long-term driving factor was a growing semi-free, semi-capitalistic economy. Further, for almost 40 years the Federal Reserve, beginning with Volcker, provided an era of extraordinarily low rates and easy money. It let governments and businesses worldwide grow their debts alarmingly fast. As I’ve demonstrated in other letters, global debt could easily reach $500 trillion in a few years. Investors and businesses act like that is normal and can continue.

At some point, we will have a recession exacerbated by extraordinarily high corporate debt. Just like subprime mortgage debt triggered the last recession, corporate debt will trigger the next one. (I am sure there will be congressional hearings and global angst, and new rules will be instituted to limit future corporate debt, at the same time ignoring and indeed increasing government debt. Sigh.)

This corporate debt will precipitate a liquidity crisis and create havoc in all sorts of “unrelated” markets. Investors will learn, once again, that all asset classes are globally correlated in a crisis. There will be few places to hide.
But then the recession will end, as all recessions do, and recovery begin, because that is what happens after recessions. Except it will be different this time.

Recovery from the Great Recession was the slowest on record. The next recovery will be even slower. I have written about that, citing Lacy Hunt and others. Debt that is not self-funding is future consumption brought forward. We are currently enjoying consumption and growth that cannot happen in the future. Debt, then, is a drag on future growth, and the amount of debt the world now has will be a monster drag on future growth. (Note the distinction between debt for current consumption and debt for future production. There is an enormous difference.) “

* The tax cut did not trickle down, it trickled up; it produced a further widening in the gap between the haves and have nots. As Seth Klarman recently warned, the “Screwflation of the Middle Class” will likely have adverse economic, social and investment ramifications:

“Social frictions remain a challenge for democracies around the world, and we wonder when investors might take more notice of this. The recent “yellow vest” marches in France, which subsequently spread to Belgium, Holland, and Canada, began as a petition against fuel tax hikes, and grew through social media into a mass protest movement led by suburban commuters, small business owners, and truck drivers. The demonstrations, which appear to have broken out spontaneously throughout the country, became widespread and even violent. While the French government is clearly concerned – in December, it reversed the planned tax increases while announcing a higher minimum wage – the financial markets have taken the unrest largely in stride, as the French 10-year note at year-end yielded a meager 70 basis points…

Social and economic advancement in America today seems increasingly dependent on demography and geography. The economic advantages enjoyed by college graduates continue to grow. Unsurprisingly, income growth in most major metropolitan areas surpasses gains in rural areas of the country. Economic inequality continued to worsen in 2018, and for many, real wages have not increased in decades. It seems clear that economic anxiety contributed to the election of Donald Trump in 2016.The divide between Americans has been exacerbated by the echo chambers of modern- day media and the internet. Many have written of how, in only about four decades, an America of three broadcast networks has become an America of hundreds of cable channels. A few decades ago, we had less connectivity but more connection. David Brooks and others write regularly about the challenges of increased loneliness and isolation. A person today can have a thousand Facebook friends, and few, if any, actual friends.”

* Lower price/earnings ratios. The failure of the largest tax cut in three decades to catalyze economic activity is not market- or valuation-friendly.

* An opportunity for Democrats and a likely Trump defeat in 2020. As I wrote recently:

“With real GDP turning negative in 2019’s second half, Democrats attempt to replace Republicans’ supply-side economics with a smarter theory of growth. Recognizing just as inflation and other ills opened the door for criticism of Keynesian economics in the 1970s, so have inequality and disinvestment done the same for critiques of supply side today. In 2019, the Democrats turn the table on the supply-siders and give a voice through thoughtful proposed legislation, making the affirmative case for the Democratic theory of growth geared to raising wages and putting more money in the hands in working- and middle-class people’s pocket and investing in their needs. Americans enthusiastically embrace this alternative of how the economy works and grows and spreads prosperity and reject and defeat the longstanding Republican economic narrative, seeing it as a better way to spur on the economy than giving rich people more tax cuts.

Asking the question “Has it worked for you?” and given the fairy tale of added revenue from growth and the widening hole in the deficit, rampant inequality, the fear of being bankrupted by medical catastrophe and massive student debt obligations, Democrats provide a practical alternative to cutting taxes for the rich and decreasing regulation, which has failed to unleash as much innovation and economic activity as was promised by the Trump administration. The legislation, which puts more money in middle-class pockets, defends and supports the notion that the public sector can make better decisions than the private sector. Referred to as the “middle- income economic bill,” it is co-sponsored by a leading, conservative and respected Republican member of Congress and begins to gain bipartisan support in Congress, driving a stake through the supply side’s heart.”

Bottom Line

The largest tax cut in more than three decades has failed to catalyze business fixed investment and aggregate domestic economic growth, once again calling into question the virtue of supply-side economics.

This policy failure will have economic, political and market ramifications,- most of which are not market-friendly.

Kass – Market Continues To Underprice Risk

“The world’s economy is growing more slowly than expected and risks are rising.” – – Christine Lagarde, IMF Managing Director

The recent market rally, which I had expected, has not surprisingly overshot many observers’ upside expectations.

A possible explanation for the market’s extreme moves in the last two months or so is likely market structure in which the dominant force in the market (passive investors) worship at the altar of price momentum and are increasingly agnostic to balance sheets, income statements and “intrinsic values.” Indeed, in a market dominated by ETFs and quant trading (structured to “buy higher and sell lower”) and in which there is nothing like price to improve sentiment — investors seem to be ignoring the market’s shaky fundamental foundation.

The three core reasons to be bullish (and my responses) seem to be:

* A more dovish Federal Reserve – I continue to believe the Fed, facing a disappointing domestic economy, will cease rate hikes in 2019. While many see this as positive, I think it reflects slowing growth. And with federal funds at only about 2.5% there are few monetary tools to stimulate growth going forward.

* Confidence with regard to global economic growth – This view is unjustified based on high frequency economic data in the U.S. and by weakening growth in Europe and China. (See the quote from IMF’s Lagarde above) Even if interest rates are not increased, I don’t see it as a factor that will even stabilize U.S. growth. My baseline expectation is for +1% to +2% first half U.S. growth and a negative print in this year’s second half based on restrictive Fed policy (Quantitative Tightening), untenable debt loads, the widening national debt, political turmoil and a lapping of fiscal stimulus. The chances of a rate cut are increasing for this year (See my 15 Surprises for 2019).

* The improving prospects for a resolution of our trade dispute with China – Over to my right, Jim “El Capitan” Cramer makes the case (which now seems to have become consensus) that China’s economic weakness improves the chance of a negotiated trade compromise with China. This is something I strongly disagree with – as I wrote in mid-January, 2019 in “An Optimistic View of Trade Talks With China May Not Be Justified”:

“If you are going to take them on, now is the time to take them on.

That was a prevailing sentiment I got from a surprising number of people in the tech world who do not like President Trump but do endorse his policy to get China to play fair or risk the consequences of losing our market to sell its wares.

Given the timing — Sunday night we learned that China’s exports were down 4.4% in December while imports were off 7.6%, the worst since 2016, while the trade surplus with the U.S. hit a record in 2018 — I think this harsher-than-expected-view may be more realistic than most investors think…

I think it’s because China has never been more vulnerable and we have rarely been as strong as we are right now.”–Jim “El Capitan” Cramer, It is Now or Never to Push Change With China

That makes sense.

However, I don’t see the “other side’s” sense of urgency — even as China’s economy continues to disappoint. Stated simply, China thinks in a time frame of decades while President Trump thinks in a time frame of a tweet.

While a superficial agreement with China is always possible, I don’t see anything meaningful that addresses the core issues of intellectual property, technology exchange, etc.

As well, I suspect President Trump has his hands filled with other issues (the government shutdown and the border wall dispute, personal issues, etc.), and though in need of a win or a distraction, may find it difficult to focus on China.

My guess is that China guts out its economic weakness and little progress is made on trade between the two parties over the next few months. (This is a consistent view I have had).

Bottom Line

“You’ll be swell! You’ll be great!
Gonna have the whole world on the plate!
Starting here, starting now,
honey, everything’s coming up roses!”– Ethel Merman, Everything’s Coming up Roses

The market’s market structure (and limited natural price discovery) means that equities will increasingly moves to extremes, in a new regime of volatility (which will likely continue until there is the next significant “Flash Crash”). And the list of possible outcomes (many of them adverse) has never been higher in an increasingly flat and interconnected world.

Excessive pessimism and poor price action contributed to a Christmas Eve low which provided an opportunity to go long.

Excessive optimism and good price action is now contributing to a late January high which might be providing an opportunity to sell stocks.

Sorry, Ethel, everything is not coming up roses.

Kass: Follow The Money

The Tremor Before the Quake and the Fed’s $450 Billion Balance Sheet Reduction

The combination of rate hikes and balance sheet reductions from the Federal Reserve in 2018 sucked up global U.S. dollar liquidity and put emerging markets under immense pressure in 2018. Emerging market equities were 20-30% lower from February through October, then the S&P played catch-up to the downside. This, combined with tariffs from the White House, has placed global manufacturing in a significant slowdown that has begun to circle back into the United States. After all, over $60T of global GDP is OUTSIDE the USA.” – Lawrence McDonald, “Fed Cave-athon Driving Stocks Higher For Now

Why did Fed Chairman Jerome Powell’s comments on Friday get such a ringing endorsement from the equity market?

The answer is simple.

The driver to market movement is not valuations. Rather, it is the degree of the system’s liquidity condition.

Valuations generally don’t matter much when liquidity is injected and expanding price- earnings ratios don’t end bull markets.

But when markets perceive a drying up in liquidity or central bankers pivot, as in late 2018, markets suffer.

Watch the money!

The problem is not rising interest rates in 2019. Regardless of the Fed’s actions this year — and I continue to believe there will be no fed fund hikes this year — the bloated Fed balance sheet will be running off as quantitative easing (QE) is reversed.

The relationship between liquidity and capital markets volatility is inversely related. That is why in the first half of 2018 I called for a new regime of volatility, which we have gotten in spades since late September 2018. And that is why I see a continuation of heightened volatility throughout this year.

Tightened Liquidity

Last week, Dennis Gartman produced this chart of the declining monetary base: 

My pal John Mauldin, after seeing the above chart, asked Dr. Lacey Hunt to explain the ramifications. Here was his response:

“There are two important equations that show the potential power of the monetary base (MB):

  1. M2 = MB x m (the money multiplier);

  2. World Dollar Liquidity = MB + Foreign Official Holdings of US Treasury Securities

#1 means that that the base is not money but that it can be turned into money but only if little m cooperates. The determinants of little m are known, unlike those of the velocity of money. Currently, MB is declining and m is countervailing to a slight degree, but the drop in the base and the increased Federal funds rate has resulted in sharp slowdown in M2 growth from a peak of 8% per annum to slightly less than 3.9% per annum now. Slower M2 growth resulted in a sharp slowdown in nominal GDP in the third quarter of 2018.

In the fourth quarter velocity of money appears to have declined and combined with slow M2 growth has resulted in an even lower rate of growth in nominal GDP. This trend should continue well into 2019. Thus, the academic economist would say that the aggregate demand curve is shifting downward, cutting the upward sloping aggregate supply curve at a lower rate of growth in nominal GDP, with a reduced pace of growth in both real GDP and inflation.

#2 means that world dollar liquidity declines when the base falls unless it is countervailed by an increase in foreign official holdings of Treasury securities. Both of these components constitute tier one capital and can be leveraged. Presently, both components of world dollar are falling, draining liquidity in global markets. Tangible signs of this include: a sharp slowdown in M2 growth in Japan, the Eurocurrency zone and China, a drop in world stock and commodity prices as well as synchronized deceleration in major foreign economies. Chinese money growth recently fell to the lowest in four decades, while Japanese money growth was below the trough in two of the last three recessions. Equation #2 holds as long as the Fed is de facto the world’s central bank.

One other point: Excess reserves have declined far more sharply than the monetary base, serving to severely restrict the US depository institutions. Excess reserves have dropped from a peak of $2.7 trillion to $1.6 trillion. Quantitative tightening cut excess reserves about approximately $400 billion while the first eight hikes in Federal funds rate reduced excess reserves about $700 billion. We don’t have sufficient data post the ninth increase in the funds rate to yet measure its impact. QT, if sustained, will reduced excess reserves $50 billion per month in 2019 or $600 billion for the year. Thus, excess reserves would drop to slightly less than $1 trillion by the end of this year.”

Peter Boockvar noted last week that in the fourth quarter of 2017 the combined asset purchases of the Fed, European Central Bank (ECB) and Bank of Japan (BOJ) were $100 billion per month. The total dropped to zero in late 2018 and this quarter will turn negative, to withdrawals of roughly $20 billion per month.

This is a lot of liquidity coming out of the financial system.

As worrisome is the extended nature of the worldwide economic recovery that is now petering out and the political turmoil on our shores.

The Path of Global Economic Growth Has Grown More Ambiguous

The data below underscore the weakening trajectory of worldwide growth:

China: 52.4 to 49.4
Germany: 63.3 to 51.5
Eurozone: 60.6 to 51.4
Canada: 57.1 to 53.6
United States: 61.3 to 54.1

Recent data are worsening. As an example, Germany’s factory orders (just announced) fell by 5%, the greatest amount in six years.

Source: Zero Hedge

Meanwhile, the Ratio of Corporate Debt to GDP Makes A New High

A zero interest rate policy made debt a far cheaper source of capital than equity, and corporations responded in kind by borrowing from banks and accelerating issuance of debt in the public market.

But, as I have written, debt loads in both the private and public sectors are untenable and pose substantive cycle risks.

Credit markets have grown concerned with the economic slowdown and spreads have widened considerably in the last two months.

And Then There Is the Political Turmoil (Read: The Orange Swan)

* Hastily crafted policy conflated with politics, written on the back of a napkin and delivered by tweet, is joining the other risks of declining liquidity and lower economic growth.

* The disruption of the post-World War II world order by the current administration raises market and economic risks in an increasingly flat and interconnected world.

Bottom Line

“Never make predictions, especially about the future.” –Casey Stengel

I am not arguing whether Jay Powell’s pivot on Friday was right or wrong. I am arguing that money moves markets.

Leading up to late last week, market participants had grown more bearish.

That helps to explain, with the market on the verge of retesting December’s lows on Thursday, why the markets rose with so much vigor in Friday’s trading session.

Money flows move markets more than any other single independent determinant.

Regardless of the Fed’s action or inaction on interest rates this year, the liquidity risks are growing at the feet of a slowing global economy and amid political turmoil.

To use John Mauldin’s term, we were “living dangerously” late last year, and that condition likely will continue in 2019.

As to the market consequences, declining liquidity likely will serve as a governor to the upside and should provide a tailwind to the continued regime of volatility.

With so many market participants poorly positioned after Thursday’s schmeissing and with the growing pessimism in investor sentiment, I sense some runway toward higher prices over the near term.

To me, a pattern similar to 2011 seems possible.

By means of background, in 2011 the Spyders opened the year at $127, rallied to $135, dropped to $117 and closed the year at about the same price they started the year.

2019, seen as 2011:

* A beginning-of-the-year rally (an overshoot above my 2400-2500 S&P fair market value) as the markets are relieved about the Fed’s more dovish narrative and that Powell may not pressure liquidity as much as previously feared

* A first-half retest of the prior lows as it becomes clear that the U.S. economy will deliver only 1% to 2% real GDP growth

* Another liquidity rally taking us upward at year-end (where we started 2019) as the specter of QE4 moves closer to reality following a negative GDP print in the third quarter of 2019 

Kass: 10-Surprises Which Could Spike The Market 5% In One Day

Look up and not down; look out and not in; look forward and not back, and lend a hand.” – Edward Everett Hale

Make no mistake about it, the stock market panic and Bear Market of November-December 2018 is serious and profoundly threatens the economic and profit pictures.

As mentioned on Friday, a fragile domestic economy may be undermined by the negative wealth effect of lower equity prices:

“The wealth effect is a theory suggesting that when the value of equity portfolios are on the rise because of accelerating stock prices, individuals feel more comfortable and confident about their wealth, which will cause them to spend more. In 1968, for instance, economists were mystified when a 10 percent tax hike failed to put the brakes on consumer spending. Later, the sustained spending was credited to the wealth effect. Even though disposable income declined because of the additional tax burden, wealth continued to grow because the stock market persistently climbed higher.”— Investopedia

According to Wilshire Associates, the U.S. stock market fell by $2.1 trillion last week. That loss in value is more than 10% of the 2017 U.S. Gross Domestic Production (GDP) of $19.3 trillion. (Our domestic GDP represents approximately 31% of world GDP). The loss in value from the September 2018 market top is well in excess of $5 trillion, representing about 25% of projected 2018 U.S. GDP.

The fixed income’s message of slowing economic and profit growth has been resounding — and until recently has been dismissed by most who were intoxicated by rising equity prices and favorable (but lagging) economic data.

Given the steady drumbeat of disappointing high-frequency economic data that suggest consensus growth expectations are too optimistic and underscores the fragile state of the domestic economy, this is a particularly untimely period for stocks to crater.

The economy — from a rate of change standpoint — is now at a critical point. No doubt a lot of damage to forward 2019 economic growth has already occurred and will result in a reduction in consensus profit forecasts. Any further damage to the stock market will amplify the heightened and powerful headwinds of the negative wealth effect — something few have considered.

All is Not LostLook Up and Not Down

To many who have taken a large hit to their investment portfolios over the last six weeks, all seems lost.

As bad as things feel this morning (the worst month of December since 1928), all is not lost.

Though rising recession risks are expanding and the U.S. growth outlook will be tested in 2019, history shows that it truly is darkest before the dawn.

That said, investor sentiment – based on many measures – has now been reduced to pure fear, an ingredient that didn’t exist during the lengthy Bull Market in Complacency so apparent over the last 2-3 years. Under the weight of near unprecedented financial market volatility many of the most confident optimists prior to October are now the most confident pessimists today. (Like the panicky ETF holder community – who too often emotionally redeem at or near the bottom – and the levered risk parity boyz, they too often buy high and sell low).

I’m astounded by people who want to ‘know’ the universe when it’s hard enough to find your way around Chinatown.”- Woody Allen

My annual Surprise List is not about predictions. Rather, my Surprise List incorporates the notion of Possible Improbables. In sports, betting my surprises would be called an “overlay”, a term commonly used when the odds of a proposition are in favor of the bettor rather than the house.

The List is the outgrowth of five core lessons I have learned over the course of my investing career:

  1. How wrong conventional wisdom can consistently be.
  2. That uncertainty will persist.
  3. To expect the unexpected.
  4. That the occurrence of Black Swan events are growing in frequency.
  5. With rapidly changing conditions, investors can’t change the direction of the wind, but we can adjust our sails (and our portfolios) in an attempt to reach our destination of good investment returns.

With the S&P (cash today at 2350 and not 2930 – the September high), today’s Top Ten (surprises) take a different and more upbeat tone that my year end 15 Surprises for 2019.

Given my calculus that the S&P’s “fair market value” is approximately 2450, we should begin to look up and not down as the upside reward v. downside risk has finally shifted into positive ground.

Two quotes, one from an acquaintance (The Oracle of Omaha) and one from a friend (By) come to mind this morning:

“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.” – Warren Buffett

“Disasters have a way of not happening.” – Byron Wien

And we should be considering what positive Surprises may occur that could reverse the carnage of the last few months in our markets…

My Top Ten List

Here are the Top Ten possible events that could cause stocks to rise by at least 5% in one trading session:

1. An announcement by the Federal Reserve that it plans to transition from the rigid language of “gradual increases” to a more flexible economic data and market dependent policy. Investors immediately interpret this message to mean that the Fed will (1) cease interest rate increases (in 2019) based on the tightening financial conditions, and (2) will likely slowdown the reduction in the size of their balance sheet.

2. Europe extends QE and it gets authority to buy European stocks. Mario Draghi decides not to retire next year.

3. China introduces a major easing policy that has substance, clout and power.

4. Treasury Secretary Mnuchin resigns and is replaced by Hank Paulson.

5. The U.S.China trade war ends with a full resolution.

6. Democrat Joe Biden and Republican Mitt Romney, aiming at bringing back national unity, jointly declare they are running on the same ticket for President and Vice President in 2020.

7. The Mueller investigation concludes that the President was guilty of collusion and obstruction. Trump immediately resigns and Mike Pence becomes the President of the United States.

8. The SEC initiates broad reform aimed at curbing the dominance of high frequency (quant) strategies and products and reestablishing the uptick rulePassive investing begins to lose market share to active investing.

9. On the same day that Berkshire Hathaway (BRK.A) (BRK.B) announces a premium bid for 3M (MMM) , KKR and Blackstone announce separate $25 billion acquisitions. Apple (AAPL) follows this M&A explosion with a proposed leveraged buyout, (also) partially financed by Berkshire Hathaway.

10. On the same day, 1Q2019 earnings for Amazon (AMZN) and Alphabet (GOOGL) report substantially better than expected results.

We’ll see.

Kass: Nowhere To Run, Nowhere To Hide?

“Nowhere to run, baby, nowhere to hide
Got nowhere to run to, baby, nowhere to hide
It’s not love I’m running from
It’s the heartbreak I know will come
Cause I know you’re no good for me
But you’ve become a part of me
Everywhere I go, your face I see
Every step I take you take with me…” – Martha Reeves and the Vandellas, Nowhere to Run

For the past year I have concluded that the market was vulnerable to a number of factors and was likely making an important top and likely setting up for a Bear Market:

  • Global economic growth was becoming more ambiguous and the fragility of worldwide growth would be shortly exposed
  • An avalanche of debt would serve as a governor to growth
  • Corporate profit expectations for 2018-20 were too elevated
  • The pivot to monetary restraint by the Federal Reserve (taking the punch bowl away) would be market unfriendly
  • With less liquidity would come a new regime of volatility
  • The risks of fiscal and monetary policy mistakes were growing
  • The behavior of the President and hastily crafted policy (e.g. the U.S. retreat from Syria) would make economic uncertainty and market volatility great again (#muvga)
  • The reduction in the corporate tax rate has failed to deliver the growth expected to reduce the burgeoning deficit – the benefit has trickled up and not down
  • Market structure represented a potential market threat that was being underestimated
  • Investors, participating in The Bull Market of Complacency, were ignoring the risks of a large market drawdown

I concluded that the notion of T.I.N.A (“there is no alternative) was no longer applicable and that rising short term interest rates made the compelling case for C.I.T.A. (“cash is the alternative”):

Chart Courtesy of Charlie Bilello of Pension Partners

Out of 15 major asset classes ranging from stocks to bonds to REITs to Gold and Commodities, only one is higher in 2018: Cash.

After the markets responded quite vigorously to the corporate tax reduction and cash repatriation bills in January, markets swiftly moved higher – making a top near month end. Consolidation and a multi-month period of choppiness followed but the markets made a new high by mid-September at about 2920.

The toxic cocktail of the above factors have contributed to a more than 400 handle drop (-13%) in the S&P Index to 2500 currently – below my (short term) expected trading range of 2550-2700.

Back in early July I presented this suite of projections for the S&P Index – which proved reasonably prescient, and to the penny we have just hit my six month projection of S&P 2500 (!):

By the Numbers

As SPYDERS moved towards $273 yesterday afternoon — on a full day spike in the S&P Index of over 20 handles — I moved back to market neutral.

Should the S&P Index climb back to 2,750-2,750 (my very short term prognostication), I will move back again to a net short exposure, as downside risk expands over upside reward.

My gross and net exposures remain light in a background of uncertainty (e.g., current trade battle with China) and in the new regime of volatility. Quite frankly, I am playing things “tight” in light of these factors — and in consideration that I have had a very good year thus far.

Again, my expectations below should be viewed not with precision, but rather as a guideline to overall strategy:

Very Short Term (in the next five trading days)

–Higher, but not materially so. 2,750-2,775 seems a reasonable guesstimate. 

–I plan to scale into a net short position on strength, but I will give the market a wider berth today and into the first few days of the second half (inflows expected). 

Short Term (in the next two months)

–Lower, but not materially so. 

–I expect a series of tests of the S&P level 2,675-2,710. 

Intermediate Term (in the next six months)

–Lower, a break towards “fair market value” of about 2,500 is my expectation. 

More Lessons Learned

When we ask for advice we are looking for an accomplice.”– Saul Bellow

The investment mosaic is complex and Mr. Market is often unpredictable.

There is no quick answer or special sauce to capture the holy grail of investment results – it takes hard work, common sense and the ability to navigate the noise.

The common thread of these naked swimmers are self confidence, smugness and the failure to memorialize their investment returns (because the typically are so inconsistent and dreadful).

They are bad and deceptive actors who are in denial to themselves and are artful and accountable dodgers to the investing masses.

“In my next life I want to live my life backwards.– Woody Allen

Take Woody Allen’s advice (above) – be forewarned and learn from history as common sense is not so common as:

“A nickel ain’t worth a dime anymore.”– Yogi Berra

– Kass Diary, Who’s Swimming Naked?

I have spent a lot of time over the last few months exposing the bad actors who, we learned, were swimming naked this year; as the market’s tide went out.

I did so, not because of any hatred but because I saw this also in 2008-09 and we should finally be learning from history so that we don’t call on those same resources in the futures.

Where Do We Go From Here?

“I’ll just conclude by saying most of the issues we are dealing with today are induced by bad political choices.– Fred Smith, CEO Of FedExpress (conference call)

Over the last year I have consistently written that “fair market value” (based on a multi-factor analysis) for the S&P Index was between 2400-2500 – well below the expectations of every major Wall Street strategist. I posited that 2018 would be the first year (in many) in which the revaluation of price earnings ratios would be headed lower. (Multiples are down by nearly 20% this year).

The major indices have had the worst month of December since the Great Depression – declining by about -9%. Though many pin the loss (especially yesterday’s) on the Federal Reserve’s actions and communications, the recent market drawdown is a function of the reality of the headwinds I listed at the beginning of this morning’s missive (that most have dismissed).

We are now at 2500 (down from 2920 three months ago) – which means the market is at the upper end of being fairly valued for the first time all year. It also means that an expanding list of stocks are now attractive if my recession expectations prove unfounded.

Expanding problems facing the White House and policy blunders (underestimated by investors – see FedEx quote above), reduced domestic economic expectations and a continuation of Fed tightening (and balance sheet drawdowns) have contributed to the latest market swoon. That drawdown has occurred in a backdrop of rising fear and some extreme sentiment readings – abetted by a changing market structure in which passive products and strategies “buy high and sell low.”

As posited this week I believe we are now going to have a playable year end rally from here but as we move into the New Year things get more problematic.

In my Surprise List for 2019, I wrote:

Surprise #3 Stocks Sink

“Though the third year of a Presidential cycle is usually bullish – it’s different this time.

Trump confusing brains with a bull market can’t fathom the emerging Bear Market. At first he blames it on Steve Mnuchin, his Secretary of Treasury (who leaves the Administration in the middle of the year). Then he blames a lower stock market on the mid-term election which turned the House. Then he blames the market correction on the Chinese.

The S&P Index hits a yearly low of 2200 in the first half of the year as the market worries about slowing economic and profit growth and a burgeoning deficit/monetization. The announcement of QE4 results in a year end rally in December, 2019. In a continued regime of volatility (and in a market dominated by ETFs and machines/algos), daily swings of 1%-3% become more commonplace. Investor sentiment slumps as redemptions from exchange traded funds grow to record levels. The absence of correlation between ETFs and the underlying component investments causes regulatory concerns throughout the year.

Congress holds hearings on the changing market structure and the weak foundation those changes delivered during the year.

Short sellers provide the best returns in the hedge fund space as the S&P Index records a second consecutive yearly loss (which is much deeper than in 2018).

As the Fed cuts interest rates the US dollar falls and emerging markets outperform the US in 2019. The ten year Treasury note yield falls to 2.25%.

I, like many, are concerned about corporate credit (See Surprise #8) and though credit is not unscathed, it is equities that bear the brunt of the Bear since they are below credit in the company capitalization structure.

Bottom line, after a steep drop in the first six months of the year, the markets rise off of the lows late in the year in response to this shifting political scene (the decline of Trump) and a reversal to a more expansive Fed policy – ending the year with a -10% loss.”

Bottom Line

* For now, think like a trader and not an investor”

The illusion of positive possibilities is fading quickly in a market hampered by political turmoil and strapped with untenable debt loads.

The key to delivering superior investment performance in 2018 was not a buy and hold strategy. Rather, it was opportunistic and unemotional trading and for the foreseeable future this will likely be the case.

While I believe we are likely to rally into year end, the near term upside to that rally has been markedly reduced (though I still believe we can reach to at least 2600 or so on the S&P Index by year end, a gain of 100 handles or more) — the likelihood of a recession and Bear Market in 2019 has increased.

Good morning Vietnam!

Kass: Top 10 Reasons Why We May Be Entering A Bear Market

It’s okay to be wrong; it’s unforgivable to stay wrong.” Marty Zweig, (October 16, 1987 Wall Street Week – at six minute and 40 second mark!)

As observed on Wall Street Week 31 years ago by Lou Rukeyser, the Dow Jones Industrial Average “crashed” by more than 230 points in the week ending October 16, 1987 – knocking out all previous records. In the aforementioned video (above) Lou cited a tumbling in Treasury bonds, jitters in the Persian Gulf, an discouraging political situation, scary layoffs on Wall Street and, of course, the mindless computer based (“portfolio insurance”) selling. (Full disclosure I managed some of the family’s wealth while a General Partner at Glickenhaus and Co.)

Sound familiar? It is (as last week’s market dive was also conspicuous in it’s character)!

But the worst was yet to come on the following Monday (October 19, 1987) , when the DJIA dropped by 22% on the day.

As I have often noted history rhymes – though history doesn’t necessarily repeat itself. And (as Benjamin Disraeli reminded us), what we have learned about history is that we have not learned about history.

Beginning early this year I argued that the market was in the process of making an important top. I described a market top and bottom as resembling an ice cream cone – that tops are processes and bottoms are events.

With the benefit of hindsight it is clear that the market’s nine year uptrend and Bull Market have likely been broken.

The question is whether we are entering a full fledged Bear Market.

While I believe we may get some seasonal respite over the next two weeks, I would conclude (with the normal caveats) that we have not only broken the Bull Market uptrend but that the odds are rising that we may be approaching a Bear Market.

At 103 months, we are currently into the second longest Bull Market in modern investment history. (The 1990-2000 Bull Market lasted 110 months). On average, those seven Bull Markets have lasted 76 months. And, on average, the mean decline from the peak of the last six longest Bull Markets has been -51%.

Here are the top ten reasons why we may be entering a Bear Market:

1. Markets Generally Move in Anticipation of a Change in the Rate of Economic and Corporate Profit Growth – That Path and Trajectory Are Deteriorating: Since 1860 there has been at least one recession in each decade – representing 47 recessions since the Articles of Confederation was approved in 1781. We have not yet had a recession in the current decade but, my view is that this decade will not be spared and that we will likely be in a recession in the second half of next year. (See my 15 Surprises for 2019).

2. President Trump is Making Economic Uncertainty and Market Volatility Great Again (#MUVGA). Trump’s more frequent and incendiary twitter utterances and behavior reflects badly on him, his office and our country. His conduct and policy (often seemingly written ad hoc on the back of a napkin) are arguably beginning to adversely impact our markets as his Administration’s dysfunction and policy (conflated with politics), and have begun to reduce business and consumer confidence and is starting to negatively influence the real economy.

We are in a unprecedented politically toxic and divisive backdrop – which was underscored during Wednesday’s funeral for President George H.W. Bush. As my good pal Mike Lewitt (‘The Credit Strategist’) wrote over the weekend,

The saddest thing is not that Bush passed – it was his time – but that his generation is succeeded by a bunch of greedy, narcissistic empty suits.”

This is happening at a point in history where the world has grown more complex, interrelated, networked and flat. With these conditions in place, there are more dominoes today than yesterday and more yesterday than the day before. Again, from Mike,

“The next crisis is approaching and not only is it self-imposed but we are ill-equipped to manage it precisely bc there are few men like George H.W. Bush to lead us.”

a. The United States is leaning more and more “purple” – moving to the Left at a time that the Right is feeling terribly insecure after 10 years of The Screwflation of the Middle Class (something I initially discussed in an editorial I wrote for Barron’s in 2011). The schism between the “haves and have nots” has not been addressed by policy (and has been worsened by the trickling up from the tax bill, which was intended to trickle down and by such provisions as real estate tax and mortgage interest limitations which have served to dent the residential real estate market). Further neglecting or failing to narrow this split will likely have grave social, economic and market ramifications down the road (or sooner).

b. It is becoming increasingly clear that the 2016 election was materially a vote against Hilary Clinton. Trump’s road to nomination in 2020 is growing more precarious and the odds, after barely winning the first time, are not favorable that he wins reelection (given the Wisconsin voting results as well as the outcomes in Michigan and Pennsylvania). It is hard to see markets prospering with Washington D.C. in such a mess – preventing anything from getting done on deficits, debt, taxes, spending and infrastructure.

c. “The Orange Swan” has grown increasingly untethered in the face of divisive and extremely partisan midterm elections (that brought the House under Democratic control), the implicit threats of the Mueller investigation, the hostility of the Kavanaugh hearings, the controversy surrounding the Khashoggi killing, etc. The White House’s dysfunction and repeated personnel changes would be laughable if they weren’t so sad. Most recently, a hardline approach on trade (with China) seems to have tipped over the markets in recent days. Increasingly, short term solutions are being advanced in the face of long term problems. (A classic example is our burgeoning deficit, endorsed by both parties, that is unchecked and is running wild this year).

d. As we are move further from the midterm elections. my core expectation is that the President will likely be impeached by the House. Though there may be far less reasons for Senate Republicans to tie their political futures to such an individual – especially with a plethora of qualified Republican presidential hopefuls – the Senate vote on impeachment could be closer than many expect.

3. A Pivot in Monetary Policy: For years a zero interest rate policy in the U.S. has served to repair the domestic economy as it came out of the Great Recession in 2007-09. Unfortunately it has had second order consequences like pulling forward economic growth – already seen in Peak Housing and Peak Autos. Artificially low rates have served to protect many corporations who have been temporarily resuscitated. Some of those should not have been permitted to survive – and they won’t in the next recession. This served with liberal loan terms (“covenant lite”) could produce a surprisingly steep economic downturn compared to consensus expectations.

4. Economic Growth and Profit Estimates Are Substantially Too High: With U.S. Real GDP forecast to fall back into the +1% to +2% range in 2019’s first half and turning negative in the second half, the contraction in valuations (so apparent thus far in 2018) may continue in 2019. (See my 15 Surprises for 2019). Over there, matters are worse. England has never been more divided (Brexit), Italy (one of the largest economies in the EU) is on the economic deathbed, Deutsche Bank (DB) (and its monstrous derivative book, poor loan quality and systemic money laundering) is the most dangerous financial institution in the world and two of Europe’s most important leaders (Merkel and Macron) are so unpopular that both may be on the way out.

5. The Chinese Challenge to U.S. Hegemony Is a Battle For the Next Century – It Will Likely Be Long Lasting, Disruptive to Current Supply Chains and Costly to Profits: We have likely started a lengthy ‘Cold War in Trade’ with China – a time frame measured in years not (three) months.

6. The Apple Complex (its suppliers) Have Been Upended by a Maturing High-End Smart Phone and Weakening iPhone Market and The Social Media Space is Under Increased and Costly Regulatory Scrutiny: These factors have a broad impact on the market leading technology stocks and for the market as a whole. Moreover, over the last decade technological progress has outpaced regulatory supervision – but this is now being reversed as the social media companies now face the existential threat of rising regulations. The costly imposition of regulatory oversight is something I have been writing about for over a year.

7. An Avalanche of Debt: The private and public sector are levered more than any time in history as, rather than addressing the flaws in our system, we tried to solve the last debt crisis with trillions of dollars of more debt. It is the existence of this mountain of debt that has delivered a fragile economic recovery despite a 2 1/4% Federal Funds rate. Given this, a rate hike of only 25 basis points today has about the same impact of 75 basis points a decade ago. As such that accumulated debt loads are vulnerable to a weakening economy and/or rising interest rates (there have been eight rate hikes since the 2016 election.

8. The Market’s Structure Has Made Equities More Vulnerable Than At Any Time Since October, 1987 (see the Wall Street Week interview from October 16, 1987, above): Passive products and strategies (which are generally agnostic to fundamentals) are the dominant factors in market trading. Like “Portfolio Insurance” 31 years ago, they “buy high and sell low.”

9. With Short Term Interest Rates Now Meaningfully Above the Dividend Yield on the S&P 500 Index – There Is Now an Alternative to Stocks: The dividend yield on the S&P is about 1.8% compared to a one month Treasury note rate of 2.35%, a six month note yield of 2.54% and a one year note yield of 2.68%. Goodbye T.I.N.A. (‘there is no alternative’) to C.I.T.A. (‘cash is the alternative’). In terms of valuations, too many look at Non GAAP earnings (15-16x forward EPS) and ignore the record difference between Non GAAP and GAAP which would move the price earnings ratio to close to 20x. As well price to book, price to sales, market capitalization to GDP and Shiller cyclically adjusted P/E ratio speak (graphic) volumes about the degree of overvaluation today.

10. Technical Damage: Uptrends in place for nearly a decade have been reversed.

More Marty

On a more upbeat note, here is some more wisdom from the legendary Marty Zweig:

  • Patience is one of the most valuable attributes in investing.
  • Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.
  • Success means making profits and avoiding losses.
  • Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major decision.
  • The trend is your friend.
  • The problem with most people who play the market is that they are not flexible.
  • Near the top of the market, investors are extraordinarily optimistic because they’ve seen mostly higher prices for a year or two. The sell-offs witnessed during that span were usually brief. Even when they were severe, the market bounced back quickly and always rose to loftier levels. At the top, optimism is king, speculation is running wild, stocks carry high price/earnings ratios and liquidity has evaporated. A small rise in interest rates can easily be the catalyst for triggering a bear market at that point.
  • I measure what’s going on and I adapt to it. I try to get my ego out of the way. The market is smarter than I am so I bend.
  • To me, the “tape” is the final arbiter of any investment decision. I have a cardinal rule: Never fight the tape!
  • The idea is to buy when the probability is greatest that the market is going to advance.

Bottom Line

“More than any other time in history, mankind faces a crossroads. One path leads to despair and utter hopelessness. The other, to total extinction. Let us pray we have the wisdom to choose correctly.” – Woody Allen

Slowing economic growth, lower than expected profit growth, an untethered President, a dangerous change in market structure (impacting the trading transmission) and the other conditions listed in my Top 10 (above) provide robust headwinds to the U.S. stock market in 2019.

A hugely underappreciated fact is that because of the large accumulated debt loads in the private and public sectors over the last decade, a 25 basis point rate hike today is equivalent to almost a 75 basis point rate hike in 2008. So the eight hikes since the 2016 election is equivalent to almost 24 hikes of the past!

As is often the case in a maturing economic recovery and an extended Bull Market we are now finding out who is swimming naked. That tide is moving out further than at any time since the Generational Low in March, 2009.

Volatility, inversely related to liqudity, has entered a new regime – not seen since the early 2000s – providing a further challenge to investors’ confidence as they have grown unaccustomed to large daily market swings.

The Bull Market uptrend, in place for almost a decade, is now being threatened – investors are underpricing and under appreciating risk.

I am sticking to my baseline expectation that the market has been making an important top since late January, 2018, and that a Bear Market may be imminent.

Indeed, the four decade benign backdrop for financial assets may now be over.

I remain in the 2550-2775 S&P trading range camp over the next month (the Index closed at 2633 on Friday) – implying a slightly positive reward v. risk ratio skew:


Source: NorthmanTrader.com

There were some positive divergences (e.g., number of NYSE new highs v. new lows) on Friday as well as some other near term positives including the positive RSI and MACD divergences which resemble the 2015 and 2016 lows and show the potential for double bottoms.

While my view is that we might get some seasonal strength in the next few weeks, the upside will likely be limited and could set the stage in 2019 for a far more challenging year than in 2018.

Heed Marty Zweig’s pearls of wisdom (above).

I am.

Kass: China’s “Trump & Dump” or “He Said, Xi Said”

“I will eat my hat if this means anything substantive”… as “neither side is fully ready for war, but neither side will budge.” – Michael Every, Rabobank’s Head of Asia financial markets

  • Xi is the “Wolf of Wall Street”
  • The weekend agreement may backfire
  • We may have three months of uncertainty that freezes business decision making – U.S. economic growth may slow and not reaccelerate
  • An explosive market advance based on this weekend’s U.S./China trade news may provide one of the best shorting opportunities since September, 2018
  • He said, Xi said
  • Last night I moved (with futures +48 handles) from a small net long exposure to a small net short exposure
  • I plan to expand my short book on any further near term market strength

A “pump and dump” scheme is a well known securities fraud that involves artificially inflating the price of an owned stock through false and misleading positive statements, in order to sell the cheaply purchased stock at a higher price or to otherwise benefit from the declaration.

Over this weekend, the trade war between China and the U.S. temporarily ended with a truce in which the U.S. agreed to keep the rate on existing tariffs for an additional $200 billion of goods at 10% for another three months in return for greater purchases of American goods. (In addition, China’s policy towards Taiwan and a nuclear free North Korea was also agreed by Xi and Trump).

President Trump has heralded the deal as “incredible,” but like the pump and dumpers in the brokerage boiler shops in Boca Raton, Florida and Long Island of years ago, the agreement had little substance in the face of the forceful and powerful deal headwinds and China interests – which principally involve the very structure of China’s economy, the nation’s reputation and the Chinese party’s authority.

While the worst-case G-20 meeting scenario (never a very likely outcome) is off the table, I couldn’t disagree more with the market’s Pavlovian response (with S&P futures +48 handles as I write this missive on a plane to Los Angeles yesterday). Indeed, of the hopes for good news heading into the weekend, the proposed agreement was on the lowest rung of positives. (Remember that Trump, many months ago, had rejected a Chinese deal to buy more U.S. “stuff.”)

I see the “agreement” as nothing more than a Chinese “Trump and Dump” scheme (though the meeting was anything but a “cold call”) – full of sound and fury signifying nothing – which failed to make tangible progress regarding the core and deep rooted structural divides that separate business practices and other fundamental differences. (Including, but not restricted to intellectual property rights, forced technology transfers and public sector subsidies for strategic industries).

The deal was a “nothing burger.”

It still leaves us with 10% tariffs which are not helpful and fails to solve the underlying problems. Effectively, all the agreement did was to punt the ball for another three months.

No All Clear Signal

Indeed the “agreement” might cause more uncertainty and a slowdown in U.S. economic activity and capital spending
China has effectively executed a “Trump and Dump” scheme that will likely artificially raise the short term trajectory of stock prices as poorly positioned market participants reposition – only to recognize, in the fullness of time, that the buyers of stocks on the news have likely been duped.

This agreement comes at a time that the Chinese and American markets are on the precipice of Bear Markets. It’s soothing message, which to some, may result in buying a continued ramp in U.S. equities , may be nothing more than providing an opportunity for China to resume aggressive means to reaccelerate domestic economic growth (like reducing margin requirements last evening).

He Said, Xi Said!

Not surprisingly, there was no joint statement following Saturday’s dinner. China didn’t reference the 90 day deadline nor did the U.S. highlight the One China policy. Rather, the agreement itself has already been interpreted differently by both parties – based on the official responses from the two countries.

For the U.S. there is a real risk that the three month hiatus or cooling off period may have the absolute contrary results – it could serve to spur more business uncertainty – delaying purchases and capital expenditures. This comes at a critical time in which signposts of growth domestically and overseas are worrisome and during a continuing pivot of monetary restraint.

Bottom Line

“You only think I guessed wrong! … You fool! You fell victim to one of the classic blunders – the most famous of which is “never get involved in a land war in Asia” – but only slightly less well-known is this: Never go in against a Sicilian when death is on the line!” – Vizzini,The Princess Bride

China has executed the perfect “Trump and Dump” scheme. The President didn’t receive a phone call from someone just as devious as Stratton Oakmont’s Jordan Belfort – he sat over dinner with him!

Trump has bought (and has apparently persuaded others overnight) into Dollar Time Group and the Aquanatural Company at the top without any knowledge of the company with the hope of riches, the need to show a “deal” (Its been a bad few weeks with Jamal Khashoggi, Michael Cohen, a weakening of the U.S. economy, the downtrend in markets, etc.) and the desire to be more popular.

And so might investors have been duped who buy the post trade agreement euphoria (S&P futures are +48 handles at 6:30 pm on Sunday night ) – with the quixotic ease of a phony deal and “quick buck” anticipated.

The divergence in world views between China and the U.S. were not addressed on Saturday. That schism is fundamental, structural and the rift will likely be long lasting – measured in years not weekends.

It is also my view that this weekend’s trade agreement may serve to further slow down domestic economic growth as businesses grow more uncertain of the ultimate outcome and recognize that this trade dispute will be measured in years and not in weekends.

As I wrote last week:

“I have written much about trade over the last few weeks – most recently this week’s “Is Trump Manipulating the Market With His Frequent China-Trade Comments? #MUVGA!”

What follows is a great quote made in 1972 by Chinese Premier Zhou Enlai — it’s something to keep in mind when listening to opinions on the subject of China/U.S. trade.

When he was asked about the impact of the French Revolution (of 1789), he replied “It is too early to tell.”

That quote is from sixty years ago.

Unlike many, I believe the Chinese can outlast us in a trade war.

China is a patient civilization. The country takes the long view of history (often measured in hundreds of years) — as expressed in the witty and Oscar Wildean response above by Enlai.

While Americans are focused on 2020, the Chinese are focused on 2120!

The hardliners in the White House and the dopes on Wall Street don’t have a sense of history.”

I see nothing in this weekend’s agreement to alter the view that the dispute will be long lasting (with similar characteristics of the beginning of the 1948 “Cold War) and is likely to be more far reaching than trade. (See Spence’s two recent speeches at The Hudson Institute and at APEC, here and here

With both leaders facing their own problems, Xi got Trump to kick the can down the road for another 90 days without extracting much in return. Our President heralded the agreement as a victory (and he will likely voice that in tweets today about the market’s spectacular response) though he exacted only a temporary respite from what will likely be years of negotiations and rifts.

In the next few weeks (or even days), we may very well witness the best shorting opportunity since the end of January and September.

China has executed a perfect “Trump and Dump” scheme, buying more time (at little expense).

Don’t be duped, too.

Position: Short SPY

Kass: There Is Nothing Like Price To Change Sentiment

“Tops are a process, bottoms are an event.” – Wall Street adage

It is remarkable to me how, as Divine Ms. M puts it, “There is nothing like price to change sentiment.”

Some of the same people in the business media who were Bearish last Thursday (well, even Tuesday), are now Bullish based on a Federal Reserve who said (and always has been) data dependent.

It is amazing to me how so many investors mark-to-market their market views on an increasingly short term basis. However, to this analyst, a one day (or even three day advance) doesn’t reestablish a “confirmed uptrend” when the signposts of a more meaningful market topping process are still likely intact.

The question at hand this morning is whether it is wise to follow yesterday’s remarkably strong advance (the second best gain of the year) and to conclude that all is safe?

From my perch, that would be foolish – based on the core problem facing the global economy. That is, growth is slowing… and that the slowdown is accelerating. Indeed, for the first time since September, 2017, the Bloomberg Economic Surprise Index has turned negative – as housing (the President blew up the residential real estate market with his tax bill!!), core durable goods, industrial production, jobless claims, consumer sentiment and regional Fed manufacturing data disappoints:


Source: Zero Hedge

There was less than meets the eye in the 3Q GDP print – as if we take out inventory growth (the largest rise in seven years), growth in real GDP would have been under +1.25%.


Source: Zero Hedge

We only have to look at the yield on the ten year U.S. note (which seems likely to break 3% shortly) to see how the fixed income markets are envisioning such an economic growth slowdown. (Remember in my 15 Surprises for 2019 I am looking for a 2.25% low yield in the first half of next year!) Moreover, the price of crude oil just broke below $50/barrel (to $49.80) – another indicator of moderating economic growth.

Meanwhile, how quickly investors have forgotten the current pivot in monetary policy with the Fed’s balance sheet still shrinking by $50 billion per month and the ECB only one month away from ending QE.

Here are some relevant tweets from Rosie (David Rosenberg at Gluskin Sheff):

  • The irony with Powell is what history tells us about what happens when the Fed pauses. The inevitable recession starts six months hence. The bulls should pray he has reason to keep tightening
  • But a market that is so hitched to every word or nuance a central bank official has to say cannot possibly be viewed as a particularly healthy one.
  • Before Powell’s remarks, we had 37% of investors betting on at least three Fed hikes for 2019 and that was dialed down to 32% by the end of the day. How that translates to a 617 point surge in the Dow truly is anyone’s guess.
  • Here’s how you know the stock market is way over-reacting to Powell – the one security that should have screamed “rally!” based on any dovish Fed is the 2-year T-note…and the yield is down a grand total of 2 basis points today??
  • Powell blinked! The gap between being “a long way” from neutral to being “just below” was a measly 25 basis points! Who knew?

That Powell blinked (slightly) and the Federal Reserve has come to the same recognition as some of us bears on the economy does not seem supportive of the degree of enthusiasm seen in the markets on Wednesday.

In “Yell and Roar and Sell Some More“, I wrote:

“On the spectacular market strength post the Powell comments, I have continued to fade the machines, algos and price momentum based strategies that “buy high and sell low” today.

This counter punching (both on the downside when I bought and on the upside when I am now selling) got me to the dance – and I am not changing my tactics nor am I changing my tactical approach to the market based on the difference between the current S&P level relative to the expected trading range for the S&P Index which has resulted in an increasingly unattractive reward v. risk.

I may be wrong, but, in my view, the Fed wasn’t likely going to be aggressive in 2019 based on the deterioration in domestic economic fundamentals I have frequently pointed to in my Diary. In fact, my Surprise List for 2019 incorporates NO rate hikes. Rather I see a rate cut in the second half to be followed by another round of quantitative easing as GDP turns negative.

I am holding on to ALL of my individual longs but I continue to build up my (SPY) short.”

Tactically and despite the strength exhibited at this time of the season I began to hedge my medium-sized long exposure yesterday afternoon – by shorting Spyders (SPY) , on average at a price of about $273.50 (I scaled that short from $272.30 to $274.30). This put me back to market neutral in exposure.

S&P cash closed on Wednesday at slightly over 2740 (SPY equivalent of $274.50) and I plan to move back into a net short position on further strength towards the high end of my three to six months trading range of 2550-2775.

Bottom Line

There is little doubt that the dovish tilt provided by Fed Chair Powell lit the market’s fire.

But there is also little doubt that the move was exaggerated by market participants’ poor positioning and the dominance of passive strategies (ETFs and Quants) who exacerbate daily moves – similar to what happened on the day after the midterm elections (but that time, to the downside) when, in a quite similar image to Wednesday’s 60 point S&P advance, rallied from 2755 to 2813.

Despite the resounding rally yesterday, the backdrop of global economic and corporate profit growth is shaky and my baseline expectation is unchanged – the Fed will not hike interest rates in 2019 as Real GDP may display a stunningly swift descent over the next three quarters. So I am, frankly, nonplussed by Powell’s verbiage.

I would observe that with yesterday’s 600 point rise in the Dow Jones Industrial Average, the cumulative increase of all the up-days this year is nearly 22,000 points. The last time that happened was in the Bear Markets of 2000 and 2008.

Indeed, the S&P Index is still more than 5% lower than the last Powell comments weeks ago.

So the Dow pops 354 points – add up all the up-days in 2018 and they come to over 21,000 points. Last time we came close to that was in 2008 and before that 2000. In other words, these happen in bear markets!

To me, Wednesday’s rally was part and parcel of an important topping process that began in late January, 2018 fully described in July in Tops are Processes and We May in That Process Now:”

“Tops are a process and bottoms are an event, at least most of the time in the stock market. If you looked at an ice cream cone’s profile, the top is generally rounded and the bottom V-shaped. That is how tops and bottoms often look in the stock market, and I believe the market is forming such a top now.

Consider the following fundamentally based issues and concerns:

* Downside Risk Dwarfs Upside Reward. I base my expected market view on the probabilities associated with five separate (from pessimistic to optimistic) projected outcomes that seize on a forecast of economic and corporate profit growth, inflation, interest rates and valuation. In the past I have suggested that this exercise is a guide and is not intended to be a precise calculation, especially in uncertain times. The averages recently have surpassed my expectations of a top in the trading range by about 120 S&P points, or about 4%. With the S&P 500 Index at 2923 at Friday’s close we are significantly above my calculation of intrinsic value.

* Global Growth Is Less Synchronized . The trajectory of worldwide growth is becoming more ambiguous. I have chronicled extensively the erosion in soft and hard high-frequency data in the U.S., Europe, China and elsewhere, so I won’t clutter this missive with too many charts. But needless to say (and as shown by these charts here and here), with economic surprises moderating from a year ago and in the case of Europe falling to two-year lows, we are likely at “Peak Global Growth” in the current quarter. (The data are even worse in South Korea, Taiwan, Indonesia and Thailand.)

* FAANG’s Dominance Represents an Ever-Present Risk. I have warned that earnings disappointments in the FANG stocks represents an immediate risk to this league-leading sector, and to the markets FANG has become GA! Since I initially wrote this article investors have been clearly rotating out of FANG, reflecting misses in important metrics (subs) and some lower broader guidance ahead. As well, the existential threat of increased regulation and antitrust hostility that I warned about nearly a year ago are now on the front burner.

* Market Structure Is One-Sided and Worrisome. Machines and algos rule the day; they, too, are momentum-based on the same side of the boat. The reality that “buyers live higher and sellers live lower” represents the potentially dangerous condition that investors face in a market dominated by passive investors — a threat I have focused on since early 2017.

* Higher Interest Rates Not Only Produce a More Attractive Risk-Free Rate of Return, They Also Make It Hard for the Private and Public Sectors to Service Debt. And over the last 2 1/2 months short-term interest rates have made a decisive move higher. This also serves to reduce the value of stocks as every dividend discount model incorporates a discount factor based on the current level of interest rates.

* Trade Tensions With China Are Intensifying and Mr. Market Is Improperly Looking Past Marginal Risks. From Goldman Sachs’ David Kostin (h/t Zero Hedge). Remember, as previously discussed, the dispute has buoyed second- and third-quarter U.S. GDP. The benefit soon will be over and a third-quarter economic cliff is possible.

* Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window by Both Political Parties. This has very adverse ramifications , which shortly may be discounted in lower stock prices, especially as it relates to the servicing of debt — a subject I have written about often. Not only are our legislators acting irresponsibly and recklessly, but the Republican Party is now considering more permanent tax cuts. Should economic growth moderate, tax receipts diminish and undisciplined spending continue, stock valuations will likely continue to contract.

* Peak Buybacks. Buybacks continue apace, but look who’s selling. As Grandma Koufax used to say, “Dougie, that’s quite a racket!” If I am correct about the peaking in corporate profits, higher interest rates and slowing economic growth, we shortly will have another rate of change — negative in buybacks.

* China, Europe and the Emerging Market Economic Data All Signal a Slowdown. It’s in the early innings of such a slowdown based on any real-time analysis of the economic data. The rate-of-change slowdown on a trending basis is as clear as day. A rising U.S. dollar and weakening emerging-market economic growth sow the seeds of a possible U.S. dollar funding crisis. This slowdown has not gone unnoticed by investors, as emerging markets have declined absolutely over the summer, materially lagging the strength in the S&P index and the Nasdaq.

* The Orange Swan Has Returned. Again, hastily crafted policy delivered by Twitter that conflates politics is dangerous in a flat and networked world. The return of an untethered Orange Swan is market-unfriendly… brace yourselves as the Supreme Tweeter will likely “Make Economic Uncertainty and Market Volatility Great Again” (#MUVGA) This weekend’s allegations against the Supreme Court nominee likely raises the risks of more volatility and may jeopardize some elements of the administration’s agenda.

* We Are Moving Closer to the November Elections, With Their Uncertainty of Outcome and the Potential For a “Blue Wave.” The current sub-40% approval rating (which is trending lower) for the president is historically a losing proposition for the incumbent. We also may be moving toward some conclusion of the Mueller investigation, creating even more uncertainty.

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” – Benjamin Graham

The search for value and comparing it to risk taken is, at its core, the marriage of a contrarian streak and a calculator.

While it is important to gauge the possibility that the market may be making an important top, it is even more important to distill, based on reasonable fundamental input, what the market’s reward versus risk is. This calculus trumps everything else that I do in determining market value.

On that front, I continue to believe that downside risk dwarfs upside reward.

Moreover, there is a growing fundamental and technical list of signposts — many highlighted this morning — that the market is starting to look like it is in the process of making a possible, and important, top.”

As Columbia University’s Joel Greenblatt wrote:

“There’s a virtuous cycle when people have to defend challenges to their ideas. Any gaps in thinking or analysis become clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.”

The S&P has now climbed to the upper end of my short-term projected trading range and I have moved to a market neutral position (from net long) – I will move into a short position on any further strength.

Yell and roar and sell some more – at least I am – as the market’s topping process seems intact.

Note: This missive’s title is a quote from the Divine Ms M (Helene Meisler)

Position: Short SPY

Kass: My 15 Surprises For 2019

White House Politics:

(When asked what he wanted to give thanks for during a press gaggle Thanksgiving Thursday, Trump responded), “for having a great family and for having made a tremendous difference in this country. I’ve made a tremendous difference in the country. This country is so much stronger now than it was when I took office that you wouldn’t believe it… And I mean, you see, but so much stronger people can’t even believe it. When I see foreign leaders they say we cannot believe the difference in strength between the United States now and the United States two years ago.” – President Trump (Comments on Thanksgiving

Policy:

“You only think I guessed wrong! … You fool! You fell victim to one of the classic blunders – the most famous of which is “never get involved in a land war in Asia” – but only slightly less well-known is this: Never go in against a Sicilian when death is on the line!” – Vizzini,The Princess Bride

The Economy:

“The missing step in the standard Keynesian theory (is) the explicit consideration of capitalist finance within a cyclical and speculative context… finance sets the pace for the economy. As recovery approaches full employment… soothsayers will proclaim that the business cycle has been banished (and) debts can be taken on. But in truth neither the boom nor the debt deflation… and certainly not a recovery can go on forever. Each state nurtures forces that lead to its own destruction.”  Hyman Minsky

The Markets:

“Every new beginning comes from some other beginning’s end.” Seneca the Elder

Contrary to the expectations of many (including myself), the uncertainties following the surprising Trump presidential election victory, which produced a number of possible outcomes (some of them adverse), was enthusiastically embraced by investors in 2017 and in the first month of this year. A market on steroids was not a conclusion or forecast by any mainstream Wall Street forecaster that year. There was no sell side strategist who expected equities would rise anywhere near the 20%+ gains in the major indices recorded in 2017, nor do I know any who predicted that the S&P Index would make more than 70 individual highs a year ago.

As I expected, that enthusiasm continued in and through most of the month of January, 2018. But, after a year of historically low volatility and ever-rising stock prices, the bullish consensus became troubled as the complexion of the market changed throughout most of 2018 .

As I noted in last year’s commentary, I thought that the biggest surprise in 2018 would be that extrapolation of the market uptrend didn’t work after many years of working, and that we will witness the emergence of multiple non-consensus developments, including:

  • A dramatic drop in the price of bitcoin (to under $2,000)
  • A devastating decline in many bitcoin collateral plays
  • A much higher oil price
  • A slowing (not expanding) rate of economic domestic growth as the tax bill “trickles up,” not down
  • A mean reversion higher in volatility
  • The bursting of the global short volatility bubble which serves up a 20% drop in equities (aided by both weaker earnings results and lower valuations).
  • And, of course, I anticipated that there would be an abundance of surprises in the fertile political arena with the incalculable Orange Swan at the helm in Washington, D.C., and in his role as the “Supreme Tweeter.”

“Expect the unexpected and, whenever possible, be the unexpected.” Kurt VonnegutBreakfast of Champions

As we enter 2019, the scent ofGroup Stink” is still thick despite a heady list of multiplying uncertainties. Nevertheless, while the Bull Market in Complacency has been pierced in October, 2018, most market forecasts remain optimistic.

Warren Buffett once observed that a bull market “is like sex. It feels best just before it ends.'” While some of us in the ursine crowd debate whether the investment orgasm has already passed, in the extreme it finally may be Minsky’s Moment and year after nine years of recovery and prosperity following The Great Recession.

This year I have decided to publish my “Surprise List” a bit earlier than usual.

As you all know, my Surprises are what I term to be Probable Improbables – events that have a greater possibility of occurring than are seen by the consensus. I try to make you think apart from that diabolically dangerous “Group Stink” and, particularly as it relates to politics (but with other subjects as well), I feel that I should offend you at least once, or I am not doing my job. But, any offense is meant in the spirit of the great Romantic poet William Blake who taught us that “Opposition is true friendship.

My Surprises are shorter in length than in previous years. (I want to quickly get to the important points of the Surprise List – available on one or two pages – rather than deliver a more flowery prose and bunch of stories that I have commonly done in the past).

We will start the new investment year about one month from now with a completely different “feeling” of previous years – as I mentioned previously, the complexion of Mr. Market seems to have changed:

  • Investors (retail and institutional), previously comfortable being among the herd of optimism, are beginning to panic.
  • The dominant investors of the decade – Exchange Traded Funds and Quantitative Strategies and Products (e.g. risk parity) – are selling into weakness (just as they bought into strength) – serving to overwhelm active investors.
  • Hedge funds are completing another unfavorable year in which their investment performance is poor. Against a backdrop of a high fee structure (at a time in which passive management fees are “moving to zero” ) – redemptions are growing and even some of the most competent managers are hanging up their spikes and closing down.
  • Public companies, in some measure to increase the value of their stock options) who have gone on a massive buying streak of their own securities (propping up stocks and nominal EPS at the expense of building their businesses and improving productivity) may begin to get second thoughts as stocks founder and interest rates have risen.
  • The two “shiny objects” crypto currency and FANG – revered and hyped by the many – is likely having a more profound impact on the herd’s newly found negative sentiment than many realize.
  • Global economic growth prospects continue to grow more ambiguous – with the schmeissing of the price of crude oil another warning and conspicuous signpost of a broadening slowdown.
  • The Federal Reserve has made a profoundly important change from easing to restraint.

“In ambiguous situations, it’s a good bet that the crowd will generally stick together — and be wrong.” – Doug Sherman and William Hendricks

The core themes and roadmap for 2019 is that a standard run-of-the-mill Bear Market may run into something bigger in a year enveloped in unprecedented political turmoil (and electorate disgust and anger), an escalating trade (and cold) war with China and continuing global economic disappointments — dragging down a mature, an extended and fully exploited economic growth and market cycle.

Not surprisingly, my Surprise is that a slightly down year of performance for the S&P Index in 2018 may turn out to be something worse in 2019.

But the biggest and most provocative surprise is the decline and fall of President Trump in 2019 – in which an anti-imperial rebalancing is successfully mounted by a more assertive Congress, bringing the country back into constitutional equilibrium.

Without further fuss, here are my outside of consensus 15 Surprises for 2019:

1) A U.S. Recession in 2019 Followed by Stagflation:

We learn, in 2019, the extent to which economic activity was pulled forward by the protracted period of historically low interest rates – as capital spending, retail sales, housing and autos founder further.

With U.S. Real GDP growth dropping to +1% to +2% in the first half of 2019, inflation remaining stubbornly high (especially of a wage-kind as the labor market remains tight) and with cost pressures unable to be passed on, the threat of recession intensifies.

By the third quarter of 2019 U.S. Real GDP turns negative. Tax collections collapse as government spending continues to rise. The budget deficit forecasts are lifted to over $2 trillion.

The U.S. falls into a recession in the last half of 2019 – followed by a lengthy period of stagnating economic growth and higher inflation (stagflation).

A dysfunctional, non-unified and discombobulated Europe also falls into a recession in 2019 – with significant ramifications for U.S. multinationals that populate the S&P Index.

U.S./Chinese trade tensions push the global economy down the hill as the year progresses and GDP growth in China comes in below +5.0%. The IMF reduces it’s global economic growth forecast three times next year.

S&P per share earnings fall by over -10% in 2019.

2) The Federal Reserve Pauses and Then Cuts as Currencies and Interest Rates Swing Wildly: 

It’s a wild year for fixed income and currency volatility.

The Fed cuts rates in 3Q2019 and by year-end announces that QE4 will commence in January, 2020.

The 2018 tantrum in Italian bonds is just a precursor for hissy fits throughout the European bond market as the ECB is no longer expanding its balance sheet and tries to get out of NIRP.

The BoJ throws in the towel on their drive for higher inflation. The Japanese bond market sees sharp selloff.

During 2019 the yield on the ten year U.S. note falls to 2.25% before ending the year at over 3.50% as the selloff in European and Japanese bonds and the announcement of QE4 drive our yields higher. Gold falls to $1050 before ending the year at over $1700.

3) Stocks Sink:

Though the third year of a Presidential cycle is usually bullish – it’s different this time.

Trump confusing brains with a bull market can’t fathom the emerging Bear Market. At first he blames it on Steve Mnuchin, his Secretary of Treasury (who leaves the Administration in the middle of the year). Then he blames a lower stock market on the mid-term election which turned the House. Then he blames the market correction on the Chinese.

The S&P Index hits a yearly low of 2200 in the first half of the year as the market worries about slowing economic and profit growth and a burgeoning deficit/monetization. The announcement of QE4 results in a year end rally in December, 2019. In a continued regime of volatility (and in a market dominated by ETFs and machines/algos), daily swings of 1%-3% become more commonplace. Investor sentiment slumps as redemptions from exchange traded funds grow to record levels. The absence of correlation between ETFs and the underlying component investments causes regulatory concerns throughout the year.

Congress holds hearings on the changing market structure and the weak foundation those changes delivered during the year.

Short sellers provide the best returns in the hedge fund space as the S&P Index records a second consecutive yearly loss (which is much deeper than in 2018).

As the Fed cuts interest rates the US dollar falls and emerging markets outperform the US in 2019.

I, like many, are concerned about corporate credit (See Surprise #8) and though credit is not unscathed, it is equities that bear the brunt of the Bear since they are below credit in the company capitalization structure.

Bottom line, after a steep drop in the first six months of the year, the markets rise off of the lows late in the year in response to this shifting political scene (the decline of Trump) and a reversal to a more expansive Fed policy – ending the year with a -10% loss.

4) Despite the Appearance of the Bear, FANG Stocks Surprisingly Prosper (Both Absolutely and Relatively) as Investors Seek Growth (at any cost) In a Slowing Economy – Facebook’s Shares Rebound Dramatically:

While there is a growing consensus that FANG will lead a Bear Market lower – that is not the case as growth, in a general sense, is dear and cherished by market participants next year. Among FANG, Facebook’s shares have a reversal of fortune (and is the best performing FANG stock) as the company announces aggressive management changes and moves to remedy the misinformation trap.

As more previously unrevealed information reduces her valuation, Sheryl Sandburg’s special status as a female leader (in a seascape of men at Facebook and in industry) is questioned. In the first half of 2019, Sandberg becomes a sacrificial lamb and is sacked – and is forced to lean out after leaning in.
At the suggestion of Warren Buffett (who has accumulated a sizable stake in the company), former Board Member Donald Graham is named as the new, independent and Non-Executive Board Chairman of Facebook.

This unexpected move encourages FB investors to believe that the company is quickly moving to fix its multiple data and privacy issues.

Fewer (than feared) Facebook members opt out and growth in usage resumes in the back half of 2019.

FB’s stock popularity (and market capitalization) increases as it becomes a more dominant holding in “value investors” portfolios – the shares trade above $200/share late in the year.

5) “Peak Trump” – the President Bows Out in His Pursuit of a Second Term:

The President’s dismissal of the murder of Washington Post reporter Jamal Khashoggi is seen as delivering tacit support to Saudi Arabia’s MBS – it is a pivotal turning point in Trump’s popularity and ultimate reputational decline in 2019. “Pay enough and you can get away with murder” becomes the mantra of the Progressive Left. Trump acceptance by his Republican party peers quickly diminishes as they are further worried about his motivation to side against the findings of his own intelligence department. After Trump’s personal dealings with authoritarian and autocratic countries are revealed in the Mueller probe (along with possible emoluments violations), Trump’s popularity fades further as Lindsay Graham and other prominent Republicans repeal their support and denounce the President.

An anti-imperial rebalancing is mounted, in which a more assertive Congress brings the country back into constitutional equilibrium.

Though the public and political leaders (even on the right) increasingly reject the President, there are no impeachment efforts by the Democrats. Instead (and surprisingly), House Speaker Pelosi (recognizing that constructive steps are the recipe for a Democratic 2020 Presidential win) exacts discretion and stops the Democrats from moving on an impeachment in the House. Democratic leadership turns to reforms and a torrent of new legislation in the areas of improving the environment and climate control (and the halt of growth in fossil fuel by the development of alternative energy programs), the opioid crisis, education, crime, voting rights, healthcare and prescription drug prices, immigration, etc.- showing the electorate that their Party can demonstrate the framework for a positive agenda, a vision and a social contract (and can rule instead of obstruct).

But, most importantly… With real GDP turning negative in 2019’s second half, Democrats attempt to replace Republicans’ supply-side economics with a smarter theory of growth. Recognizing just as inflation and other ills opened the door for criticism of Keynesian economics in the 1970s, so have inequality and disinvestment done the same for critiques of supply side today. In 2019, the Democrats turn the table on the supply-siders and give a voice through thoughtful proposed legislation (making the affirmative case for the Democratic theory of growth geared to raising wages and putting more money in the hands in working- and middle-class people’s pocket and investing in their needs). Americans enthusiastically embrace this alternative (of how the economy works and grows and spreads prosperity) and reject and defeat the long standing Republican economic narrative – seeing it as a better way to spur on the economy (than giving rich people more tax cuts). Asking the question “has it worked for you?” and given the fairy tale of added revenue from growth (and the widening hole in the deficit), rampant inequality, the fear of being bankrupted by medical catastrophe and massive student debt obligations Democrats provide a practical alternative to cutting taxes for the rich and decreasing regulation which has failed to unleash as much innovation and economic activity that was promised by the Administration. The legislation, which puts more money in middle class pockets, defends and supports the notion that the public sector can make better decisions than the private sector. Referred to as the “middle – in economic bill,” is cosponsored by a leading, conservative and respected Republican member of Congress and begins to gain bipartisan support in Congress, driving a stake through the supply-side’s heart.

Despite his loss of popularity (which plummets to 25%) and the push back from the Republican establishment, Trump declares he is still planning to run for President. Nevertheless, a challenge from Senator Mitt Romney (who’s motto is “Make Republicans Great Again”) gains steam as McConnell, Graham, Kennedy Et al. throw their support for the Senator.

As Trump’s problems multiply, Romney becomes the heavy favorite to defeat Trump in the Republican primary.

Recognizing a sure election defeat, by year-end the President announces that his medical team has disclosed a health issue and he is advised not to run for office. Reluctantly, Trump agrees and bows out of the 2020 Presidential race late in the year.

The Trump mantra of “Make America Great Again” is replaced by “Make Economic Uncertainty and Market Volatility Great Again.”#MAGA/#MUVGA

6) The Year of the Woman:

With a Trump withdrawal from 2020 the election is wide open.

The arc of history influences the Democratic Presidential nomination march and the leading candidates that emerge for 2020 are mostly women. The potential contenders include progressive firebrands like Elizabeth Warren, Stacey Abrams, Kristen Gillibrand and Kamala Harris, and moderates like Senator Amy Klobuchar and Rhode Island Governor Gina Raimondo.

Michael Bloomberg, Howard Schultz and Joe Biden bowout from the race by year end 2019 By year-end, Klobucher, Harris and Warren surface as the three leading Democratic Presidential candidates.

It appears that an all women Democratic ticket (President/Vice President) is increasingly likely.

Nationally, several high profile sexual harassment suits are disclosed. Allegations against a number of well known television, other entertainment and political icons/leaders serve to reinforce the candidacy of the above women who aspire to gain the Democratic Presidential nomination. After Congressional hearings, non partisan and strict harassment legislation are introduced forcing several well known male politicians to resign from office.

7) A New (But Old) Shiny Object Appears As A Stock Market Winner in 2019:

Bitcoin trades close to $3,000 in December, 2018 and spends most of 2019 under $5,000 (as numerous trading irregularities, thefts and more frauds are exposed).

England’s Financial Conduct Authority (FCA) takes the lead, in instituting a comprehensive regulatory response to regulating the crypto currency markets. The U.S. follows by imposing broad-based crypto currency regulation in 2019.

A leading business network (who’s bitcoin “bug” has become the new cover of magazine contrary indicator!) faces a class action suit for their seeming encouragement in buying into the asset class in their too frequent broadcasts during 2018. Several crypto currency guests who were prominent on the network’s coverage are indicted for fraud. In an agreement with regulatory authorities, the biz network’s programming is reconstituted.

Marijuana stocks, after a weak final few months in 2018 (are down by over 50% from their highs), explode back to the upside reflecting a quickened pace of alternative health applications. (MJ) is the single best performing exchange traded fund and (TLRY) makes another move to $300/share.

8) Private Equity, High Yield Debt and Leveraged Loan Problems (Which Have Doubled in Size Over the Last Ten Years) Emerge as the Resurgence of Leveraged Finance Comes to An End:

Private equity, in particular, the biggest winner in the decade long cycle since The Great Decession of 2007-09, suffers – and so do the endowments at several prestigious universities. Covenant- lite financings in junk and leveraged loans – often in opaque and complex structures – topple under the weight of loan defaults. (HYG) (last sale: $83.17) trades $75-$80 as redemptions spike.

Publicly-held private equity shops (KKR) and Blackstone (BX) are among the largest percentages losers in 2019, High yield bonds fulfill their characterization as “junk,” and are among the worst performing asset classes. The spread between junk bonds and Treasuries more than doubles – widening dramatically during the summer months.

9) The China/U.S.Rift Intensifies as Trump’s Anger Shifts Towards That Region:

The trade war with China goes into full effect with 25% tariffs. Walmart (WMT) is adversely impacted and its shares fall by -20% from the recent highs. The Chinese retaliate against major American brands like Apple (AAPL) . (“Peak Apple” actually happens and its shares fall below $125/share).
Peter Navarro resigns.

A major cyber-attack against the U.S. financial system, who’s source is initially not diagnosed, is ultimately reportedly to have been delivered by China. The U.S. enters a cold war with China that resembles the emergence of the cold war with Russia in 1948 – it becomes clear it will be lengthy, nasty and unfriendly to the trajectory of worldwide economic growth.

10) Bank Stocks Are Surprising Winners in 2019:

Despite some pressure in net interest margins (and income), sluggish loan demand and a pickup in loan losses – bank stocks (and EPS) are surprisingly resilient and manage to have a positive return next year as better relative EPS growth is supported by aggressive buybacks and (starting) low valuations. Investors look forward to a recovery in economic growth in 2020-21 and bank stocks (flat for most of the year) have a vigorous move in the last few months of the year and are one of the few sectors to advance in 2019.

Oil stocks, depressed from the late 2018 crude oil price fall also recovery mightily in the later months of 2019 as the price of oil advances coincident with dovish turn in monetary policy.

11) Tesla’s Problems Shift From Production to Demand to Financial:

Tesla (TSLA) loses its tax subsidy in the U.S. and in the Netherlands (a large market for them).

European competition grows.

Europe doesn’t allow the Tesla Model 3 due to safety reasons. The Chinese won’t let an American company have video data over millions of miles of roads and bans Tesla. Lenders balk and access to the public debt market evaporates. The company’s financial position deteriorates and its credit default swaps widen dramatically.

An accounting “issue” surfaces – and it morphs into an accounting fraud. Elon Musk, who has leveraged his TSLA equity holdings, faces margin calls and is forced to sell Tesla shares.

After being rushed to the hospital after an overdose, Musk leaves his CEO post to enter drug rehab.

12) Berkshire Hathaway (BRK.A) (BRK.B) Announces the Largest Takeover in History – The Transformational Acquisition of 3M for $150 billion.

13) Amazon (AMZN) Makes a Bid for Square (SQ) but Alphabet/Google (GOOGL) Eventually Acquires Both Square SQ and Twitter (TWTR)

14) With its Share Price Consistently Trading Under Its Book Value During the First Few Months of 2019, Goldman Sachs’ (GS) Partners Take the Brokerage Private in a Leveraged Buyout at $238/share.

15) Brexit Happens: The world continues and the pound is the best global currency.

Here Are 5-“Also Eligible” Surprises:

  • AE1) Ford (F) defaults on its loans. Steve Rattner again becomes the “car czar.”
  • AE2) A major and unexpected global event judged to be impacted by climate issues causes a massive amount of health problems and deaths. Demand for a reversal of Trump policy on climate change comes from his within his own Party and represents another fissure between the White House and the legislative branch.
  • AE3) Warren Buffett announces his successor. The name, however, is no surprise.
  • AE4) Angela Merkel doesn’t make it thru the year and Germany has a new leader.
  • AE5) As is typical with maturing economic cycles, two large accounting frauds of S&P Index constituents are uncovered late in the year. A previously “sainted” and revered CEO does a prep walk.

Kass: A Changing Market Structure or “WTF Is Going On?”

Mother, mother
There’s too many of you crying
Brother, brother, brother
There’s far too many of you dying
You know we’ve got to find a way
To bring some lovin’ here today” Marvin Gaye and Al Cleveland, What’s Going On?

After Renaldo Benson of The Four Tops witnessed police brutality and violence in Berkeley’s People’s Park during a protest held by anti-war activists (hailed as “Bloody Thursday”), he discussed it with songwriter Al Cleveland who wrote “What’s Going On?”:

“‘What is happening here?’ One question led to another. Why are they sending kids so far away from their families overseas? Why are they attacking their own children in the streets?” – Renaldo “Obie” Benson

The Four Tops turned down his request to record the song in the belief that it was “a protest song.” Cleveland next went to Marvin Gaye who was already inspired by social ills committed in the U.S. (“with the world exploding around me, how am I supposed to keep singing love songs?” ) – like the 1965 Watts riots. Gaye revised the song to his liking, retitled it and added melody (“added some things that were more ghetto, more natural, which made it seem like a story than a song … we measured him for the suit and he tailored the hell out of it”).

In 2004, Rolling Stone Magazine ranked “What’s Going on?” as the fourth greatest song of all time.

So, Dougie, what’s going on and what lessons should we learn from 2018?

A Changing Market Structure

“Price is what you pay. Value is what you get.” Warren Buffett

The markets are ever changing – even the dominant players have their season. But, ultimately, when too many adopt the same strategy (who is left to buy?) and valuations go the extreme, the strategy nearly always implodes.

When I graduated Wharton in 1972 the bank trust departments dominated the markets. Banks concentrated their investments in the “nifty fifty” – a group of large cap growth stocks that became the market darlings of the late 1960s and the early 1970s. They were seen as great companies that became known as “one decision” stocks – stocks (like Avon Products (AVP) , Polaroid and Xerox (XRX) ) that you should buy, no matter how expensive and hold forever (sound familiar?).

In time, there valuations rose to elevated levels (Xerox at 50x, Avon at 65x and Polaroid at 95x earnings.)

Helping to restore the myth that the price you pay does not matter came from an unlikely source, Wharton finance professor Dr. Jeremy Siegel. In his book, Stocks for the Long Run, Siegel demonstrated that the fifty highest-priced stocks on the NYSE had basically matched the performance of the S&P 500 Index. This “demonstrated” that the market was not irrationally pricing those stocks.

The bear market of 1973-4 saw these stocks collapse dramatically in both magnitude and time (not dissimilar to the dot.com bust in mid -2000) and the previously dominant market player – the bank trust department – was replaced by an emerging mutual fund industry.

Fidelity, Putnam (where I worked), Templeton and other mutual fund families quickly became the dominant market players – overtaking JP Morgan (JPM) and Citibank (C) (as it was then called) as the major market player.

Along the way, a new strategy called “Portfolio Insurance” began to take hold. Ultimately, though it was a portfolio, it provided little “insurance” and served to be the catalyst of the October, 1987 massacre in which the markets dove by -21% in one day.

In the next decade, hedge funds (with their spectacular performance records) emerged as the dominant market player. George Soros and others were canonized, appearing on the cover of leading trade journals. But, as their performance deteriorated and the 1997-2000 dot.com boom became a tech wreck in 2000-02, active managers were beginning to replaced with passive exchange traded funds (ETFs) who provided a low-cost, tax-efficient, liquid and diversified vehicle for the retail investor. Soon thereafter, machines (and algos) began to further gain market share from active managers, producing high frequency trading and other quant strategies (e.g., risk parity) that outperformed active managers on a consistent basis.

As previously noted, these strategies and products are generally agnostic to balance sheets, income statements and private market value – that, to myself and others, is a dangerous precedent.

By most estimates ETFs and quants now account for nearly 3/4 of daily average volume. With the quantum rise in the popularity of ETFs and quant strategies we, as I have warned, have run the risk of Portfolio Insurance (Part Deux). It was clear, with the benefit of hindsight, that one of the risks associated with the popularity of passive products is that the market, like in 1968-1972 and again in 1998-2000, placed a small number of stocks in too important portfolio roles representing a disproportionate weighting (with elevated valuations).

The problem today is, like Portfolio Insurance in the mid to late 1980s (which produced a dramatic -21% drawdown in a day), the dominant players (ETFs and the machines and algos) worship at the altar of price momentum (and/or the perception of risk by asset class) – so they tend to “buy high and sell low.”

Regardless of reason (higher interest rates, widening credit spreads, trade disagreements, policy concerns, political uncertainty, etc.) the price momentum began to deteriorate earlier this year. That selling of the most dominant market players began to increase.

Then the fundamentals began to soften as global economic ambiguity increased. Homebuilders reported weak order guidance as market participants ignored the increasing lack of home affordability (as rates and home prices rose rapidly against a lesser rate of wage growth). Semiconductors proved, once again, that they are commodity plays. Former market darling Nvidia (NVDA) proved to be more of a crypto currency play that investors realized. Signposts of peak business data center emerged (as an overbuilt developed almost overnight). Apple (AAPL) whiffed and even Alphabet/Google (GOOGL) and Amazon (AMZN) reported uninspiring third quarter earnings reports. This all occurred amid the emergence of a substantive regulatory threat (to Facebook (FB) in particular) – something I have been very concerned about since mid-2017.

Recently dips are no longer bought (machines and algos don’t play that game and who beyond them is left to buy, save the company buybacks?) and the selling has escalated.

While as Byron Wien says, “Disasters have a way of not happening,” I am fearful of a repeat of the machine-induced market loss of October, 1987 in a backdrop of soft fundamentals and still too much optimism.

Lessons Learned

“Only when the tide goes out do you discover who’s been swimming naked.” Warren Buffett

I can’t overstate how important it is to understand and learn from market cycles and history.

Howard Marks writes in Mastering the Market Cycle:

The superior investor is attentive to cycles. He takes note of whether past patterns seem to be repeating, gains a sense for where we stand in the various cycles that matter and knows those things have implications for his actions. This allows him to make helpful judgments about cycles and where we stand in them. Specifically:

  • Are we close to the beginning of an upswing, or in the late stages?
  • If a particular cycle has been rising for a while, has it gone so far that we’re now in dangerous territory?
  • Does investors’ behavior suggest they’re being driven by greed or by fear?
  • Do they seem appropriately risk-averse or foolishly risk-tolerant?
  • Is the market overheated (and overpriced) or is it frigid (and thus cheap) because of what’s been going on cyclically?
  • Taken together, does our current position in the cycle imply that we should emphasize defensiveness or aggressiveness? 

As I wrote in “Swimming Naked:”

Bear markets and steep corrections reveal the bad actors.

The recent market schmeissing has uncovered these market Fugazzis. I have in the past (and in today’s opening missive) hit these bad actors hard because of the damage they deliver. But, like Warren Buffett, I prefer to criticize by category and not by the individual. We should learn from this reveal in order to better navigate the market’s noise going forward:

* Corporate managements who never met an outlook they didn’t like. In my more than four decades I have interviewed hundreds of managements and observed, in the business media, thousands more. I can not recall one management in my career who had negative observations about his/her company’s secular growth prospects. To paraphrase the Oracle of Omaha again, “corporate managements often lie like ministers of finance on the eve of devaluation.” [Treat their incessant optimism, in the future, with skepticism. Watch what they do (e.g., insider buys) not what they say.]

* Business media moderators who have no skin in the game and are quick to criticize when an investment professional makes an investor boner – reminding me of a wonderful (and oft repeated) quote by Mickey Mantle, “I never knew the game of baseball was so easy until I entered the broadcasting booth.” (There are plenty of value added moderators on the three main business channels, but turn off the channel when these bad actors appear.)

* “Talking heads”– guests who parade in the media – and too often make smug observations and confident market forecasts. Like the bandleader Johnny Mercer they emphasize the positives… but deemphasize or “sweep under the carpet” the negatives, in an attempt to gain viewership, raise their assets under management and/or sell you a service. (Don’t fall for their gambit.)

* The “special sauce” guys who have a special formula to beat Mr. Market. The most venomous are the “unusual call activity” crowd – a constant diet of which will end most up in the poor house. Most have little skin in the game. But, importantly, their consistent failure to memorialize the results of their recommendations is testimony to the mug’s game they use as a “hook” to snare the unsuspecting. I have contempt and little respect for those that show the “rolls” of their winners and too often ignore their trades that go to zero (e.g. out of the money calls bought on (ROKU) , (SQ) , (AAPL) , (TSLA) , (NFLX) , (GS) and many other high beta stocks of that ilk that have recently collapsed). (There is no special sauce. I give these players – with limited accountability and selective disclosure – no respect at all – for basically trying to deceive the individual investor.)

* “Long only” investors who rationalize poor performance in a steep market decline to their “charter” and take credit for good performance in a broad market advance. (They will reappear in the next up cycle – ignore them and remember ‘what they have learned from history is that they haven’t learned from history.’)

* The hedge fund community that is again, despite a sky-high fee structure, underperforming the S&P Index.

* Leveraged players who dramatically underperform when the tide goes out and exhibit superior returns when the tide comes in. (They mostly will be entirely wiped out and typically will never reappear – as they have likely changed careers.)

* Market strategists who parade in the business media, like self professed investment icons, when the going is good – only to disappear at the end/close of every Bull Market when the seas get rough. (They, too, will return in the next cycle but hide your children and your portfolios from them.)

We must learn from this history in order to avoid making the same mistakes in the next investment cycle!

Bottom Line

The changing market structure and dominance of new market players (that are agnostic to fundamentals) that has evolved over the last decade is eerily reminiscent to past cycles (in particular Portfolio Insurance in October, 1987).

History demonstrates that a changing (from positive to negative) narrative surrounding the technology industry (in fundamentals and in the current case of added regulatory threats) often produces an influential and negative market inflection point.

What also points to additional market vulnerability is the age of the economic and market cycles – by historic standards (as Lee Cooperman discussed at my country club on Sunday evening). As well, a tipping point in monetary policy is a new cycle development – serving to reducing liquidity and increase volatility. (It took two years but real interest rates are now about to turn positive as the Fed’s balance sheet is shrinking).

I remain in a net short exposure.

Kass: Who Is Swimming Naked?

“Only when the tide goes out do you discover who’s been swimming naked.” – Warren Buffett

Bear markets and steep corrections reveal the bad actors.

The recent market schmeissing has uncovered these market Fugazzis. I have in the past (and in today’s opening missive) hit these bad actors hard because of the damage they deliver. But, like Warren Buffett, I prefer to criticize by category and not by the individual. We should learn from this reveal in order to better navigate the market’s noise going forward:

* Corporate managements who never met an outlook they didn’t like. In my more than four decades I have interviewed hundreds of managements and observed, in the business media, thousands more. I can not recall one management in my career who had negative observations about his/her company’s secular growth prospects. To paraphrase the Oracle of Omaha again, “corporate managements often lie like ministers of finance on the eve of devaluation.” [Treat their incessant optimism, in the future, with skepticism. Watch what they do (e.g., insider buys) not what they say.] 

* Business media moderators who have no skin in the game and are quick to criticize when an investment professional makes an investor boner – reminding me of a wonderful (and oft repeated) quote by Mickey Mantle, “I never knew the game of baseball was so easy until I entered the broadcasting booth.(There are plenty of value added moderators on the three main business channels, but turn off the channel when these bad actors appear.)

* “Talking heads”– guests who parade in the media – and too often make smug observations and confident market forecasts. Like the bandleader Johnny Mercer they emphasize the positives… but deemphasize or “sweep under the carpet” the negatives, in an attempt to gain viewership, raise their assets under management and/or sell you a service. (Don’t fall for their gambit.)

* The “special sauce” guys who have a special formula to beat Mr. Market. The most venomous are the “unusual call activity” crowd – a constant diet of which will end most up in the poor house. Most have little skin in the game. But, importantly, their consistent failure to memorialize the results of their recommendations is testimony to the mug’s game they use as a “hook” to snare the unsuspecting. I have contempt and little respect for those that show the “rolls” of their winners and too often ignore their trades that go to zero (e.g. out of the money calls bought on (ROKU) , (SQ) , (AAPL) , (TSLA) , (NFLX) , (GS) and many other high beta stocks of that ilk that have recently collapsed).

(There is no special sauceI give these players – with limited accountability and selective disclosure – no respect at all – for basically trying to deceive the individual investor.)

* “Long only” investors who rationalize poor performance in a steep market decline to their “charter” and take credit for good performance in a broad market advance. (They will reappear in the next up cycle – ignore them and remember ‘what they have learned from history is that they haven’t learned from history.’)

* The hedge fund community that is again, despite a sky-high fee structure, underperforming the S&P Index.

* Leveraged players who dramatically underperform when the tide goes out and exhibit superior returns when the tide comes in. (They mostly will be entirely wiped out and typically will never reappear – as they have likely changed careers.)

* Market strategists who parade in the business media, like self professed investment icons, when the going is good – only to disappear at the end/close of every Bull Market when the seas get rough. (They, too, will return in the next cycle but hide your children and your portfolios from them.) 

Bottom Line

“When we ask for advice we are looking for an accomplice.” Saul Bellow

The investment mosaic is complex and Mr. Market is often unpredictable.There is no quick answer or special sauce to capture the holy grail of investment results – it takes hard work, common sense and the ability to navigate the noise.

The common thread of these naked swimmers are self confidence, smugness and the failure to memorialize their investment returns (because the typically are so inconsistent and dreadful).

They are bad and deceptive actors who are in denial to themselves and are artful and accountable dodgers to the investing masses.

“In my next life I want to live my life backwards.” – Woody Allen

Take Woody Allen’s advice (above) – be forewarned and learn from history as common sense is not so common as:

“A nickel ain’t worth a dime anymore.” – Yogi Berra

FOX BUSINESS


Impact Of The Fed Raising Rates On The Markets

Market Is Fearful Of Trump Administrations Hard Line On Trade

Kass: Market Jumps On Short Squeeze – It Won’t Last

Though we will hear many “after the fact” explanations, I can not (with any confidence or with honesty) explain the magnitude of yesterday’s remarkable market ramp:

Perhaps it is as Albert Camus once said, 

“Stupidity has a knack of getting its way.” 

But, that is probably too glib of me.

Frankly, I just don’t know.

  • Was it market participants’ poor positioning? (It’s hard to explain such a massive ramp on this factor)
  • Was it a post election relief and a view that the gridlock would be beneficial (from a policy standpoint)? (To the contrary, I see, as written recently in “Split Decision,” a period of political chaos)
  • Was it relief that the Mueller investigation will be dulled with the Attorney General’s dismissal? (Not likely as things could now get hotter for the President with the Democrats owning committee leadership.)
  • Was it better than expected EPS reports? (I saw nothing to make me believe this to be was a catalyst)
  • Was it based on a more benign Fed? (No evidence of that either)
  • Was it “seasonality?” (Not enough to matter relative to the sizable gains)
  • Was it a function of machines/algos and ETFs (rebalancing) going wild? (Probably some of this but it is hard to explain the magnitude of the rip) 

Investment vision is always 20/20 when seen through the rear view mirror.” 

So, let’s leave it to the geniuses in the business media to explain to us why the S&P gained more than 50 handles on Wednesday – they seem to have all the answers!

Tactically I covered my trading short rental (for a loss) on the pot stocks and I continued to raise my cash reserves.

After the close, when I returned to my trading desk and digested the gains and assessed reward v. risk, I reestablished a trading long in at $35.04 – which I will likely sell today (win, lose or draw).

I am committed to being authentic in my Diary – if I don’t understand the markets (and its reaction) I write that. Unlike some, I don’t answer questions on every subject (because I don’t have anywhere near all the answers). I don’t B.S. our readers and I call out B.S. when I see it in the business media and elsewhere.

There is so much I don’t understand in the markets, in the (mis)interpretation of global economic growth, policy risks, political uncertainties.

I Am Poised to Move Back to a Large Short Position

As the market broke down late last month I penned a column, “A Contrarian’s Thoughts” (while I unemotionally took on a number of trading long rentals based on the expectation of a possible rally in the S&P Index towards 2800-2850): 

“The pessimism is thick now – in marked contrast to the last six months. Everyone who can read a chart sees the breakdowns.

There are now likely “bad shorts” (read: inexperienced) in the market. Many who rejected the notion of a market top in September now seem very confident in a bearish short term viewpoint.Meanwhile, the CNN Fear & Greed Index is still at extreme fear. 

My contrary view is that we see a rally over the near term – despite the ten handle drop in the S&P Index this morning. I have added to my net long exposure this morning.

And, as I mentioned on Bloomberg “Market Surveillance” this morning, I plan to move back into a net short exposure on a possible rally in the S&P Index towards 2800-2850. As I also mentioned on Bloomberg, shorts are principally trading positions that have to be “hovered over” and actively managed.

That’s my tactical approach and these are my time frames.”

We are now back into the 2800-2850 range and I am preparing (again, unemotionally) to move back to a large net short position.

Here is a partial look at my book which is materially comprised of short term Treasuries (maturities one month to two years): 

  • Longs: (TWTR) , (BOX) (speculative), (DWDP) (HIG) , (C) , (BAC) , (JPM) , (WFC) , (SPY) puts
  • Shorts: (IYR) small

Kass: A Divided Nation We Stand

“As societies grow decadent, the language grows decadent, too. Words are used to disguise, not to illuminate, action: you liberate a city by destroying it, Words are to confuse, so at election time people will solemnly vote against their interests.” – Gore Vidal

* Conventional and consensus wisdom – regarding the election outcome – was confirmed last night

* The end of one man’s rule (Trump), without any restraint, is now over

* Democratic marquee candidates disappointed and the Republicans were rewarded with a larger than expected Senate majority

* The Democratic House win comes with powerful committee ownership – for the first time in two years the Administration will now have a check against their agenda

* Even more volatility and uncertainty lies ahead

* I am now (opportunistically and in premarket trading) adding to my short book

Thus far, the stock market’s immediate response to the split decision last night is upbeat – with S&P futures +26 handles at 5:25 a.m. For now this is affirmation of the notion that gridlock is market friendly – but that can change on short notice!

Adjusted for the futures rise, the S&P Index is now slightly above my projected 3-6 month range.

With risk v. reward now stretched, I am shorting S&P futures at an equivalent of $287.20 in the premarket.

Some Brief Observations:

1) The ugliness of the political scene over the last two years is likely to get more ugly. Though Trump will likely be emboldened – there is now a fundamental difference and divide from the recent past (“checks and balances”). The President no longer has a subservient (Republican) House to deal with anymore – the new (Democratic) House is in marked opposition to his agenda. The President will continue to argue that he is at the epicenter of power (see his tweet of a few minutes ago, below) – he no longer is.

Donald J. Trump @realDonaldTrump

.@DavidAsmanfox “How do the Democrats respond to this? Think of how his position with Republicans improves-all the candidates who won tonight. They realize how important he is because of what he did in campaigning for them. They owe him their political career.” Thanks, I agree!

Donald J. Trump @realDonaldTrump

Those that worked with me in this incredible Midterm Election, embracing certain policies and principles, did very well. Those that did not, say goodbye! Yesterday was such a very Big Win, and all under the pressure of a Nasty and Hostile Media! 

2) As we move towards 2020, the U.S. political scene is headed for a period of elevated animus (even more than we have seen in the past few months) between the Democratic and Republican parties. Whether it’s the affirmation/restoration of voting rights, gerrymandering, infrastructure, the border wall (and other immigration moves), healthcare, etc. – rhetoric will grow even more heated.

3) There will be more finger pointing and infighting between the Administration and the traditional Republican leadership (“Paul Ryan branch of Congress”) over the next few weeks.

4) There will likely be a host of White House Cabinet firings over the next few weeks. Some that are staying will be getting “lawyered up.”

5) In the lame duck session there will be plenty of fighting over the border wall and other Trump initiatives – it will get messy.

6) I suspect little administratively will be achieved over the next 12-18 months – as the end of one man’s rule (The President) is over.

7) The President now faces a hostile judicial and intelligence committees which will have subpoena power over the President.

8) While some industries like the financial sector seem, in theory, to be vulnerable to new committee leadership – I am uncertain as to whether any meaningful changes will be introduced.

9) The legitimacy of the Mueller investigation – a constant thorn in the President’s side – will likely be reinforced by the Democrats. (The political and other consequences are yet unknown).

10) The cast of Democratic Presidential hopefuls probably got even longer as a result of last night’s elections. Harris, Booker, Warren, Sanders and Biden – the preliminary early line favorites – will have a lot of company on the dais.

Bottom Line

After last night’s election, the political sands are likely shifting.

While I have a view of the market’s vulnerability from current levels based on economic, interest rate, etc. influences it is unclear (at least to me) how last night’s election split-decision results will impact the markets over the near term – despite the initial positive reaction overnight.

Gun to my head, I would say the probability that the early and favorable market response to last night’s split-decision will be short lived.

I believe, as in September, 2018, an overshoot to my expected trading range remains possible – I plan to short that overshoot, if it extends further.

While the only certainty is the lack of certainty, the period of a new regime of heightened volatility should continue and is likely to be a steady state through 2019.

In summary, more volatility and uncertainty lies ahead.

The markets will get harder, not easier, to navigate over the next six to 12 months.

Kass: Playing the (Trading) Fool & Avoiding the “Stock Trading Jones”

My trading activity during the spooky month of October was frenetic and my monthly’s trading (in shares) eclipsed any three month period of trading in the last several years.

By benefiting from the new regime of volatility and by the sharp drop in the indices (I was positioned short during the free fall) – I had my best month in over almost two years.

This morning I want to explain why I was so active (in a trading sense) – what were the conditions that moved me towards this strategy – and why it should not be a permanent condition.

I have long tried to take what Mr. Market gives me – whether its during a clearly defined trend or if we are in a trading range.

I buy stocks I like with a funnel approach (and short them the same way) – as prices go lower and become discounted to “intrinsic value” I buy more, not less as the opportunity set is improved. I care little if I am catching a falling knife (rather, I embrace the opportunity) or if the price momentum is weak.

And, I increase my trading activity when the opportunity set expands – when stocks and markets enter a volatile period (much like we have seen in the last couple of weeks).

My Basic Trading Tenets

Let’s say in normal times the daily range of the S&P Index (in percentage terms) is about one half of one percent or approximately 13 handles (I am guessing on this as I cant find reliable data). As a rule of thumb I do not trade actively in “normal times” like these.

I become more active when volatility picks up. The greater the prospects for volatility the more active I become.

And, with ETFs risk parity and other products and strategies becoming more dominant influences – and with everyone on the same side of the boat – I suspect we will see many more periods of heightened volatility and ever more opportunities for unemotional trading.

As we know, one-two percent daily price changes became commonplace in the last few weeks – but the intraday swings were much greater (as in one case, two days ago, it approached a four percent swing). 

I expected this, embraced the rising volatility and I became far more active in the last week.

But… Beware the Stock Market Trading Jones

During the last two weeks, in particular, I have chronicled much of my frenetic trading activity.

Though the volume of trading decisions were likely confusing to many I purposely wanted to illustrate how active I get when volatility rises – and, at the same time, I have tried to demonstrate the rationale of my individual trading decisions, so you can better understand the trading process.

Nevertheless:

(1) This sort of active trading is not for everyone (in fact, it is for the few).

(2) I want to remind everyone that the more trading decisions one makes, the more likely trading boners will surface.

(3) Longer term investing will still be the principal fountain of returns for most investors. 

My 2012 article “The Stock Market Trading Jones” details my views on the risks associated with too active trading:

“Yes, I am the victim of a basketball jones
Ever since I was a little baby, I always be dribblin’
In fac’, I was de baddest dribbler in the whole neighborhood
Then one day, my mama bought me a basketball
And I loved that basketball
I took that basketball with me everywhere I went
That basketball was like a basketball to me

I even put that basketball underneath my pillow
Maybe that’s why I can’t sleep at night
I need help, ladies and gentlemens
I need someone to stand beside me
I need, I need someone to set a pick for me” 
– Cheech and Chong, “Basketball Jones

Growing up on the South Shore of Long Island, my friends and I had one passion that we shared — watching and playing basketball.

We played basketball at least five times a week at the Rockville Centre Recreation Center, at Hickey Field on Sunrise Highway, at St. Agnes High School or at nights at my friend Mark Merson’s court, which was connected to his garage (because his court was the only one in the neighborhood with a floodlight). We even traveled to Midwood High School’s outdoor courts in Flatbush, Brooklyn, for the really good competition.

When we weren’t playing basketball we were watching basketball. Mostly, we would go to the old Madison Square Garden and watch the New York Knicks. In those days, the best of the New York City high schools played games before the NBA Game. I saw Lew Alcindor from Power Memorial and many of the other high school greats there.

We had what was called in those days the basketball jones, an obsession with basketball.

Today I see many traders and investors with a similar affliction, which I call it the stock market trading jones. Market participants feel compelled to overtrade. It comes in the form of a near-obsession in overtrading both on news-based dislocations (to the upside and downside) and on non-dislocations in the normal course of business, typically through chart gazing. The need to play too many earnings reports and the desire to trade macroeconomic events reside among numerous other catalysts.

There are several obvious influences that contribute to the addiction of too-frequent trading:

  • Brokers. Brokerage companies have made trading at home easy and inexpensive. Sophisticated Internet-based trading platforms allow individual investors to trade actively at markedly reduced commission rates relative to any other time in history.
  • Societal pressures that favor short term over long term. As a society, we have grown increasingly impatient. The media (and for that matter our society) increasingly emphasizes short term over long term and instant gratification over building value through intermediate/long-term value. Today, we even communicate more briefly than ever in staccato-like form via tweets of under 140 characters on Twitter and the acronym soup of instant messaging. How-to-profit books, teaching us how to gain money and fame quickly, outsell more thoughtful investing books such as Benjamin Graham’s The Intelligent Investor. All of these pressures (in the pursuit of instant riches) contribute to excessive trading by individuals.
  • Quick solutions and foolish acceptance of a special sauce to investment success. We too often seek quick solutions to complex problems/issues. Increasingly, traders seek a special sauce, an algorithm or stock chart that evokes the promise of immediate success, often shunning the heavy lifting and time-consuming analysis. In its simplicity, this also leads to excessive trading, as if the appearance of a chart is an almost mystical and certain way to produce the Benjamins. Technical analysis has a broad definition and when utilized intelligently can be a very helpful adjunct in making (and timing) trades and investments. But too often the decision to make so many of these trades is seen purely through the narrow interpretation of a stock chart, a view that historical price action will provide us with a guide into the future. I see this often on Real Money Pro – particularly in front of an earnings release. Does anyone really think that prior to, say, Nike (NKE), or any other company reporting its most recent earnings, a trader can outsmart the legions of other traders by virtue of looking at a chart? Does that really make sense to any of you?
  • Shortening cycles. In our fast-moving world, economic, corporate and investment cycles are ever more truncated. Performance definitions grow ever briefer, whether it is the duration of a CEO’s or baseball manager’s career, measuring a company’s profit performance, investors’ patience with their investments (manifested in heavy turnover and reduced holding periods compared to any time in history) or with defining investment performance.

All of the above factors contribute to the impatience and heavy trading manifested in the stock market trading jones.

I have believed that by developing a variant view through hard-hitting and investigative research (e.g., contacting company managements, their competition, suppliers or through other means), you will have a much better chance of succeeding with an occasional trade. But, even that fundamental approach (which is time-consuming and doesn’t fit in with some who believe that trading gains can be as easy as gazing at a chart) represents a difficult journey toward trading success, especially when it, too, is done with too much frequency.

Regardless of the rationale for action, however, a large portion of traders simply seem to have a trading jones – a need to play, a need for action. (Just look at the lion’s share of the remarks in our Comments section every day; they are dominated by intraday or multiday trading plays.)

In my investment experience, I have seen many more professional traders armed with every trading system that money can buy (who have been inflicted by the jones of constant trading) blow up rather than succeed over time. Then, why should you, as an individual investor, be more successful?

The answer is that, in all likelihood, you will not be.

Nonstop Trading Is a Mug’s Game

So, let me be direct and straightforward on this subject – nonstop, excessive trading is a mug’s game.

Any market mathematician will tell you that the more trades you make the less successful you will be.

I have written for years that waiting for the right pitch in trading and investing is the way to succeed over the long run in this game.

I believe this now as strongly as ever.

Constant Trading Has Always Been the Media’s Selling Point

Constant craving
Has always been –
 k.d. lang,Constant Craving

The business media is well-intentioned and inhabited by a lot of my friends. I am respectful of their contributions, but they too often encourage the stock market jones.

By and large, the media have an agenda that is different from yours. It doesn’t make them bad guys – their objectives of a growing audience and higher ratings are inherently dissimilar to your objective of making money.

Moreover, as I have recently chronicled, the media’s reaction to events of the day (e.g., the sovereign debt crisis, the Presidential election, the fiscal cliff, etc.) is often hyperbolic and simply wrong-footed (from an investment standpoint).

Always remember that they are in the press box, and you are on the playing field.

Not surprisingly and understandably (it’s in their basic interest), the media too often advance the idea of constant craving of trading and even, at times, (by inference) the dream of instant investor gratification. For every long-term investor queried, it seems as if there are at least 10 traders (maybe more) questioned in the business media.

Maybe it wouldn’t sell as well, but I wish there were more forums and time spent on long-term investing in the media.

Unfortunately, many investors watching and listening can’t help from being influenced by the media’s barrage and sometimes short-term emphasis of time frame. By contrast, long-term price targets (defined in years) are deemphasized, as these are not subject matter seen as capturing ratings and audiences, and typically take a backseat in discussions.

We are often inundated with ways to make fast money. By inference, the pundits and talking heads tell us that this is best accomplished by trading almost every market or individual stock wiggle, often based on technical levels and/or in the knowledge of how to react to certain triggers or events.

In the ultimate level of the absurd, the media conduct contests to guess where the S&P 500 and DJIA will close at month’s end, what will be the exact jobs number and so on, as if these guesses will provide some sort of magic market elixir to delivering outsized trading gains. The thrust of many of the conversations on CNBC and Bloomberg are too often based on mindless guessing of short-term forecasts of which few really have any edge whatsoever.

How often does a business show start with the moderator saying something like this: “The S&P is up by half a percent today, so where is it going to end the day?”

Or the dialogue goes something like this:

  • “What is the next move in Apple (AAPL) ?”
  • “How do we play IBM’s (IBM)  earnings report tonight?”
  • “Whither Research In Motion (BB) ?”
  • “If Friday’s jobs report is 150,000 or more, how will the market react?”
  • “How will the fiscal cliff debate impact the market today?”
  • “Sovereign debt yields are lower today – how will our markets react?”

You get my point by now – continually going one on one against the trading world by guessing on near-term market and individual stock moves is a difficult (if not impossible) pathway to investment success.

Trade in Moderation

Importantly, I want to emphasize that there is a place for trading, as I believe intelligent trading can be a profitable adjunct to investing.

I am very much an advocate of opportunistic trading, especially when one concludes that the market is range-bound without a clear bias in either direction or, for example, when one can get in front of an earnings report with an informed and variant view or by responding quickly to an earnings quality in an earnings report (among other means).

Done effectively, trading can result in a cash-register effect, contributing to the aggregate returns in your investment account.

But only in moderation and only when the right pitch (read: enhanced reward vs. risk) is offered up.

In Summary

“Millions of people die every year of something they could cure themselves: lack of wisdom and lack of ability to control their impulses.” – Irving Kahn, Chairman Kahn Brothers Group

The essence of today’s opening dispatch is that my definition of a good trading setup is far narrower and more selective than most on Real Money Pro and elsewhere.

My advice is to stop dribbling your way into multiple and numerous trades that one justifies by reacting to the media, based on technical analysis or based on any number of other reasons – unless you are very lucky, it will not pay off in the long run.

More likely, you will trade (and churn) your way into investment oblivion!

Oh, it feels so good, gimme the ball
I’ll go one on one against the world, left-handed
I could stuff it from center court with my toes
I could jump on top of the backboard
Take off a quarter, leave fifteen cents change
I could, I could dribble behind my back
I got more moves than Ex-Lax I’m bad”
 “Basketball Jones

Kass: High Anxiety In The Markets

“Brophy: I got it. I got it. I got it. 

[thump] 

Brophy: I ain’t got it.” – Mel Brooks, High Anxiety

Arriving at Los Angeles International Airport, Dr. Richard Thorndyke has several odd encounters (such as a flasher impersonating a police officer, and a passing bus with a full orchestra playing inside it). Dr. Thorndyke remarks:

“What a dramatic airport!”

He is taken by his driver, Brophy, to the Psycho-Neurotic Institute for the Very, Very Nervous, where he has been hired as a replacement for Dr. Ashley, who died mysteriously. Brophy has a condition of nervousness, and he takes pictures when he gets nervous. Upon his arrival, Thorndyke is greeted by the staff, Dr. Charles Montague, Dr. Philip Wentworth, and Nurse Charlotte Diesel. When he goes to his room, a large rock is thrown through the window, with a message of welcome from the violent ward.

During the movie, Thorndyke suffers from a neural disorder called “High Anxiety”, a mix of acrophobia and vertigo, and tries to overcome the infliction.

We Live In Mel Brook’s Crazy World Now

With an intraday move of almost 4% – the S&P futures fell by a remarkable 100 points from the day’s high to the day’s low. A large sell program at around 3:30 p.m. abruptly moved the market down by fifty handles in one of the largest sell programs I have ever seen hit the floor. (The day’s swing in the Dow Jones Industrial Average exceeded 900 points!)

The Spyders peaked at over $270 at around 10:10 a.m. and bottomed at under $260 (with 30 minutes left in the trading session). Spyders closed the day at $263.86.

Talk about High Anxiety!

As I write this morning’s missive the market volatility has continued. When I started writing this column, S&P futures were +18 and Nasdaq futures were +38 . They are now essentially flat, on no new news.

What Was Trump Thinking?

Since early 2018 I have warned that the return of The Orange Swan introduces more uncertainty – “Making economic uncertainty and market volatility great again.” #MUVGA I have and continue to caution that Trump’s behavior and his (hastily crafted) policy – conflated with politics – are now hurting the markets.

Case in point, futures rose early on Monday after the president said that he is going to make a great deal with China.

Then, in the middle of Monday’s volatile trading session (at around 2 p.m.), the president added fuel to the trade war with China with another threat to introduce more tariffs on the rest of China’s imports to the U.S.

As I wrote late in the day, Karen Finerman, on CNBC’s Fast Money, asked an interesting question – why did Trump bring up the Chinese tariff debate again?

After all he already has stated (as has Steve Mnuchin) that the stock market is a real-time judge of the administration’s economic policy and he must have known that his comments would be market unfriendly.

So, what was it?

Here are some possibilities:

  1. He is doubling down and posturing against the Chinese (I doubt it because he has already been quite hawkish in his trade rhetoric).
  2. Is the president simply oblivious and doesn’t care about the impact of his actions? (That’s hard to believe because we are so close to the important midterm elections).
  3. Is he not focused? (I don’t know)
  4. Was the statement part of a broader or more grand strategy? (I have no idea)
  5. He just felt like saying it, wants to humiliate China and is appealing to his base. (No clue, here)
  6. Is he playing chess while everyone else is playing checkers? (Doubtful)
  7. Is he testing the market’s response to a ridiculous policy that he has no intention of implementing? (Again, I am clueless)
  8. Is he overplaying his hand? (Clueless, Part Trois)
  9. Is it simple arrogance and ignorance? (Clueless, Part Four)
  10. Is he trying to change the narrative from the bomb mailings and the terrorist act in Pittsburgh? (You get the point by now!) 

I Have Warned About The Growing Risks of A “Flash Crash” in 2018

Back in December, 2017, I warned:

Surprise #9: Volatility Spikes, Causing a Major Flash Crash

“Though large daily drops in the markets are rare, the factors that could contribute to a quick drop have increased.

Investors have been concerned about the VIX for years, but the positioning has now moved to an extreme. Such positioning could accelerate a market drop as the chances of a flash crash have escalated.

Hyman Minsky has warned about the risks of becoming numb to the risks associated with a period of stability amid rising asset prices; it is not only inevitably followed by instability, it inevitably creates it.

In a world in which the chances of an external market shock are rising and at a time when volatility is cratering and stock prices never decline, the risks of a flash crash caused by the one-sided market positioning in VIX futures is increasing and are at a higher probability of occurring than at any time in history.” – Kass Diary, 15 Surprises for 2018

Kill The Quants Before They Kill Our Markets

Most observers are of the view that there is order in our markets today – that fundamentals and/or technicals are understandable and analyzable stars that shine above us and give us direction.

If you believe the market’s volatility is a function of the earnings reports, trade wars or interest rates concerns – I believe you are mistaken. Rather, this is the cruel cocktail consisting of the proliferation of ETFs and other quant strategies.

But, its not our “fathers’ market.” These factors used to be an important determinant to stock prices – they still are, but markets are now too frequently punctuated by the influence of ETF flows and risk parity leveraging or deleveraging.

As an example, it’s commonplace, in a market that moves by nearly 1000 DJIA points from high to low for bond markets to exhibit a “flight to quality”, for gold to rise and/or volatility to explode to the upside. None of this happened yesterday. There was no movement in bond yields lower (bond yields were up one basis points) nor a rise in the price of precious metals (gold fell). Credit spreads would also normally widen in the sort of volatility we saw on Monday – this, too, did not happen. And, importantly, volatility rose by a mere 50 cents.

I used the 3:30 p.m. “woosh lower” to add to my trading long rentals. It was not an easy tactic as markets were in a scary free-fall (a likely occurrence that I predicted previously in my Surprise List 10 months ago).

Tactical Approach to an Anxiety-Driven and Machine/Algo Influenced Market 

Throughout 2018 I have been looking at a projected S&P range of approximately 2550-2800. (In September we overshot the top end of my range by about 120 S&P points.) 

My “fair market value” calculation has been about 2500 and my pessimistic case has circled around the 2400 level.

I have been consistent with my forecasts – and I continue to basically have the same range projection (2550-2775), “intrinsic value” of (2500) and pessimistic case (2400). 

There are numerous reasons to be cautious today – a changing and more problematic market structure, a monetary pivot, trade rhetoric/wars, ambiguous global economic growth, political (The Orange Swan) and geopolitical uncertainties, etc. The market is still “a full on Monet”.

The new regime of volatility is now another bona fide reason to sit on the sidelines.

All these factors, I have argued, cap the market’s upside to levels much lower than believed by the consensus.

Nevertheless I am sticking with my process and trying to trade unemotionally and let the market’s wild moves work to my advantage. (In days like yesterday it was tough to divorce myself from the volatility in order to reach for opportunity – but I purchased the late afternoon “woosh” based on the move to the lower end based on my projected the 3-6 month trading range of 2550-2775 and what the current price provided in terms of reward v. risk. (At around 3:30 p.m. S&P cash traded at about 2598 – within 50 handles from the estimated low of the range).

Unlike many talking heads I do not confidently make these projections – as I recognize that the plethora of fundamental outcomes as well as the dangers of a changing market structure (in which too many are on the same side of the bullish boat and an increasingly large amount of traders/investors worship at the altar of price momentum).

The global stock markets are damaged (non U.S. markets led this decline which, in many stocks, are already in bear market territory) – it’s still “a full on Monet!”

“It’s like a painting, see. From far away it’s okay, but up close it’s a big ol’ mess.” 

I am still of the view that we made important tops in late January, 2018 and in September, 2018 – and that tops are processes, not events.

But, when anxiety and fear are elevated, trading opportunities abound.

Bottom Line 

I started Monday on an optimistic note, “The Case For an Oversold, Contra Trend and Playable Rally Higher Increases in Probability” – and, on cue S&P futures rose by over 30 handles in the early going:

The last thirty minutes of trading on Friday bears witness to the disproportionate role of passive strategies (ETFs and risk parity and other quant strategies that worship at the altar of price momentum – and exaggerate short term market movement – in which the Dow Jones Industrial Average moved up and down in excess of 400 points.

This unnatural backdrop – which showed a sharp drop in the last few minutes – was likely artificial and provided yet another short term trading opportunity.

As I have been harping on, the market is dynamic and we, or at least I, have to unemotionally and opportunistically trade in order to deliver superior investment returns. The machines and algos should be taken advantage of. (I covered my (SPY)  short on Friday at very nice prices and for a quick, few hours, +$4 to $5 gain.)

Though I have little idea how long it will last, there are several factors that may contribute to higher stocks in the next few weeks:

* As the Reporting Period (for 3Q2018 earnings) Matures, Buybacks Will Soon Be Back

* Investor Sentiment Is Dismal: The CNN Fear & Greed Indicator is at an ‘extreme fear’ level.

* Many talking heads in the media, formerly bullish, are now fearful.

* An Oversold Market: Several market Indices are 2-3 Standard Deviations Below 50 Day Moving Averages.

* The End of Mutual Funds’ Fiscal Year: Loss taking may soon be over as the month and fiscal year end on Wednesday.

As previously mentioned, I (unemotionally) purchased the “woosh” lower on Monday and I am temporarily net long based on my calculation of upside reward v. downside risk.

Kass: An Open Letter To Larry Kudlow

“We believe that free market capitalism is the best path to prosperity!” – The Kudlow Creed

Dear Larry,

You and I go way back – we have been friends for many years.

I deliver this letter to you out of respect and in recognition of that friendship. It is being submitted and is intended to be respectful, courteous, analytical and forward thinking.

This letter is being offered in several parts:

  • Our strong friendship
  • Why domestic economic growth is weaker than is apparent and the White House believes
  • Risks associated with the delivery and substance of the Administration’s current policy towards China 
  • Suggestions

The Current Trajectory of Domestic Economic Growth is Weaker Than It Appears

* Look bottom up and not top down to decipher U.S. growth trends and risks

All this said, I respectfully disagree with you on a number of statements you made recently in an interview with Scott Wapner on CNBC in which you said:

“Our economy and the people and the workers and entrepeneurs, they’re killing it. We’re the hottest in the world. We’re crushing it right now, and I think that’s going to continue regardless of China… I don’t think this is anything resembling a sugar high… America is on a tear… It has strong legs”

To begin with, the jobs market is not as strong as it is being heralded – this is not “the greatest jobs market in history.” Indeed, the Obama Administration created, on average, 211k non farm payroll jobs/month in its last 20 months compared to 190k jobs/month in the first twenty months of the Trump Administration. And since the total US population climbs every year (+250% in the last seven decades), the percentage improvement, on a per capita base, is not that impressive in 2017-18. The same observation applies to wages – they are not simply anywhere as grand as currently advertised by the White House.

There is now ample ‘bottoms up’ evidence (discussed in the next section) that the domestic economy is much weaker than you suggested last week as numerous companies are missing the consensus expectations. More importantly, as reported by Schwab’s Liz Ann Sonders, we are now experiencing the highest percentage of S&P 500 companies issuing negative earnings guidance since the first quarter of 2016. Highest percentage of S&P 500 companies issuing negative earnings guidance.

Overall, the underlying economic growth story, outside of one-time events and natural disasters, isn’t nearly as strong as reported. My pal and former advisor to Dallas Federal Reserve President Richard Fisher, Danielle Dimartino Booth, concurs with my assessment:

“Against that backdrop, it’s becoming clear that many companies are rushing to secure products and materials before prices rise regardless of current demand. You could say they are in panic-buying mode. The upside is that this behavior bolsters economic growth in the short term. The downside is that there is likely to be a nasty hangover. The noise in the economic data will be amplified by the rebuilding from Hurricane Florence. The estimates of the storm’s damage span from $20 billion to $50 billion.”

Given the size of the tax cuts and the increase in government spending it should not be surprising that Real U.S. GDP has risen from about +2.5% to more than +3.75%. But this boost is a “sugar high” and not sustainable. Tax cuts and relentless government spending only serves to push forward and borrow from future economic growth. And so has the financial repression (zero interest rate policy) of the last nine years served to pull forward domestic economic growth.

Considering the age and strength of our economy we should be achieving a surplus – instead the deficit is expanding. Economic growth is greatly debt dependent and is therefore unsustainable in a very real sense. Fiscal 2017 GDP rose by $1.3 trillion but the federal deficit rose by exactly the same amount – $1.3 trillion. Tax cut based and increased spending help to explain why confidence is so high, but the delta (rate of change) in these two factors will not exist in perpetuity.

Rising government debt, sanctioned in the U.S. by both parties, is fiscally irresponsible and, with rising interest rates, growth will be sapped. This imprudence is not restricted to the U.S. as, if we look at the 180 most important economies of the world, only seven have in their estimates an improvement in commercial and fiscal imbalances – so almost no government in the world plans to reduce the rate of debt increases.

Over the last decade, the tools of monetary ease, (providing more and more liquidity) and rising government spending have been increasing less productive – for every $3 in debt created has only resulted in $1 of GDP in the U.S. We are now at a point of diminishing returns of policy and potentially even at a point of saturation.

Since The Great Recession in 2007-08, the accumulation of large debt loads in the private and public/sovereign sectors are now being adversely impacted by rising interest rates and, when combined with harsh trade rhetoric (with China) is serving to jeopardize economic growth.

Already the auto industry is foundering and housing has stalled. These are two industries, as our mutual friend Jim Cramer says, that punch above their weight in terms of aggregate impact on the US economy.

Globally, in a flatter and more interconnected world (reflected by a record share of non U.S. sales/profits of S&P 500 companies), we are impacted by first and second order consequences of our policy and rhetoric – with risks to higher costs and disruption in important supply chains.

Risks Associated with the Delivery and Substance of the Administration’s Current Trade Policy

Though the headline (and lagging) high frequency economic data may appear promising we are already seeing rising cost and supply chain problems in the current third quarter earnings reporting period – much of which is in the province of and directly derived from the trade disputes with China.

Recent warnings have been communicated by cyclically sensitive companies like Fastenal (FAST) , Ford (F) , General Motors (GM) , Lennar (LEN) , Trinseo (TSE) (a Dow Company spin out), United Rentals (URI) , Textron (TXT) , W.W. Granger (GWW) , Sealed Air (SEE) and PPG (PPG) as well as by more stable companies like Kimberly-Clark (KMB) , Kraft Heinz (KHC) , Campbell Soup (CPB) and many others.

The prices of Drs. Copper and Linerboard are telling a story of weakening economic activity. And so are numerous other commodities prices.
According to JP Morgan, the U.S. economy has a roughly 28% chance of falling into a recession in the next 12 months. The recession probability surges to 60% if the forecast period is extended to two years.

The bankruptcy of Sears (SHLD) and K Mart could add 75k-100k in layoffs as Joseph Schumpeter’s creative destruction and the Amazoning (AMZN) of our economy continues apace – providing a further and secular headwind to growth.

The world is flat and global growth is slowing. The Fed is now on autopilot (and is jacking up interest rates) and the world’s global bankers are also making a monetary pivot.

Tariffs are a tax on the U.S. consumer and trade talk is now impairing global trade and the IMF has, once again (last week), downgraded worldwide growth projections for 2018 and 2019.

Our largest S&P companies have successfully penetrated overseas markets and have steadily expanded their non U.S. exposure (in sales/profits) over the last several decades. Our country’s largest companies are called “multi nationals” for a reason – and their future prospects are increasingly tied to the health (of non-disruptive) world trade and sound trade policies.

The global stock markets are a leading economic indicator. For some time non U.S. markets (led by Europe and China) have been dropping, in recent weeks the U.S. stock market has followed suit. Markets are not coincident indicators, not lagging indicators – they are leading indicators. And in the last few weeks (and particularly in the tantrum since Wednesday) the markets are telling a story – and, based on price action, it’s not a fairy tale.

Finally, the President’s open and harsh trade dispute with China and our country’s renewed isolationist policies may threaten China’s willingness to finance our deficits (anywhere near the current level of interest rates) by offering up their excess savings. With over $10 trillion of global corporate bonds maturing over in the next five years (from a recent McKinsey Global Institute study , $7 trillion of Treasuries (currently paying on average a coupon of only 2%) rolling over, near all-time debt/GDP ratios and central banks’ quantitative tightening around the world – unlike “The Street Car Named Desire’s” Blanche DuBois – we may no longer be able to rely on “the kindness of strangers.”

From a forward looking economic standpoint, this compounding curve of debt is quite worrisome.

Bottom Line Observations and Suggestions

“We should be slow to speak and patient in listening to all…Our ears should be wide open to our neighbor until he seems to have said all that is in his mind – St. Ignatius

First, we should be cognizant of the fragile state of the U.S. economy and that there are already signposts of a weakening in the rate of growth, rising cost pressures, and developing supply chain disruptions – which, if it continues, will lead to lower business activity and deterioration in U.S. corporate profits. These perceptible warning signs should not be ignored.

Second, the U.S. stock market’s recent tantrum and the continued, steady weakness in overseas markets are likely a warning signpost of “Peak Global Growth.”

Third, policy rhetoric should be more subdued and conflated less with politics – behaving less like singer Meghan Trainor who (to paraphrase) famously sang that “it was all about the base, the base, the base” and more like St. Ingatius.

Fourth, the global economy is flat and interconnected. There are more dominoes today than yesterday and more yesterday than there were the day before. Again, our policies need to follow the path of St. Ignatius who wrote that “nations should be linked for good.”

In order to avoid a policy mistake and to hold off a deterioration in consumer and business confidence that leads to a quick downturn in our economy, the current President must begin to act more like President Teddy Roosevelt who carried a big stick but talked softly. As it relates to our current trade dispute with China (and others), President Trump might consider taking the advice from St. Ignatius who advised that if one must correct another, it ought to be done “without hard words or contempt for people’s error.” And so might Vice President Pence tone it down, who, in a recent speech at the Hudson Institute strongly suggested that the dispute with China goes far beyond the realm of trade.
“America had hoped that economic liberalization would bring China into a greater partnership with us and with the world. Instead, China has chosen economic aggression, which has in turn emboldened its growing military. As history attests though, a country that oppresses its own people rarely stops there. And Beijing also aims to extend its reach across the wider world.

The American people deserve to know: in response to the strong stand that President Trump has taken, Beijing is pursuing a comprehensive and coordinated campaign to undermine support for the President, our agenda, and our nation’s most cherished ideals.

China is also applying this power in more proactive ways than ever before, to exert influence and interfere in the domestic policy and politics of this country. And worst of all, China has initiated an unprecedented effort to influence American public opinion, the 2018 elections, and the environment leading into the 2020 presidential elections. To put it bluntly, President Trump’s leadership is working; and China wants a different American President.

There can be no doubt: China is “meddling in America’s democracy.”

To paraphrase President Lincoln’s “A House Divided Against Itself Cannot Stand” speech in June, 1858, I do not expect the U.S. economic recovery to be dissolved and I do not expect our economic house to fall anytime soon.

But I do expect that the economic recovery will cease and corporate profits will fall from current levels if we continue to be divided and engaged in harsh rhetoric and trade battles with our neighbors that will, in the fullness of time, bring on multiplying and adverse first and second order consequences.

Fondly,
Doug Kass

Kass: Tops Are Processes – Part Deux

“Tops are a process, bottoms are an event.” –Wall Street adage

Back in July I wrote about the possibility of a market top; that warning “bears” repeating in an updated form and version.

In that column I wrote that tops are a process and bottoms are an event, at least most of the time in the stock market. If you looked at an ice cream cone’s profile, the top is generally rounded and the bottom V-shaped. That is how tops and bottoms often look in the stock market, and I believe the market is forming such a top now.

Consider the following fundamentally based issues and concerns:

* Downside Risk Dwarfs Upside Reward. I base my expected market view on the probabilities associated with five separate (from pessimistic to optimistic) projected outcomes that seize on a forecast of economic and corporate profit growth, inflation, interest rates and valuation. In the past I have suggested that this exercise is a guide and is not intended to be a precise calculation, especially in uncertain times. The averages recently have surpassed my expectations of a top in the trading range by about 120 S&P points, or about 4%. With the S&P 500 Index at 2923 at Friday’s close we are significantly above my calculation of intrinsic value.

* Global Growth Is Less Synchronized . The trajectory of worldwide growth is becoming more ambiguous. I have chronicled extensively the erosion in soft and hard high-frequency data in the U.S., Europe, China and elsewhere, so I won’t clutter this missive with too many charts. But needless to say (and as shown by these charts here and here), with economic surprises moderating from a year ago and in the case of Europe falling to two-year lows, we are likely at “Peak Global Growth” in the current quarter. (The data are even worse in South Korea, Taiwan, Indonesia and Thailand.)

* FAANG’s Dominance Represents an Ever-Present Risk. I have warned that earnings disappointments in the FANG stocks represents an immediate risk to this league-leading sector, and to the markets FANG has become GA! Since I initially wrote this article investors have been clearly rotating out of FANG, reflecting misses in important metrics (subs) and some lower broader guidance ahead. As well, the existential threat of increased regulation and antitrust hostility that I warned about nearly a year ago are now on the front burner.

* Market Structure Is One-Sided and Worrisome. Machines and algos rule the day; they, too, are momentum-based on the same side of the boat. The reality that “buyers live higher and sellers live lower” represents the potentially dangerous condition that investors face in a market dominated by passive investors — a threat I have focused on since early 2017.

* Higher Interest Rates Not Only Produce a More Attractive Risk-Free Rate of Return, They Also Make It Hard for the Private and Public Sectors to Service Debt. And over the last 2 1/2 months short-term interest rates have made a decisive move higher. This also serves to reduce the value of stocks as every dividend discount model incorporates a discount factor based on the current level of interest rates.

* Trade Tensions With China Are Intensifying and Mr. Market Is Improperly Looking Past Marginal Risks. From Goldman Sachs’ David Kostin (h/t Zero Hedge). Remember, as previously discussed, the dispute has buoyed second- and third-quarter U.S. GDP. The benefit soon will be over and a third-quarter economic cliff is possible.

* Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window by Both Political Parties. This has very adverse ramifications , which shortly may be discounted in lower stock prices, especially as it relates to the servicing of debt — a subject I have written about often. Not only are our legislators acting irresponsibly and recklessly, but the Republican Party is now considering more permanent tax cuts. Should economic growth moderate, tax receipts diminish and undisciplined spending continue, stock valuations will likely continue to contract.

* Peak Buybacks. Buybacks continue apace, but look who’s selling. As Grandma Koufax used to say, “Dougie, that’s quite a racket!” If I am correct about the peaking in corporate profits, higher interest rates and slowing economic growth, we shortly will have another rate of change — negative in buybacks.

* China, Europe and the Emerging Market Economic Data All Signal a Slowdown. It’s in the early innings of such a slowdown based on any real-time analysis of the economic data. The rate-of-change slowdown on a trending basis is as clear as day. A rising U.S. dollar and weakening emerging-market economic growth sow the seeds of a possible U.S. dollar funding crisis. This slowdown has not gone unnoticed by investors, as emerging markets have declined absolutely over the summer, materially lagging the strength in the S&P index and the Nasdaq.

* The Orange Swan Has Returned. Again, hastily crafted policy delivered by Twitter that conflates politics is dangerous in a flat and networked world. The return of an untethered Orange Swan is market-unfriendly… brace yourselves as the Supreme Tweeter will likely “Make Economic Uncertainty and Market Volatility Great Again” (#MUVGA) This weekend’s allegations against the Supreme Court nominee likely raises the risks of more volatility and may jeopardize some elements of the administration’s agenda.

* We Are Moving Closer to the November Elections, With Their Uncertainty of Outcome and the Potential For a “Blue Wave.” The current sub-40% approval rating (which is trending lower) for the president is historically a losing proposition for the incumbent. We also may be moving toward some conclusion of the Mueller investigation, creating even more uncertainty.

Bottom Line

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” –Benjamin Graham

The search for value and comparing it to risk taken is, at its core, the marriage of a contrarian streak and a calculator.

While it is important to gauge the possibility that the market may be making an important top, it is even more important to distill, based on reasonable fundamental input, what the market’s reward versus risk is. This calculus trumps everything else that I do in determining market value.

On that front, I continue to believe that downside risk dwarfs upside reward.

Moreover, there is a growing fundamental and technical list of signposts — many highlighted this morning — that the market is starting to look like it is in the process of making a possible, and important, top.

As Columbia University’s Joel Greenblatt wrote:

“There’s a virtuous cycle when people have to defend challenges to their ideas. Any gaps in thinking or analysis become clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.”

I do a lot of back and forth every day in my Diary as I try to communicate my own views, which today seem most contrarian to the consensus and to those who worship at the altar of price momentum!

Kass: The Bullish Bias Resounds

This morning the futures (S&P and Nasdaq) are, as is the custom, higher.

The markets continue to ignore a number of cautionary signposts/macroeconomic events/concerns and are benefiting from the float shrink of 5-7 years of corporate share buybacks, the dirty water of liquidity (contributed by the world’s central bankers), the heightened role of price momentum based and other (risk parity) quant strategies and the rising popularity of passive, index funds.

Adding significantly to the demand for stocks are central banks (most notably BOJ and the Swiss National Bank) who, through their active equity investing, make them the sovereign equivalent of Fidelity Management as they have become one of the dominant investors of our time.

Moreover, in a backdrop of reduced retail activity (in individual stocks, save whatever is the speculative play du jour), materially reduced mutual fund turnover and the lower role of active hedge funds (they too have mostly become quants) the demand v. supply equation for equities continues to favor buying over selling.

Bouts of selling are quick – and when stocks trade lower the buy on the dip crowd makes its rescue and arrests the drop.

Finally, probably 4-8 very large (long biased) macro funds are likely dominating what little activity/volume there is, buoying stocks as the water sloshes around in the bathtub of equities.

The sort of cautionary technical signs – like a lagging Russell Index (yesterday) – no longer provide the historical predictive role that has been the case in the past. Iomega-like speculation in stocks like NIO and TLRY are viewed as normal. And the breakdown in selected, market leading technology stocks and the lackluster performance of financials are dismissed as “one offs” by the bullish cabal.

Reactionary technicians find the markets to be titillating (scoffing at the anticipation of untoward fundamentals) and unconcerned about reward v. risk or, arguably rising economic ambiguities (low interest rates and a narrowing yield curve), the unprecedented lack of cooperation between world powers (in a flat and interconnected world), large public and private debtloads, the unstable political setting, the failure of fiscal policy to trickle down, the divergence between the S&P Index and other world (emerging) markets, orange and black swans and the global pivot of monetary policy.

In particular, the fact that the rising wave of debt and central bankers’ liquidity injections have failed to produce steady wage growth and productive investments in the real economy go unnoticed by those that worship at the altar of stock price momentum.

And I will remind everyone, what caused the ten percent correction in late January/early February was the rise in interest rates. Well, today, we are right back a fresh ten year high in the yield on the two year note and the ten year Treasury yield is back to 2.99%.

How long this investment bliss and consistent buying continues is anyone’s guess but the degree of complacency (and the absence of fear and doubt) are off the charts.

Signs Of A Problem

In “The Bear in the Market Is Roving Right Now,” Jim “El Capitan” Cramer zeroes in on the developing carnage in selected groups.

“We’ve got roving bear and bull markets all over the place and they have come to define what happens every day including today.

That’s a big change from my previous view of this market where I had held that there are roving bull markets and when stocks weren’t in bull mode, they rested.

No, I am not saying that the market’s become too treacherous for most people to handle.

I am saying that there are some incredible declines that must be addressed because they are so glaring and, at times, so nasty, particularly when they occur intraday.”

The bear market not only can be seen in Intel (INTC) , Micron (MU) and Facebook (FB); it can be seen, as I have cautioned, in other regions in the world. Indeed, the divergence between the S&P 500 Index and the MSCI Emerging Markets Index hit a 15-year high this week. As meaningful and looking out over the last seven years, the S&P Index is up by nearly 180% while the emerging markets are only up 14%:

Source: Pension Partners

Again, from Jim:

“If you want to see what a textbook bear market looks like, consider the emerging markets with the Hang Seng from Hong Kong, down 21%, Russian, down 20%, Greece, off 29%, the Shanghai index of mostly larger capitalization stocks is off 26%, and the Shenzhen, with smaller cap stocks is off 31%.”

As I wrote late yesterday, Wednesday’s strength in consumer staples (such as Kraft Heinz (KHC) , PepsiCo (PEP) , Unilever (UN) and Procter & Gamble (PG) ) and a drop of two basis points in bond yields may be construed as a risky backdrop and indicative of concerns regarding a slowdown in the rate of domestic economic growth. Also, weakness in regional bank stocks (I issued a cautious warning yesterday on bank third-quarter earnings) and the foundering FANG are not healthy signposts.

While the constant flow of corporate buybacks and the stronghold of fearless investors in ETFs continue to provide a tailwind to our markets, it remains my belief that the large stock declines Jim mentions above may broaden out and that we already may have experienced the highs in the Nasdaq and the S&P indices for the year.

Both the bull market and the economic recovery are long in the tooth and face the challenges of a pivot in global monetary policy, competition from ever-higher risk-free rates of return (the one-month Treasury bill yields more than 2.00% compared to the S&P 500 dividend yield of about 1.80%) and a number of other possible adverse outcomes in the economic, political and policy spheres.

Bottom line

Regardless of one’s market view, if you left early please make sure to read El Capitan’s late Wednesday synopsis of the market. It has a lot of merit, it’s a great read and provides pithy food for thought.

Market tops are processes and, from my perch, I believe that since late January 2018 we have been making an important one

Kass: Fallen Angels & Lessons Learned

“Hello I Mr. Ed.

A horse is a horse, of course, of course,
And no one can talk to a horse of course
That is, of course, unless the horse is the famous Mr. Ed.

Go right to the source and ask the horse
He’ll give you the answer that you’ll endorse.
He’s always on a steady course.
Talk to Mr. Ed.”  – Theme Song to Mr. Ed

The rapid decline in Tesla’s (TSLA) shares over the last month and the continued fall of two prior market darlings, Intel (INTC) and Micron (MU) , should remind us of the poisoned cocktail of “ Group Stink.”

Should the market fall, as I expect, there will be many more fallen angels.

I wanted, therefore, to reposte a recent column, “A Horse Is A Horse Of Course, Of Course” – which “bears” repeating because of the lesson communicated:

Rising stock prices have a way of changing sentiment (h/t Divine Ms M) 

Eleven years ago, as The Great Recession was bubbling up, market commentators were nearly unanimous in the view that the proliferation of those weapons of mass financial destruction (mortgage derivatives) would not produce a contagion.

Those commentators were famously wrong. Indeed, were it not for swift monetary and fiscal relief, the deep contagion that engulfed the global financial system would have bankrupted the entire worldwide banking community and companies like General Motors (GM)  , Bank of America (BAC)  , Citigroup (C)  and many others would no longer exist.

“Contrary to the view of some, a possible change in Washington D.C. leadership and policy may have broad investment ramifications on numerous market sectors (e.g. drug, defense and financial industries)”– Kass Diary, All the President’s Men (and Mess)

Today, though the body of the Administration has been diseased (in multiple ethical, moral lapses and in other ways), many of those same commentators who dismissed the mortgage derivative problem (a decade ago) suggest ignoring the indictments and guilty pleadings of multiple campaign members of the Trump team and the general culture of corruption that currently exists in Washington, D.C. — that these considerations will have little impact on policy, the balance of power, the economy and our markets.

Many of the same “talking heads” also possess the same view that bearish market analysis rationale may sound superior to the bullish case – but, they too, in the main, are wrong. Instead, many of them quickly point to a chart or some other independent variable in support of their (non-rigorous) case.

As Ben Hunt wrote in this week’s Epsilon Theory ( Death in the Afternoon):

“Where there’s shame, for both investing and beekeeping, is not sticking with your process. And if your process is only for getting into an investment or starting a new colony … sorry, but that’s not a process. Investments and animals have a life cycle. Your JOB as an investor and a beekeeper is to be there for the entire life cycle, even for the really hard parts like culling a weak queen or getting out of a weak investment. Even if it’s raining outside.”

I remain an investor (and the author of my Diary) because I have profited over numerous stock market cycles over the last four decades.

I have consistently resisted (when appropriate) the notion of “Group Stink” and the commonly held view by many that superior investment performance can be achieved by a simplistic view or by a quick glance at “activity” or at a chart.

The investment mosaic is complicated.

Back in 1980 I entered the harness racing business – over time I raced, bred and drove trotters and pacers.

My first trainer was Pittsburgh’s Delvin Miller. Delvin was a legendary horseman but he was much more than that, for those were the days when harness racing was a popular sport.

Delvin was the single most accomplished and popular trainer and owner in the world. He was a close friend of three presidents and Arnie Palmer’s closest pal. (And for the first five years of my involvement in the sport, Arnie was one of my three partners).

One word of advice from Delvin that I have held on to over the last 30 years was something that he said to me while we were attending the annual and largest Standardbred auction at the Farm Arena in Harrisburg, Pennsylvania back in the early 1980s:

“Dougie, look carefully at the crowd bidding on the yearlings this morning. There is a reason why, every year, there are the same sellers, but the buyers seem to routinely change every few years.”

Think about Delvin’s pearl of wisdom – it holds investment weight.

Back to Mr. Ed:

“Go right to the source and ask the horse
He’ll give you the answer that you’ll endorse.
He’s always on a steady course.
Talk to Mr. Ed.”


IF….

The investment mosaic is complicated and, at least to this observer, cannot be solved easily through a simplistic and linear process like gazing at a chart or by a casual glance of “unusual activity” – or by utilizing any other one single independent determinant.

Chasing benchmarks and worshipping at the altar of price momentum may be a recipe for occasionally achieving some short term gains but is not, in my view, a recipe for long term (measured in years/decades) investment gains.

To me, a serious investor (not trader) who searches for the holy grail of alpha, must comb through a maze of fundamentals, technicals, valuations, sentiment and other (changing) factors in an objective and calculating way.

***

With the benefit of hindsight, the past 10 years has been skewed by several positive influences which have resulted in an uncommonly resilient Bull Market:

  • The influence of passive investing – ETFs and quant strategies that are virtually agnostic to balance sheets and income statements. Rather, price momentum is their investing altar.
  • The monetary largesse of the central bankers who have inhibited natural price discovery by inundating liquidity into the system and lower interest rates to generation lows.
  • Fiscal policy that has widened the gap between “the haves (with large balance sheets of real estate and stocks) and the have-nots (with stagnating wages and rising costs of living).”
  • Both monetary and fiscal policy which have resulted in aggressive corporate share buybacks which has reduced the float of the outstanding shares of publicly traded companies (by about one fifth) – thus improving and tipping over the demand v. supply equation.

Each cycle brings new variables and challenges.

Value is subjective and its definition is liable to change. (see Valeant Pharmaceuticals and more recently the decline in the popularity of Micron (MU) and Intel (INTC) shares!)

History undoubtedly teaches lessons about investment but it does not say which lesson to apply when.

Investors are challenged by orthodoxy and consensus… or as I like to describe, as “group stink.” Many of the business media are complicit in that it delivers predominantly bullish views (optimism “sells”) – sometimes provided by rigorous participants, but most often by those that deliver a simplistic view of Mr. Market (and usually have their own service to sell).

Let’s not forget that pride goeth before fall – also publicity handshakes and celebrity. Nor shall we forget Theranos and maybe even Tesla (TSLA) .

Many perma bullish “talking heads” possess a silly (and much quoted) view that bearish market analysis rationale always sounds superior to the bullish case. This is a common and much repeated argument that holds little weight.

Always stick to your process and do not deviate from your risk appetite and profile.

As Ben Hunt wrote in Epsilon Theory ( Death in the Afternoon):

“Where there’s shame, for both investing and beekeeping, is not sticking with your process. And if your process is only for getting into an investment or starting a new colony … sorry, but that’s not a process. Investments and animals have a life cycle. Your JOB as an investor and a beekeeper is to be there for the entire life cycle, even for the really hard parts like culling a weak queen or getting out of a weak investment. Even if it’s raining outside.”

We live in an interconnected, networked and flat world – denying the risks of poorly thought out trade policy, the weakness in the Chinese and EU stock markets and the potential contagion from Turkey, Argentina or any emerging market are dangerous based on history and its consequences. Indeed, given global flatness, the odds favor that contagion is less ring fenced today than at any other time in history.

And so is ignoring hastily crafted policy (conflated with politics) by the White House a dangerous leap of faith – it shouldn’t be ignored. Though the body of the Administration seems to have been diseased (in multiple ethical, moral lapses and in other ways), many of those same commentators who dismissed the mortgage derivative problem (a decade ago) suggest ignoring the indictments and guilty pleadings of multiple campaign members of the Trump team and the general culture of corruption that currently exists in Washington, D.C. — that these considerations will have little impact on policy, the balance of power, the economy and our markets.

This may, too, be a dangerous investment route.

Kass: Trump & The Cons Of 6-Month Corporate Reporting

Trump’s call on regulators to consider changing how often companies must report earnings is foolish and poorly thought out. 

“Good afternoon and welcome to Hurlingham Park. You join us just as the competitors are running out onto the field on this lovely winter’s afternoon here, with the going firm underfoot and very little sign of rain. Well it certainly looks as though we’re in for a splendid afternoon’s sport in this the 127th Upperclass Twit of the Year Show.

Well the competitors will be off in a moment so let me just identify for you. (camera zooms in on the competitors) Vivian Smith-Smythe-Smith has an O-level in chemo-hygiene. Simon-Zinc-Trumpet-Harris, married to a very attractive table lamp. Nigel Incubator-Jones, his best friend is a tree, and in his spare time he’s a stockbroker. Gervaise Brook-Hampster is in the Guards, and his father uses him as a wastepaper basket. And finally Oliver St John-Mollusc, Harrow and the Guards, thought by many to be this year’s outstanding twit.”   Commentator (John Cheese), Monty Python’s Flying Circus (Upper Class Twit of the Year) 

Among the most foolish and thoughtless recommendations made recently by the President was his recent idea to reduce from four to two the reporting earnings periods for publicly traded companies.

Let me briefly explain my view:

  • Less Corporate Transparency Would Increase Corporations’ Cost of Capital: With a greater amount of earnings “surprises” and less transparency consistent with a more infrequent reporting schedule — the cost of capital would rise as investors would demand a larger premium than when four reports a year are delivered. This is the most important negative and it materially overwhelms whatever lower costs would follow from the reporting change. (My experience as a Board member on several public companies is that the amount of money that would be saved would be negligible. Moreover, most medium sized to larger sized companies can readily absorb the expenses of four reports per year).
  • Less Information Flow Is Unhealthy: For decades companies and their investor relations departments already managed earnings expectations – I call this “The Twit Olympics” (similar to Monty Python’s Olympic event of jumping over matchboxes). And, already companies hide behind Non GAAP vs GAAP accounting convention. (Note: The gap between Non GAAP and GAAP has never been wider!).
  • More Information, More Often, Is Essential To Understanding Business Economics and the Quality of Management: Up to date financials and operating results are critical to spotting both incipient problems, the direction of a business, and/or the honesty or quality of management.
  • Less Frequency of Reporting Periods Could Lead to Lower Valuations: After all, European companies report semi annually and sell at lower valuations than US companies.
  • (As my pal Lee Cooperman pointed out to me)It’s hypocritical that CFO and pension plan heads focus on monthly and quarterly performance yet they complain about investor short term focus!’
  • There Is Already Too Much Lag Time Between Reporting Periods: Less frequent reporting gives management way too much time for “Monkey Business.” I also believe it would impair management discipline – as there might be better ways to deal with short termism
  • Less Transparency Doesn’t Necessarily Impact Short Term Decision Making and Doesn’t Preclude
  • Manipulation of Results: Bad actors will be bad actors, regardless of frequency of reporting periods.
  • Quarterly Reporting Doesn’t Create Short Term Thinking: Smart managements, like at Berkshire Hathaway (BRK.A)   (BRK.B) , report quarterly but think long term. And so do smart investors.
  • Wise Long Term, Fundamental Investors Worry About ‘Earnings Power’ and Not Short Term Earnings Momentum

Here are some second order consequences:

  1. It would likely materially reduce the trading volume on all of the Exchanges – this would be quite bad for the brokerage community.
  2. Such a change in reporting, if enacted, would reduce overall market liquidity – which has already been materially reduced owing to large corporate share buybacks over the last decade.
  3. It will dramatically reduce the viewership of CNBC, Bloomberg and Fox Business as well as at related information sources (like Reuters, etc.)
  4. It would hurt the activist community (which might be a good thing!).

Bottom Line

The President’s “recommendation” is dead at birth and will never be implemented.

That said, it’s a foolish idea on many grounds and not particularly well thought out.

Kass: Global Potholes Threaten Decade-Long Bull Market

  • Peak Housing, Peak Autos, a Pivot in Monetary Policy Spell Peak Global GDP and an Economic Slowdown in late 2018 and in 2019
  • Watch the Fixed-Income Markets (and the flattening yield curve) That Are Providing the “Tell” that Slower Growth Lies Ahead
  • The Buzz of Synchronized Global Growth Has Faded
  • What Makes Equities Even More Vulnerable is that the Leading Component of the Markets, ‘FANG,’ Has Become Diminished and Is Now ‘GA’
  • Tops Are Processes, and We May Be in That Process Now

“In one corner, U.S. Treasury Secretary Mnuchin in a truly out-of-character gaudy, shiny white satin robe brandishing a big 3%. Opposite the optimist is the old guard Federal Reserve representing nearly 800 of the country’s PhDs. They’ve donned black as night robes with a difficult-to-make-out 2% on the back. In the case you get out more than we do, you’ve arrived at the battle royal for potential gross domestic product (GDP) growth! Mnuchin contends the U.S. economy is “well on the path” to sustained annual growth of 3% for “several years.” The Fed’s army of economists foresees a much lower speed limit of 1.8%.” Danielle Dimartino Booth, The Daily Feather

While the global markets have generally ignored terrorist attacks, a series of currency crises, trade concerns, an arguably untethered President Trump (who has conflated hastily crafted policy with politics) as well as other adverse political, geopolitical and market-unfriendly “big picture” events over the last several years, it is my view that the growing ambiguity seen in the high-frequency economic data around the world forms the principal risk to equities.

Peak Housing

In case you missed this from last Friday, Redfin (RDFN) , the residential real estate brokerage firm, fell 22%.

On the conference call Redfin CEO Glenn Kelman said this: “For the first time in years, we are getting reports from managers of some markets that homebuyer demand is waning, especially in some of Redfin’s largest markets.” He specifically cited Seattle, Portland and San Jose, but also said “The trend is continuing in July and reports are now coming in from Washington, D.C., Boston, VIrginia and parts of Chicago as well that the homes there are getting harder to sell.”

We know the reasons and it’s been stated in my Diary for weeks:

  • Mortgage applications are turning negative on a year-over-year basis
  • Mortgage rate resets and higher mortgage rates are a headwind to new home sales and refinancings (at an 18-year low)

As reported by my pal Peter Boockvar, the U.S. housing market outlook is moderating:

With mortgage rates at a 7 year high and the average price of a home at a record high, mortgage applications to buy a home fell 2% w/o/w and down for the 4th straight week. It is now down by 1.6% y/o/y and the index is at the lowest level since mid-February. Refi’s fell by 4.5% w/o/w and 35% y/o/y. This index stands at the weakest level since December 2000. This follows new home sales, existing home sales, and housing starts reflecting a plateauing in the pace of transactions.

PURCHASE APPLICATIONS

From my perch, a combination of sky-high home prices (which in many areas of the country are back above mid-2000s cyclical highs) and rising mortgage rates are squeezing home affordability, and a Peak Housing moment is upon us.

In the recently reported robust second-quarter GDP print of 4.1%, residential construction was the only category that turned negative. That follows a contraction also seen in the year’s first quarter.

Peak Autos

“(Auto) sales in the last month will underscore investor fears that auto sales have peaked and that, without ever-higher incentives to keep consumers interested, demand will continue to soften.” –Bloomberg

Ward’s Automotive reported a 16.7 million U.S. SAAR (seasonally adjusted annual rate) of sales for the month of July; that is the weakest July sales month in four years:

Source: Zero Hedge

Auto industry sales are likely to get much worse in the year ahead.

As I mentioned in a recent Bloomberg interview, the recent consumer confidence report was noteworthy for the depressed spending intentions. According to my economist pal David “Rosie” Rosenberg: 

“Plans to buy an automobile (over the last two readings) exhibited the weakest back-to-back showing in over five years.”

“Peak Autos” has been a theme of mine over the last 12 months; General Motors GM is on my Best Ideas List as a short, placed on that list at $43.43 in October 2017.

Remember: Cyclical stocks always look cheap at the top of a cycle.

Despite the hedge fund community’s endorsements by Ed Wachenheim and others, and the business media’s almost universal optimism on these name, it remains my view that GM and Ford F are “value traps.” (Note: Both companies recently guided lower in sales and profits).

Despite stagnating real personal incomes and large household debt loads, the proliferation and the popular extension of subprime auto debt (“a dollar down and off to the races” and the perpetual extension of loan maturities) and large auto price incentives have served to lift car sales over the last few years well above replacement needs. For several reasons, the favorable gap previously seen between auto sales and replacement needs is likely to reverse over the next few years.

Most importantly, with interest rates rising and likely to rise further, it is getting prohibitively expensive for manufacturers to offer incentives and deals tied to loans, so the consumer will be faced with fewer discounts on new cars. Indeed, J.D. Power reports that for the first time in almost five years the auto industry recently has cut back spending on incentives.

What makes things worse is the large number of cars coming off lease and ending up for sale in the used car lots of dealers. The “lease bubble” (below) is providing auto buyers with lower-priced alternatives to the new models.

Here are 10 troublesome charts on auto loans from Zero Hedge. If you are long the auto stocks, read the material closely.

Perhaps the most significant is the record level of average vehicle new and used car loans, at $31,100 and $19,500, respectively. But, with rates rising, so do dollar payments per month — on average, at more than $515 per month on new vehicles, which is stretching affordability for most borrowers. Meanwhile the average loan terms of 69 months for new cars and 64 months for used cars are also likely stretching limits.

Banks and other financial institutions are seeing the risks to the above loans and aggressively are slashing their auto loan origination activity, leaving captive original equipment manufacturer (OEM) finance companies to fill the void.

Look out below, and brace for a sharp fall in auto industry sales over the next year.

A Monetary Pivot

From Rosie this morning:

“All of the monetary aggregates have slowed substantially, and real M1 growth is flagging a 1% stall-speed growth economy once we get passed all the pre-tariff buying activity and fiscal sugar-high that skewed Q2.”

The monetary pivot is not a concession to the U.S.; global central bankers are also reversing course.

Peak GDP

  • A services slowdown may already be occurring as a July economic pivot may be in place
  • Peak auto sales is not a sector outlier
  • Look for consensus estimates of GDP to be revised lowered in the months ahead

Investment and economic wisdom is always 20/20 when viewed in the rear-view mirror.

The recent weak growth in nonfarm payrolls points to the issue of slowing domestic economic growth, already seen in a weakening auto sector.

But, to me, there are other more powerful July signposts that indicate that economic growth is becoming more ambiguous:

  • According to National Association of Credit Management data, which measure both manufacturing and services, July’s GDP proxy slowed by almost 1% to 3% from June’s strong rate of nearly 4%.
  • The July ISM Manufacturing/Services growth proxy has halved to 2%.
  • The July ISM Manufacturing survey for new orders fell to the lowest pace in 14 months.
  • ISM Services, reported on Friday morning, missed big, falling to the lowest level in nearly a year.
  • ISM Services backlogs dropped to a two-year low in July (51.5). We are in a services economy — 80% of the population resides there — and in our evolving economy a services downturn, rather than manufacturing, can presage an economic slowdown.
  • In the Friday jobs report, July services job creation was the slowest month in 2018.
  • July business activity, a dependable indicator, fell by 7.4 points from June; that’s the sharpest drop since late 2008.
  • The spread between business activity and employment has narrowed to 0.4 points; when it turns negative, companies are overstaffed.

Not only do we face Peak GDP, we are seeing Peak Global GDP growth, as witnessed by a two-year low in Citigroup’s European economic surprise index. It was only seven months ago that synchronized global growth was the buzz.

Bottom Line

While bulls are anticipating acceleration in the rates of U.S. and non-U.S. economic growth and an extension in the expansion in corporate profits, the reality, based on recent high-frequency economic data, is that the global economy is slowing in its trajectory and that growth in corporate profits will tail off shortly.

This is a nonconsensus view and forms the basis for my ursine market view.

Tops are processes and it is my continued view that a 2018 high in the S&P 500 Index was made in late January.

What makes equities even more vulnerable is that FANG has become GA. (Note the narrowing markets: Microsoft (MSFT) , Netflix (NFLX) and Amazon (AMZN) have accounted for more than 70% of the rise in the S&P Index year to date).

I remain at my largest net short exposure in quite a long time.

Kass: For Whom The Bell Tolls ($TSLA)

5-Reasons Why I Doubt Tesla Is Going Private

One of my most important media contacts was Barron’s Alan Abelson.

In time, Alan became a very close friend – I spoke to him nearly every Thursday afternoon for almost two decades. We went to New York Yankee games together and shared a lot professionally and personally.

Some years into our business relationship I sent him a couple of books of fiction that I thought he would enjoy. Very soon thereafter I received a call back from him saying that he doesn’t read fiction anymore because what happens on Wall Street is often much stranger than the best books of fiction.

I Still Bleed Barron’s Blue, and I still remember Alan’s comments about the weird goings on in Wall Street.

And, one of the most bizarre Wall Street events occurred yesterday with Elon Musk declaring his “intention” to take Tesla private (with “funding secured.”).

After more than one hour of a halt in the trading of Tesla’s (TSLA) shares the company has come out with a release confirming Elon Musk’s interest in taking Tesla private at $420/share — a transaction valued at about $72 billion.

I have little doubt there will be NO transaction:

  • To begin with, Elon Musk has a unique sense of humor. The number 420, or 4:20 or 4/20 (pronounced four-twenty) is a code-term in cannabis culture that refers to the consumption of cannabis, especially smoking cannabis around the time 4:20 p.m. (or 16:20 in 24-hour notation) and smoking cannabis in celebration on the date April 20 (which is 4/20 in U.S. form).
  • The company’s fundamentals and balance sheet do not support a leveraged transaction. A LBO is not financeable in the current market and this is the least demanding market in history for financing. Tesla is losing money, has large capital spending requirements, is bleeding cash, has meaningful contingent product liability risks and already has $9 billion of net debt.
  • The only way the LBO could be done is if several large strategic buyers lost their collective minds and invested in the transaction. As best I can ascertain there are no such strategic buyers that exist to support this deal — though many have lost their minds on smaller transactions!
  • There was no mention of investment banking advisors or outside legal counsel in the Tesla statement. This makes me suspect of the proposed transaction. 
  • Musk recently purchased stock in the open market. I presume Musk has been thinking about a going private deal for some time, which raises potential legal (SEC) problems.

As I wrote in my previous post, Elon Musk has gone “off the reservation” after making a choreographed and random tweet yesterday.

Not only do I believe there will be no going private transaction but I suspect Musk has gone too far with his tweets and will likely pay a legal toll for it.

Kass: Tops Are Processes & We May Be In That Process

The Yield Curve Will Likely Invert by November, 2018

  • Economic growth is less synchronized than the consensus believes
  • On a trending and rate of change basis the economic data is slowing down
  • The Fed’s continued pivot to tighter money will likely lead to curve inversion – which will likely stoke fears of recession

“China, Europe and the Emerging Market Economic Data All Signal Slowdown: It’s in the early innings of such a slowdown based on any realtime analysis of the economic data. The rate of change slowdown (on a trending basis) is as clear as day. A rising US Dollar and weakening emerging market economic growth sows the seeds of a possible US dollar funding crisis.” – Kass Diary, Investors are Not Being Compensated For Risk

At economic peaks everything on the surface looks Rosy (except to some observors like myself and Rosie (David Rosenberg)!) – until it doesn’t.

Towards that end, here is what I wrote yesterday about US and overseas economic growth in my two part opener:

“Global Growth Is Less Synchronized as the trajectory of worldwide growth is becoming more ambiguous. I have featured the erosion in soft and hard high frequency data in the US, Europe, China and elsewhere extensively in my Diary – so I wont clutter this missive with too many charts. But needless to say (and seen by these charts and here), with economic surprises moderating from a year ago and in the case of Europe falling to two year lows – we are likely at ‘Peak Global Growth’ now. (The data is even worse in South Korea, Taiwan, Indonesia and Thailand).

Indeed there is now ample evidence that 2Q2018 will also represent ‘Peak US Growth’ – as a number of trade related benefits goose the soon to be released second quarter GDP. (Note: Second quarter inventory accumulation was 4x compared to the average over 4Q2017 and 1Q2018, as companies try to secure lower cost product along the supply chain).

This cautionary view of trade tensions threatening global economic growth was confirmed in the G20 statement over the weekend:

‘Global growth remains robust and many emerging-market countries are better prepared to face crises, but risks to the world economy have increased, finance ministers and central bankers from the Group of 20 nations said in a statement published at the end of their two-day summit in Buenos Aires… The main risks are “rising financial vulnerabilities, heightened trade and geopolitical tensions, global imbalances, inequality and structurally weak growth,” the statement read. Emerging markets also face threats including market volatility and capital outflows, according to the G-20. The group’s March statement didn’t mention trade tensions.’

Both housing and autos are likely peaking, and the resetting of rates (higher) will further diminish growth prospects and provide a burden and headwind for those in the private and public sector that are stuck with variable rate debt. (Remember the debt bubble matters not until the rate rise accelerates – which is already occurring on the short end of the curve).

Meanwhile, despite protestations from the Administration, there is no evidence that the reduction in tax rates will trickle down – it’s likely to continue to trickle up to those individuals that possess large balance sheets consisting mostly of real estate and equities. This will have market and social ramifications.

Some charts in support of this view follows.

The Citigroup US Economic Surprise Index has fallen to zero (Europe is negative):

Source: Peter Boockvar

Chinese industrial production growth (year over year) is stagnating:

Source: Peter Boockvar

Chinese retail sales are dropping (year over year):

Source: Peter Boockvar

Bottom Line

” A pivot in monetary policy, a further rise in the risk free rate of return, policy and profit uncertainty and a softening in soft and hard high frequency economic data are some of the reasons that point to a lower and destabilized stock market” – Kass Diary, Investors Are Not Being Compensated For Risk

If I am correct in my forecasts of a continued Fed pivot to tightening and of emerging weakness in economic growth, history indicates a yield curve inversion lies ahead and the US will be in a recession somewhere between July, 2019 and the summer of 2020.

And, in all likelihood, stocks will begin to discount these developments (as fears of a recession are stoked) during the second half of this year.”

Tops Are Processes And We May Be In That Process

  • The search of value and comparing it to risk taken is, at its core, the marriage of a contrarian streak and a calculator
  • Investors are no longer being compensated for taking risk as the market’s margin of safety has shrunk to microscopic levels
  • Last week I liquidated my equity longs and I remain net short in exposure

“Tops are a process, bottoms are an event.” –Wall Street adage 

Tops are a process and bottoms are an event, at least most of the time in the stock market. If you looked at an ice cream cone’s profile, the top is generally rounded and the bottom V-shaped. That is how tops and bottoms often look in the stock market, and I believe that the market is forming such a top now.

  • Downside Risk Dwarfs Upside Reward. I base my expected market view on the probabilities associated with five separate (from pessimistic to optimistic) projected outcomes that seize on a forecast of economic and corporate profit growth, inflation, interest rates and valuation.
  • Global Growth Is Less Synchronized . The trajectory of worldwide growth is becoming more ambiguous. I have chronicled extensively the erosion in soft and hard high-frequency data in the U.S., Europe, China and elsewhere, so I won’t clutter this missive with too many charts. But needless to say (and as shown by these charts here and here), with economic surprises moderating from a year ago and in the case of Europe falling to two-year lows, we are likely at “Peak Global Growth” now. (The data are even worse in South Korea, Taiwan, Indonesia and Thailand.)
  • FAANG’s Dominance Represents an Ever-Present Risk. Last Monday I warned that earnings disappointments in the FANG stocks represents an immediate risk to this league-leading sector, and to the markets FANG has become GA!
  • Market Structure Is One-Sided and Worrisome. Machines and algos rule the day; they, too, are momentum-based on the same side of the boat. The reality that “buyers live higher and sellers live lower” represents the potentially dangerous condition that investors face in a market dominated by passive investors.
  • Higher Interest Rates Not Only Produce a More Attractive Risk-Free Rate of Return, They Also Make It Hard for the Private and Public Sectors to Service Debt
  • Trade Tensions With China Are Intensifying and Mr. Market Is Improperly Looking Past Marginal Risks. From Goldman Sachs’ David Kostin (h/t Zero Hedge). Remember, as discussed within this column, the dispute has buoyed second-quarter U.S. GDP. The “benefit” soon will be over and a second-quarter economic cliff is possible.
  • Any Semblance of Fiscal Responsibility Has Been Thrown Out the Window by Both Political Parties. This has very adverse ramifications (which shortly may be discounted in lower stock prices), especially as it relates to the servicing of debt — a subject I have written about often. Not only are our legislators acting irresponsibly and recklessly, but the Republican Party is now considering more permanent tax cuts. Should economic growth moderate, tax receipts diminish and undisciplined spending continue, stock valuations will likely continue to contract.
  • Peak Buybacks. Buybacks continue apace, but look who’s selling. As Grandma Koufax used to say, “Dougie, that’s quite a racket!” If I am correct about the peaking in corporate profits, higher interest rates and slowing economic growth, we shortly will have another rate of change — negative in buybacks.
  • China, Europe and the Emerging Market Economic Data All Signal a Slowdown. It’s in the early innings of such a slowdown based on any real-time analysis of the economic data. The rate-of-change slowdown on a trending basis is as clear as day. A rising U.S. dollar and weakening emerging-market economic growth sow the seeds of a possible U.S. dollar funding crisis.
  • The Orange Swan Has Returned. Again, hastily crafted policy delivered by Twitter that conflates politics is dangerous in a flat and networked world. The return of an untethered Orange Swan is market-unfriendly… brace yourselves as the Supreme Tweeter will likely “Make Economic Uncertainty and Market Volatility Great Again” (#MUVGA)
  • We Are Moving Closer to the November Elections, With Their Uncertainty of Outcome and the Potential For a “Blue Wave.” The current 40% approval rating for the president is historically a losing proposition for the incumbents. We also may be moving toward some conclusion of the Mueller investigation — is the Summer of 2018 the Summer of 1974?

Bottom Line

“Confronted with a challenge to distill the secret of sound investment into three words, we venture the motto, Margin of Safety.” –Benjamin Graham

The search for value and comparing it to risk taken is, at its core, the marriage of a contrarian streak and a calculator.

While it is important to gauge the possibility that the market may be making an important top, it is even more important to distill, based on reasonable fundamental input, what the market’s reward vs. risk is. This calculus trumps everything else that I do in determining market value.

On that front, I continue to believe that downside risk dwarfs upside reward.

Moreover, there is a growing fundamental and technical list of signposts that may suggest that the market is starting to look like it is in the process of making a possible (and important) top.

As Joel Greenblatt wrote:

“There’s a virtuous cycle when people have to defend challenges to their ideas. Any gaps in thinking or analysis become clear pretty quickly when smart people ask good, logical questions. You can’t be a good value investor without being an independent thinker – you’re seeing valuations that the market is not appreciating. But it’s critical that you understand why the market isn’t seeing the value you do. The back and forth that goes on in the investment process helps you get at that.”

And, I do a lot of back and forth every day in my Diary!

Kass – The Underpricing Of Risk

‘The boldness of asking deep questions may require unforeseen flexibility if we are to accept the answers.’ – Brian Greene

* A pivot in monetary policy, a further rise in the risk free rate of return, policy and profit uncertainty and a softening in soft and hard high frequency economic data are some of the reasons that point to a lower and destabilized stock market

Following The Great Recession of 2007-09 and a near collapse of the world financial system, the US and other developed as well as emerging economies embarked upon a near decade long expansion and global bull market. In large measure the recoveries were abetted by a worldwide coordinated monetary easing which took interest rates to generational lows and provided an unprecedented amount of excess liquidity.

Though US economic growth from 2009 to present remained substandard compared to previous recoveries, that excess liquidity provided a tailwind to higher stock prices. Corporate capital was increasingly allocated to buybacks rather than the more traditional capital spending outlays reflecting modest real growth in the domestic economy. Going back, since 1999 there were over 7500 listed securities on the NYSE and Nasdaq – today there are under 4000 listed securities (reflecting mergers, delistings offset by the proliferation of ETFs). And of the remaining listed companies nearly 20% of the outstanding shares have been repurchased.

Stocks clearly have benefited from this positive demand v. supply proposition.

If that was not enough, passive investing (ETFs) grew in popularity as did quantitative strategies — all at the expense of active investing. More than ever, investors worshipped at the altar of price momentum at a time in which the excess liquidity promoted optimism. Even central bankers (in Switzerland and Japan and elsewhere) joined in on the party – buying up equities with all that excess liquidity their central banks delivered as fear and doubt left Wall Street.

These factors – excess liquidity, company buybacks, the proliferation of ETFs and the dominance of machines and algorithms – all conspired together to produce an ideal decade for stocks.

The S&P Index famously bottomed at 666 in early March, 2009 (On CNBC’s Kudlow Report I called this a Generational Bottom in Equities and made a high this year in late January (at about 2850).

Several successful probes back down to 2550-2600 were repelled and a few rallies ensued – markets moved back and forth and provided excellent trading opportunities for unimpassioned traders. We have recently moved back to 2800 – only about 50 handles lower than the highs seen earlier in the year.

Corporate profits steadily expanded throughout the last nine years and, thanks in large measure to a significant drop in the statutory corporate tax rate (the promise of which raised S&P price earnings multiples by nearly three points last year), S&P earnings are expected to hit a record high in 2018.

I believe that, after a near decade economic expansion and bull market, investors are no longer being compensated for taking risks.

Already this year (as a possible foreshadowing of the future) – and despite the appearance of a stellar profit picture – S&P valuations have contracted by nearly two points as the indices are only slightly higher than year-end levels. (Meanwhile the stock market in China, the engine of global economic growth, is signaling that problems lie ahead for that region – and in turn for those areas of the world that benefit from Chinese trade).

In essence, 2017 marked a year in which Wall Street outperformed Main Street while, thus far, 2018 marks a year in which Main Street seems to have outperformed Wall Street. After eight stellar years of Wall Street out performance (over Main Street), we may seen more than one year of contracting price earnings multiples in the year ahead.

I continue to believe that a 2018 high in the S&P Index was possibly reached in late January (call it “Peak Hope”) and will not be eclipsed for the remainder of the year. More importantly, I believe the market is now fully priced and vulnerable to much more downside than upside – and I have liquidated every one of my individual long positions (with the exception of (GLD) ). And I am maintaining my large (SPY) short.

Investing is a complicated mosaic – making decisions on only one or two factors often leads to a dangerous journey, particularly when effected when valuations and stock prices are elevated, when a market’s leadership seems to be narrowing and certainly with the recent emergence of a “two sided market” (from a formerly one sided and bullish market) which often leads to a one sided and bearish market. And, our investment world is more transparent and the transmission of news quicker and more universal than it has ever been. Communication is instantaneous and through a plethora of broadcasting and social media platforms we are almost all armed with the same information about at the same time. It is how we interpret and analyze that information and our willingness to be open to changing data is what sets our opinion and investment performance apart.

I worship not at the altar of price momentum but rather at the altar of security analysis and margin of safety. That process provides me with a relatively concise analysis of the relationship of reward and risk.

At the core of my near term concern are the deterioration (and worsening rate of change) in reward v. risk, the growing ambiguity of the trajectory of global economic growth, the pivot in monetary worldwide monetary policy, the likelihood of a steady move higher in short term interest rates (and a higher risk free rate of return), evidence of a loss of any fiscal responsibility (on the part of Democrats and Republicans), expanding policy risks in part based on the behavior of our President, the possibility of a “Blue Wave” in November and the evolution of a one sided (long) market structure (and a rising role of FAANG stocks).

I will touch on some of these immediate and more pressing concerns in this post.

* Downside Risk Dwarfs Upside Reward. I base my expected market view on the probabilities associated with five separate (from pessimistic to optimistic) projected outcomes that seize on a forecast of economic and corporate profit growth, inflation, interest rates and valuation.

On July 9th I wrote:

Add it all up and here are my expectations – you should view these S&P price forecasts not as precise, but rather as a guideline to overall strategy:

The Very Short Term

I expect the S&P 500 to go higher, but not materially so. A 2,750-to-2,800 trading range seems like a reasonable “guesstimate” to me. (Note: Mission accomplished – as we now stand at 2800!)

Given the above, I plan to scale into a net-short position on strength. However, I’ll give the market a wider berth and into the first few days of 2018’s second half, as I expect new investors inflows during that time.

Short Term (the Next 2 Months)

I predict that the S&P 500 will go lower, but not materially so. I expect a series of tests of the 2,675 to 2,710.

Intermediate Term (the Next 6 Months)

I forecast the S&P 500 will drop lower, with a break towards my estimated 2,500 fair-market value.

Here is my current calculus of reward v. risk:

Last week the S&P Index crossed 2800 – it closed on Friday at 2801.

  • Current S&P 500 Level: 2801
  • Fair-Market Value: 2,500
  • Likely Trading Range: 2,550 – 2,750 to 2,800
  • Market Downside: 2,400 to 2,450

Based on the above, I believe that:

(1) There are 375 points of downside risk to the 2,425 midpoint of my forecast for market downside, and virtually no upside reward to the 2,800 top of my estimate of the S&P 500’s trading range.

(2) There are 300 points of downside risk to my 2,500 estimate of the S&P 500’s fair-market value and virtually no upside reward to the 2,800 top of my estimate of the S&P 500’s trading range.

(3) There are 250 points of downside risk to my 2,550 estimate of the low end of the likely trading range and virtually no upside reward to the 2800 top of my estimate of the S&P 500’s trading range.

* Global Growth Is Less Synchronized as the trajectory of worldwide growth is becoming more ambiguous. I have featured the erosion in soft and hard high frequency data in the US, Europe, China and elsewhere extensively in my Diary – so I wont clutter this missive with too many charts. But needless to say (and seen by these charts and here), with economic surprises moderating from a year ago and in the case of Europe falling to two year lows – we are likely at ‘Peak Global Growth’ now. (The data is even worse in South Korea, Taiwan, Indonesia and Thailand).

Indeed there is now ample evidence that 2Q2018 will also represent ‘Peak US Growth’ – as a number of trade related benefits goose the soon to be released second quarter GDP.

(Note: Second quarter inventory accumulation was 4x compared to the average over 4Q2017 and 1Q2018, as companies try to secure lower cost product along the supply chain).

This cautionary view of trade tensions threatening global economic growth was confirmed in the G20 statement over the weekend:

‘Global growth remains robust and many emerging-market countries are better prepared to face crises, but risks to the world economy have increased, finance ministers and central bankers from the Group of 20 nations said in a statement published at the end of their two-day summit in Buenos Aires… The main risks are “rising financial vulnerabilities, heightened trade and geopolitical tensions, global imbalances, inequality and structurally weak growth,” the statement read. Emerging markets also face threats including market volatility and capital outflows, according to the G-20. The group’s March statement didn’t mention trade tensions.’

Both housing and autos are likely peaking, and the resetting of rates (higher) will further diminish growth prospects and provide a burden and headwind for those in the private and public sector that are stuck with variable rate debt. (Remember the debt bubble matters not until the rate rise accelerates – which is already occurring on the short end of the curve).

Meanwhile, despite protestations from the Administration, there is no evidence that the reduction in tax rates will trickle down – it’s likely to continue to trickle up to those individuals that possess large balance sheets consisting mostly of real estate and equities. This will have market and social ramifications.

Some charts in support of this view follows.

The Citigroup US Economic Surprise Index has fallen to zero (Europe is negative):

Source: Peter Boockvar

Chinese industrial production growth (year over year) is stagnating:

Source: Peter Boockvar

Chinese retail sales are dropping (year over year):

Source: Peter Boockvar


* FAANG’s Dominance Represents an Ever Present Risk.

“Yes. They (FAANG- Facebook, Apple, Amazon, Netflix and Alphabet’s Google) are great companies, but ETFs may have accentuated the flow of capital into those stocks…Things that are most hyped produce the most pain… A conspicuous number of ETFs are concentrated in the same stocks. When things go cold … who is going to buy it?… If and when it ends, it will end worse for the stocks that have had momentum and for the ETFs that hold them than for the rest.” – Howard Marks, Delivering Alpha Conference (July 28, 2018)

The dominance of FAANG stocks in the increasingly popular passive market (read: ETFs) makes the acronym (and market) risky as many of the ETFs are using the same “momentum” factor. Consider that just five stocks (FAANG) are a top 15 holding in 605 ETFs:

ETF Ownership of FAANG Equities

2018: 605
2017: 501
2016: 430
2015: 332
2014: 277
2013; 230
2012: 175
2011: 101
2010: 62
2009: 14
2008: 9

Source: Lawrence McDonald

Back to Howard Marks:

“The real big money in the investment world – the dependable money, the safe money – is made not betting that the things that have gone up a lot will continue but on betting that the things that have gone down and become unloved will rebound.”

The dominance of products and strategies (quant machines and algos) that worship at the altar of price momentum also represents a near term risk to the markets. As Marks says, whenever investors/traders are on one side of the boat, problems often arise.

Today the boat could capsize from the overwhelming weight on that side – should an inflection in momentum begin to occur.

That positive price momentum can change from numerous influences – here are some immediate and potential catalysts:

  • Amazon’s (AMZN) aggressive vertical and horizontal strategy could be challenged by the President through a more modern interpretation of the Sherman Antitrust Act (which protects trade and commerce against unlawful restraint and monopolies).
  • * An earnings disappointment of any FAANG member. (Already Netflix (NFLX) has recently whiffed on sub ads).
  • * Tesla (TSLA) might have a liquidity issue. 
  • * Investors may begin to get worried about the large insider selling of FAANG.
  • * Market Structure is Also One Sided and Worrisome Machines and algos rule the day – they too are momentum-based on the same side of the boat.

When buyers live higher and sellers live lower, anything that triggers the downside may accelerate the actual decline.

By contrast, I worship not at the altar of price momentum but rather at the altar of security analysis and margin of safety.

The distortions and dominance of quant strategies and the proliferation of ETFs have (arguably) diminished price discovery and materially reduced the market’s margin of safety.

* Higher Interest Rates Not Only Produces a More Attractive Risk Free Rate of Return, They Also Make It Hard for the Private and Public Sector to Service Debt

For nearly a decade, the Fed has pushed investors into long dated assets, like equities, with the T.I.N.A. mindset (“there is no alternative”). But this has changed in the last 12 months (Treasury bill yields are much higher on a year over years basis) coincident with the Fed’s pivot – as, for the first time in years, C.I.T.A. (“cash is the alternative”). Today the yield on the three month US Treasury note (1.98%) exceeds the dividend yield of the S&P Index (1.80%). Actually, the one month bill’s yield (1.85%) exceeds the S&P dividend yield.

Source: Bloomberg and Peter Boockvar

* Trade Tensions With China is Intensifying and Mr. Market Is Improperly Looking Past Marginal Risks From Goldman Sach’s David Kostin (h/t Zero Hedge). Remember, as discussed within this column, the dispute has buoyed second quarter US GDP. The “benefit” will soon be over and a 2Q economic cliff is possible.

* Any Semblance of Fiscal Responsibility Has Been Thrown Out By Both Political Parties This has very adverse ramifications (which may shortly be discounted in lower stock prices), especially as it relates to the servicing of debt – a subject I have often written about. Not only are our legislators acting irresponsibly but the Republican party is now considering more permanent tax cuts. Should economic growth moderate and tax receipts diminish – within the context of continued and undisciplined spending – stock valuations will likely continue to contract.

* Peak Buybacks. Buybacks Continue Apace But Look Who’s Selling As Grandma Koufax used to say, “Dougie, that’s quite a racket!” If I am correct about the peaking in corporate profits, higher interest rates and slowing economic growth, we will shortly have another rate of change negative in buybacks.

* China, Europe and the Emerging Market Economic Data All Signal Slowdown It’s in the early innings of such a slowdown based on any realtime analysis of the economic data. The rate of change slowdown (on a trending basis) is as clear as day. A rising US Dollar and weakening emerging market economic growth sows the seeds of a possible US dollar funding crisis.

* The Orange Swan Has Returned, Again Hastily crafted policy (delivered by Twitter) that conflates politics is dangerous in a flat and networked world. The return of an untethered Orange Swan is market-unfriendly … brace yourselves as the Supreme Tweeter will likely “Make Economic Uncertainty and Market Volatility Great Again” (#MUVGA)

Political tribalism in the US has overwhelmed reality and Trump is at the front of the line – an untethered and isolated President presents policy risks.

Astonishingly, over the weekend Trump again reversed his reversal and has walked back on his post Putin meeting correction on what the Russian involvement in the 2016 election was (we are back to “would” from “would not”) – again more destabilization from the White House:

Last night Trump went “Full Trump” (in capitals) again tweeted another bellicose foreign policy statement (more “fire and fury”) that resembled the initial brinkmanship and emotional outblast last seen with North Korea:

Finally, though I can make no conclusion as to the impact of the conclusions of the Mueller investigation – we are moving closer to its determination which could present another market risk.

We are also moving closer to the November elections – the uncertainty of outcome and the potential for a “Blue Wave” looms.

Regardless of the outcomes, the recent unhinged and unprepared behavior of the President (towards both our allies and enemies) holds first and second order risks and will likely impact markets and the risks of policy mistakes are growing ever more likely.

Bottom Line

“Freedom lies in being bold.” – -Robert Frost

For the reasons mentioned, it is my view that stocks made a yearly high in late January and we could be in a correction mode over the balance of 2018.

The list of possible political, geopolitical, economic and policy outcomes are multiplying now (many of them are adverse and market destabilizing). 

I worship not at the altar of price momentum but rather at the altar of security analysis and margin of safety. This analysis suggests that the downside risks dwarf upside rewards.

After much thought I have liquidated all of my long positions and I have a large net short exposure now

Kass – I Call B.S.

“The sentence should have been: ‘I don’t see any reason why I wouldn’t’ or ‘why it wouldn’t be Russia’. Sort of a double negative…”  President Trump

Emma Gonzalez, the Marjory Stoneman Douglas High School student famously declared “we call B.S.” to the President, lawmakers and gun advocates after the high school shooting in Parkland,  Florida months ago.

Well, I call  B.S.  on the markets (on fundamental and valuation grounds).

Likewise in the corridors of the New York Stock Exchange and on the sets of the business media we are asked to believe in another new paradigm of a “long boom” uninterrupted by the emergence of a number of adverse headwinds (monetary pivot, ambiguous  indicators of global economic growth, the competition from short term interest rates (the three month T bill has just eclipsed 2% for the first time in a decade) and the risks of policy mistakes, among other issues). We are asked to bear witness to the products and strategies (that worship at the altar of price momentum) and, for periods of time, limit real price discovery.

Reality, not spin, will prevail in the fullness of time.

I call B.S. and I remain substantially net short.

Kass – Buffett’s Moats Are Breached

“In reference to a post yesterday on “Investing Like Warren Buffett,” Doug sent us the following article he penned in 2014 on a similar issue.”

“I start almost every column I have ever written about Berkshire Hathaway (BRK.A/BRK.B) with the sincere message that, similar to many investors, I worship at the investment altar of Warren Buffett and Charlie Munger. But that adulation doesn’t preclude me, as an investor, from questioning their and the company’s direction/strategy nor does it inhibit me from being short Berkshire’s stock (which I have been over the last nine months).

Recent earnings reports at Coca-Cola (KO) and IBM (IBM), two large Berkshire Hathaway investments totaling almost $30 billion, suggest that the companies’ moats appear to be vanishing.

Healthier drink choices and the penetration of the cloud seem to have weakened the previously seen moats and have damaged the profit results at Coca-Cola and IBM.

In the past Warren Buffett has hunted gazelles (that are undervalued); he is now hunting elephants (that are fairly valued to overvalued).

I remain short Berkshire’s shares.

Last year Warren Buffett labeled me a “credentialed bear” and invited me to ask some hard-hitting questions at Berkshire Hathaway’s annual shareholders meeting. I did quite a lot of research in preparation for that day, and I think that is what Warren expected of me and why he invited me.

It was important for me to balance my hard-hitting and pointed questions with a courteous and respectful delivery, considering the extraordinary accomplishments and the respect we all have of the men that I was addressing and the unique invitation to a short seller who was negative on their company. Initially, each of my original six questions was far too lengthy (500-1,000 words). Given the setting and Warren’s crafty ways of answering questions, my mission was to condense each into a tightly worded question.

Upon reflection, I was pleased with the questions as well as Warren and Charlie’s responses — my mission was accomplished.

Question No. 1 — Size Matters

Q: As it is said, Warren, “Size matters!”

In the past, Berkshire bought cheap or wholesale — for instance, Geico, MidAmerican Energy, the initial Coca-Cola purchase and Benjamin Moore. Arguably, your company has shifted to becoming a buyer of pricier and more mature businesses — for instance, IBM, Burlington Northern Santa Fe, Heinz (HNZ) and Lubrizol, which were done at prices to sales, earnings and book value multiples well above the prior acquisitions and after the stock prices rose.
Many of the recent buys might be great additions to Berkshire’s portfolio of companies, however, the relatively high prices paid for these investments could potentially result in a lower return on invested capital. In the past you hunted gazelles, but now you are hunting elephants.

To me, the recent buys look like preparation for your legacy, creating a more mature, slower-growing enterprise. Is Berkshire morphing into a stock that has begun to resemble an index fund that is more appropriate for widows and orphans rather than past investors who sought out differentiated and superior compounded growth?

In the past, you have quoted Benjamin Graham, saying “price is what you pay — value is what you get.” Are your recent deals and large investments bringing Berkshire less value than the deals done previously?

A: Warren admitted that Berkshire won’t grow as rapidly in the future as it has in the past but it will still generate a lot of incremental value.

“We think we will do better than the giants of the past,” he said. Charlie chimed in and said much of the same. Warren then exclaimed, “Doug, you haven’t convinced me to sell the stock, but keep trying!” — Doug Kass, “My Berkshire Q&A Recap

Unasked Question No. 2 — Are Some of Berkshire’s Bank Moats Damaged or Disappearing?

A changing bank regulatory climate has put constraints on leverage and has produced less robust return on assets and capital. As well, banking has become more homogenous and less differentiated, what Charlie and you describe as, “standing on tiptoe at a parade” — when one bank offers a new product, every bank has to offer or match it.
Given the fact that the banking industry has a lower profit growth rate potential going forward (think of it as damaged and shrinking moats of profitability), why is Berkshire continuing to acquire shares and becoming more exposed to banks, specifically Wells Fargo (WFC)?

Note: This question, too, was one of my six original questions. But, Charlie and Warren had already discussed the impact of Dodd-Frank legislation on reducing bank industry returns. – Doug Kass, “My Berkshire Q&A Recap”

There’s Something About Coca-Cola and IBM

Ted (Ben Stiller): So you’re moving down to Miami?
Pat Healy (Matt Dillon): I accepted a job offer.
Ted: With who?
Pat Healy: With… uh… Rice-a-Roni.
Ted: Isn’t that the San Francisco treat?
Pat Healy: It was. They’re changing their image.
— There’s Something About Mary

Berkshire Hathaway owns about 9% of Coca-Cola (valued at over $15 billion) and approximately 6% of IBM (valued at $13 billion). The total investment in these two companies approaches $30 billion, which represents about one sixth of the market capitalization of Berkshire Hathaway.

Recent earnings reports at Coca-Cola and IBM suggest that the companies’ moats appear to be vanishing.

Some of the more significant questions I had for Warren Buffet at last year’s Berkshire Hathaway annual meeting had to do with a changing acquisition strategy that settled for moat-less or less threatening moats — that is, large cash flow and market share elephants rather than significantly undervalued gazelles that faced a long runway of growth ahead. I further questioned whether the company’s more defensive acquisition and investment strategy would result in Berkshire Hathaway gaining the look of an index fund and remarked that its ever larger size might provide a continuing headwind for the company to differentiate its results and expand its intrinsic value relative to the S&P 500.

These questions continue to raise issues that have a direct bearing on Berkshire’s investment in IBM and Coca-Cola and speak to the general attractiveness of Berkshire’s shares.

“From 2008 to the end of 2013, the S&P 500 returned 128%. Berkshire (which computes return based on book value per Class A share) returned 80% from 2008 through September 2013, according to Bloomberg. That won’t be enough to get him past the index when the company reports 2013 results.” — Steven Perlberg, “Chart: Warren Buffett Will Fail Berkshire Hathaway Shareholders for the First Time in 44 Years,” Business Insider (Jan. 2, 2014)

To date, we’ve never had a five-year period of underperformance, having managed 43 times to surpass the S&P over such a stretch. But the S&P has now had gains in each of the last four years, outpacing us over that period. If the market continues to advance in 2013, our streak of five-year wins will end.” – Warren Buffett, 2012 annual letter to Berkshire shareholders

In defense of my conclusions, I would note that for the first time in 43 years Berkshire’s five-year rolling returns (defined as book value gains) in the period ending Dec. 31, 2013, failed to outperform the change in the S&P 500.

The answers to my questions last May in Omaha help to understand and frame why, in part, I have been short Berkshire Hathaway since last May.

Forever Is a Long Time

“Forever is a long time, and time has a way of changing things.” – The Fox and the Hound

Warren Buffett has historically invested with a forever time frame based on the notion that his investment holdings would be enduring, consisting of profitable companies that possessed moats that provided them with a nearly invulnerable market share position, sustainable profit margins and returns on invested capital, and superior earnings growth.

Recent results for IBM and Coca-Cola, which represent sizeable investments at Berkshire Hathaway, have seemingly unearthed an unexpected vulnerability to both companies’ forward revenue and profit growth rates. Specifically, major secular industry changes are exposing weaknesses in the moats that Warren thought might have existed when he initially purchased the shares of IBM and Coca-Cola.

  • IBM faces a serious competitive threat from the cloud. (As Stanley Druckenmiller said on Bloomberg TV, “Buy IBM if you want to be short innovation.”)
  • Coca-Cola faces a secular deterioration in the carbonated soft drink market — volumes in North America dropped an eye popping three percent in the most recent quarter — as healthier drink choices rip into their market share.

Forever is a long time.

While IBM and Coca-Cola started out as forever holdings for Warren, developing headwinds have unexpectedly surfaced and have threatened what might have been previously considered impenetrable franchise moats.

While there is recent evidence that both companies are trying to adapt to a changing industry environment (through internal moves and growth by acquisition), it is unclear whether the needles of growth can be moved significantly over the next few years in order to diminish the headwinds.

Those headwinds have weighed on the price performance of the shares of IBM and Coca-Cola, and I am short both of them.

As well, I remain short Berkshire Hathaway’s shares.

This Year in Omaha?

“If I forget you, O Jerusalem, let my right hand wither.” – Psalm 137 (in which the Jews lament and weep by the rivers of Babylon)

My Grandma Koufax always used the phrase, “Dougie, next year in Jerusalem.”

This was meant to be an expression of spiritual hope, as Jerusalem was the spiritual center of the Jewish world.
As I learned last year, the pilgrimage to Omaha (to Berkshire’s annual shareholders meeting) is also a religious experience to many.

Last year’s appearance in Omaha was one of the most exciting experiences of my investment career. Warren, Charlie and the rest of the Board of Directors couldn’t have been nicer to me last year.

I have more questions to be addressed toward The Oracle of Omaha and to Charlie Munger, and regardless of my view on Berkshire’s shares, I am hopeful that I will be invited back to the 2014 Berkshire Hathaway annual shareholders meeting to ask some more penetrating questions.”

Kass – An Unhealthy & Potentially Toxic Market

On Friday, I outlined my multi time-frame outlooks — very short, short and intermediate term — for the S&P Index.

As I noted it is important to emphasize that this exercise is not meant to imply precision of forecast, its just an exercise I use to develop a broader guideline to trading and investing.

In that analysis I thought the very near term (the next five days) would result in a move towards 2750-2775 – the Index peaked at close to 2750 and appeared to have failed Friday afternoon. That failure has continued yesterday morning with S&P futures down by another -13 handles before the open – and, adjusted for this, cash on the S&P Index was approximately 2710 (corresponding to SPY $270.00):

We have subscribers with differing risk profiles, from day traders to long term investors, and with differing timeframes.

So since our audience is diverse, let me briefly spell out my timeframes and investment expectations:

Short Term (in the next five trading days)

Higher, but not materially so. 2750-2775 seems a reasonable guesstimate.

I plan to scale into a net short position on strength, but I will give the market a wider berth today and into the first few days of the second half (inflows expected).

Short Term (in the next two months)

Lower, but not materially so.

I expect a series of tests of the S&P level 2675-2710.

Intermediate Term (in the next six months)

Lower, a break towards “fair market value” of about 2500 is my expectation.

Finally, here are my risk parameters for 2018:

  • Market Downside: 2400 to 2450
  • ‘Fair Market Value’: 2500
  • Trading Range: 2550 – 2750 to 2800
  • Current S&P Cash 2710 (at 5 AM)

Bottom Line

“Donald Trump Will Make Economic Uncertainty and Market Volatility Great Again. #MUVGA!”
– Kass Diary

Friday morning’s repudiation of the 2750 S&P level and this morning’s continued decline has as its proximate cause, more trade saber rattling from the White House. As I wrote on Friday in “Donald Trump and the Markets”:

The second quarter of 2018 was period in which politics, specifically the combative actions of our President, transcended (in importance) even the actions of central banks.

I expect this to be the case in the last half of this year.

The traditional view appears to be that Trump’s hardline tactics with China is another example of “The Art of the Deal,” where strategy can suddenly make a U-turn and the White House can declare a win.

I respectfully disagree and view the Administration’s stance as an act of economic warfare based on spurious economic theory. (The relationship between imports and US GDP is not inverse as Navarro and Lighthizer apparently believe. Rather, over history, there is a direct relationship between deficits and US GDP).

Moreover, it appears that Trump is targeting a more combative strategy against China’s upgrading of its economy in an attempt for the US to maintain global economic leadership. As such, Trump’s China policy may be more than just tariffs.

I see the policy relationships between the US and China as well as with Mexico, Canada and others jeopardizing and souring previous bilateral relationships as a broader protectionist strategy that could “have a life of their own.” This could have a meaningful impact on business and investor, global economic growth and on our markets.

That economic impact could even be more deleterious than the pivot of global monetary policy from ease to restraint.

At the same time hastily crafted trade policy (conflated with politics and done on the back of a napkin) is market disruptive and unfriendly, we have reached a pivot point in global monetary policy (towards restraint).

This a potentially toxic market brew.

Unabridged User’s Guide to Investing and the Diary

“You’ve got to be very careful if you don’t know where you are going, because you might not get there.”
— Yogi Berra

It’s a good time, having completed the first six months of 2018, to repost this missive:

Too many traders and investors are less thoughtful and more impulsive with regard to buying and selling securities than when they purchase a refrigerator or a television.

Too many want an easy path to investment riches — ideas coming forth from business television, or books that purport to explain “how to make millions” in the market. Even stock ideas from friends, relatives or on Twitter are often seen as pathways to investment success.

But there is no easy path for consistently profitable investing. It requires a lot of hard work.

The investment and asset-allocation processes can hold more weight and is more complex than nearly any other business decision. A host of variables, known and unknown, contribute to the investment alchemy. As well, subtle and unconscious influences and personal biases affect the process as we all seek Mr. Market’s metaphorical green jacket (like the one won by Jordan Spieth in this year’s Masters golf tournament).

What follows are some basic tenets that form my investment consciousness, which are admittedly simple to write about but far more difficult to execute.

Know Thyself, Work Hard, and Don’t Get Emotional

  • If you don’t know yourself, Wall Street is a poor place to find yourself. There is a reason why there was a church on one side of the old New York Stock Exchange building and a cemetery on the other.
  • If you enter the hedge fund biz, remember Darwin. It is survival of the fittest, the smartest and the most practical. The hedge fund industry is populated by some of the most obsessive and idiosyncratic practitioners extant, most of whom are highly educated and possessive of a greater-than-normal cerebellum. Differentiate yourself by your process and by routinely working harder than anyone else (e.g., my day routinely starts at 5:00 a.m.). As John Maxwell wrote, “Successful and unsuccessful people do not vary greatly in their abilities; they vary in their desires to reach their potential.”
  • Do not get emotional in making investments, and however eloquent the strategy is, it is the results that count. The ecstasy of getting investment performance right is always eclipsed by the agony of getting it wrong. If you are uncertain or temporarily lack confidence, raise your cash positions and reduce your risk profile.

The Investment Process Is Methodical

  • If you are a fundamentalist, write a brief synopsis of each investment analysis/conclusion. It will serve to crystallize your investment analysis, and it is an excellent personal and investment discipline. (It is the principle reason why I write my diary.) Moreover, an ex post facto reflection on why one achieved past success or failures is usually illuminating, instructive and often leads to fewer mistakes. After all, as philosopher Benjamin Disraeli once wrote, “What we have learned from history is that we haven’t learned from history.”
  • If you are a technician, keep all your charts, just as the fundamentalist should write up a summary of each investment. Reflecting on past mistakes/successes is as important to a technician as it is to a fundamentalist.
  • A combination of mostly fundamental and a dose of technical input is usually a recipe for investment success.
  • Regardless of one’s modus operandi (fundamental, technical or a combination of both), logic of argument and power of dissection are the two most important ingredients in delivering superior investment returns. Common sense, which is not so common, runs a close third!

Stay Objective and Independent

  • Neither be a Cassandra nor a Sunshine Boy! It is much easier to be critical than to be correct, as financial disasters are always impending by the ursine crowd. Conversely, the outlook is never as perfect or clear as it is seen by the bullish cabal.
  • Within limits, stay independent in view. Above all, remember equilibrium is rarely observed in the stock market. To quote George Soros, “Participants perceptions are inherently flawed” (at least to varying degrees).

Investment Discipline Is Key

  • Let your profits run and and press your winners, as knowing when to seize opportunity is one of the basic principles to investing. But stop your losses, as discipline always should trump conviction.
  • In “Reminiscences of a Stock Operator,” Edwin Lefevre wrote, “I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out. Of all the speculative blunders there are few greater than trying to average a losing game. Always sell what shows you a loss and keep what shows you a profit.”
  • Woody Allen put it even better: “I don’t want to achieve immortality through my work. I want to achieve it through not dying.”

The Past Is Not Necessarily Prologue to the Future

  • History should be a guide but not a jailer. There is little permanent truth in the financial markets as change is as inevitable as it is constant. Do not extrapolate the trend in fundamentals in your company analysis nor in the trend in stock prices. Be independent of analytical and investment conclusions, greedy when others are fearful and fearful when others are greedy, but always remember that possessing a variant view has outsized risk as well as outsized reward.

Risk and Reward Should Be Assessed Properly

  • In buying a stock remember risk/reward is asymmetric. A long can climb to indefinite heights and one can only lose 100% of the value of each investment. Buy value, but only with a catalyst. When longs have high short interest ratios, investigate the bear case completely.
  • In shorting a stock, remember risk/reward is asymmetric. A short can only return 100% (a bankruptcy) but can rise to indefinite heights. Never make conceptual shorts without a catalyst. Avoid shorts when the outstanding short interest exceeds five days of average trading volume.
  • Use leverage wisely but rarely as financial markets are inherently unstable. While the use of leverage can deliver superior investment returns when the wind is at your investments’ back, it can also wipe you out when events fail to conform to your expectations. Only the best of the best consistently time the proper use of leverage.

Knowledge of Accounting Is a Must, but Meetings With Management Have Little Value

  • There is no substitute for a thorough knowledge of financial accounting. Accounting can be misleading, opaque and unaccountable, but free cash flow rarely lies.
  • If you must meet with management, do so to understand a company’s core business but remember that managements infrequently, if ever, view their secular prospects with suspicion. In the late 1980s Warren Buffett wrote in his letter to Berkshire Hathaway’s shareholders that “corporate managers lie like Ministers of Finance on the eve of devaluation.”

Be Open to Others’ Ideas, but Rely on Your Own Analysis

  • Always be self-critical, and once your view is formulated, be open to criticism from others that you respect. Take their criticism and test your thesis (constantly). Avoid what G.K. Chesterton once mused, “I owe my success to having listened respectfully to the very best advice, and then going away and doing the exact opposite.” Bullheadedness will get you into trouble in the investment world.

Only Invest/Trade When Distractions Are Limited

  • Invest/trade/speculate only if you are not dependent upon the investment profits to maintain your standard of living.
  • A stable personal and financial life, outside of investing, is typically a necessary ingredient to investment success.
  • Take vacations and smell the roses. When you return you will be rejuvenated and a better investor/trader.
  • Be well-rested and in good shape physically.“Investing is 90% mental; the other half is physical” (another Yogi-ism).
  • Keep your investment expectations reasonable and expect to make mistakes as perfection is not attainable. Nevertheless, by all means, try to chase perfection as the byproduct will be investment excellence.

Read As Much as Possible

  • Learn from those investors who have excelled by reading and re-reading the classic books on investing.

In terms of my own contribution to your knowledge base, let me reiterate the objectives and goals of my Daily Diary:

To begin with, never lose sight that I “eat my own cooking.” I trade and invest actively, sometimes in size, with real money from my investors. When I screw up and make trading and investment mistakes, it is financially painful to me. These are not paper trades like many other services provide. When my ideas go awry, I can’t help but also be affected emotionally with regard to subscribers who have embraced my ideas. You should all know, I take this to heart.

Secondly, I work hard in delivering my Diary to you, starting my day at about 5 a.m. and often staying after 6 p.m. Maybe I don’t work quite as hard as Jim “El Capitan” Cramer (who has a remarkable work elan and ethic), but I work damn hard for subscribers.

Here is what I try to achieve every day in delivering a value-added view:

  • Above all, to keep subscribers engaged by providing profitable short-term trading and thoughtful investment ideas on both the long and short side.
  • Deliver (an often) variant and non-consensus view based on hard-hitting analysis of individual stock ideas, sector work and market views.
  • In doing so, at times I intentionally want to make you uncomfortable with some of your investments and with consensus notions — playing devil’s advocate — for the purpose of having you often question your holdings. That’s a healthy process!
  • When appropriate, my individual analysis will be extensive. Other times I will highlight an investment case more briefly with bullet points and in summary form.
  • Actively share insights and observations I gain from individual company management visits, telephone and conference calls.
  • Communicate transparently what, why and when I implement trading and investment ideas.
  • I try to deliver both fast money ideas and slow money ideas, depending on market conditions. I indicate the size (small, medium, large) of all my trades and investments so subscribers can recognize my relative commitment, conviction and weighting.
  • Communicate, sometimes in detail, an analysis of macroeconomic events that might influence the capital markets.
  • Pass on breaking business news that can impact markets/sectors/stocks.
  • Write in an easy and even fun manner through the intersection of serious research and pop culture. I want to keep you informed AND entertained.
  • Communicate special, one-off ideas — for example, The Trade of the Week, Best Ideas list, Tell Me Something I
  • Don’t Know, The Most Important Thing, etc. (There will be additional different ideas and new columns in the near term).
  • I endeavor to be objective and try not to be self-confident in view as I have learned over a couple of decades that Mr. Market is here to embarrass the most people, most of the time. Mr. Market doesn’t exist to make us money — that is our job.
  • Interact respectfully with our subscribers in the Comments section and with other contributors in the Columnist Conversation area. In doing so, I encourage you all to challenge my/our views and theses. The only thing I ask is for you to be respectful, as I will be with opposing views.
  • I will qualify my views, as the only certainty in this business is the lack of certainty.
  • I will always admit my mistakes. More importantly, I will write about why I made boners, hopefully learning from each experience.

Finally, my Diary, Jimmy Cramer and the contributions of others should not be taken in isolation. Our contributions should be used in conjunction with doing your own homework.

You hold the responsibility and pull the trigger to your own investment decisions — we do not.

As stated above in today’s opening missive, our ideas are simply jumping-off points and investment input upon which more primary research should be performed by all of you.

I hope this outline of my core investment tenets and objectives and goals of my Diary are useful to all of you this morning.

Kass – The Titanic May Be Soon Hitting The Ice

It’s just another manic Monday
I wish it was Sunday
‘Cause that’s my fun day
My I don’t have to run day
It’s just another manic Monday
— Bangles, Manic Monday

The Bangles “Manic Monday,” was actually written by Prince, using the pseudonym “Christopher.” Often compared to The Mamas and The Papas, ” Monday, Monday” it was a 1986 release and the group’s first big hit.

The proximate cause for the early morning future’s drop (-17 handles) is the heightened trade tension between China and the rest of the world with the U.S. – something Jim “El Capitan” Cramer and I have been consistently cautioning about.

The leveraged ETFs and quant strategies (e.g., volatility trending and risk parity) and changing market structure may take it from there and could create a turmoil filled and volatility trading session today.

Donald Trump is Making Economic Uncertainty and Market Volatility Great Again as the second order impact on trade, global economic growth and business confidence is being upended at a time stocks are elevated in price and valuations (particularly against GAAP expectations). ( A talking head on CNBC just told my pal Brian Sullivan that “earnings quality is terrific.” No it isn’t, that Wall Street pablum and “Group Stink” as the gap between Non GAAP and GAAP earnings have never been wider. Stocks, measured against GAAP #s are preposterously inflated).

#MUVGA

Meanwhile, the partisanship in Washington, D.C. – on both sides of the pew – has never been more pronounced and a disquieting backdrop of animus and hostility reins. The impact of this condition on consumer and business confidence remain unknown.

Valuations are contracting, stocks are beginning to ignore good results (e.g., Micron Technology (MU) ) and the risks of policy (both fiscal and monetary) miscues are rising — at a time in which monetary policy around the world is pivoting towards tightening.

Meanwhile the benefits of the corporate tax reduction is trickling up and not trickling down.

Bottom Line

I was long as the S&P Index rose in early June. but I moved back into a net short exposure (via defined risk (SPY) puts and with a short (QQQ) ) at mid-month as signs of global economic ambiguities multiplied, investor optimism grew and the threat of policy mistakes increased — and the downside risks were heightened as measured against upside reward.

  • Market Downside: 2400 to 2450
  • ‘Fair Market Value’: 2500
  • Trading Range: 2550-2750 to 2800
  • Current S&P Cash (Adjusted for this morning’s future drop): 2735 

Here are the current reward versus risk parameters (based upon the -15 handle drop in S&P futures, 2735 S&P equivalent):

  1. There are 310 points of downside risk against only 65 points of upside reward (compared to the top of the expected trading range) in my new pessimistic case (2400-2450). This is an overwhelmingly negative reward vs risk ratio (5:1). 
  2. Compared to ‘fair market value,’ (2500) there are 235 points of downside risk versus only 65 points of upside reward. That’s a negative 4:1 ratio. 
  3. Against the expected trading range, there are 185 handles of downside risk and only 65 points of upside reward (to the top end of the anticipated trading range). That’s a 3:1 adverse ratio. 

There are more Shades of 1999 and signposts that FAANG may have peaked, while we face a new regime of volatility reflecting a host of factors and the possibility of increased economic and market outcomes (many of which are adverse).

A changing market complexion is occurring coincident with global monetary tightening – making equities and other long dated assets less attractive as the risk free rate of return expands.

I wish it was Sunday.

That’s my fun day.

Kass – Navigating The New Regime Of Volatility

  • There is no place for dogma and emotion (and sometimes even an intermediate term viewpoint) in developing a strategy to opportunistically trade over short term periods in the 2018 market
  • The market’s structure (and dominance of passive and quant strategies/products) provides exceptional near term trading moments
  • Yesterday was another example of the value that can be extracted from premarket and aftermarket trading (I am a ‘pajama trader’ and proud of it!)

Yesterday I started the day with a negative outlook for the markets in my opening missive,Risk Happens Fast

Soon thereafter, in response to a -40 handle drop in S&P futures (seemingly induced by more aggressive trade rhetoric out of the White House), I covered my entire (and very large) short (SPY) position – as well as covering all my trading shorts in (ALL) and (GM) and adding to several long positions – and, I moved from a medium sized short exposure to small net long exposure in a matter of an hour or two.

For now, the move was the right one as, adjusted for the 9 handle rise in futures this morning, the Spyders are trading more than 30 handles higher than my short cover prices in premarket trading yesterday morning.

Price Discovery In a World of Machines and Algos

Some will say/write that Trump’s aggressive trade tactics, throwing a hand grenade at China’s trade policy, was another example of the market discounting the President’s hard line of policy negotiations (so often seen as part of his negotiating approach) – and another “V” type recovery in the markets, that has “learned” to know better than to take the President literally.

To some degree, I respectfully disagree. To me, it was the machines and algos that materially (and artificially) tanked futures and provided yesterday’s trading opportunity.

The Trump pronouncement over the weekend of more tariffs targeted at China was simply the fuse.

The machines and algos were the dynamite.

Explaining the Juxtaposition of Short Term Bullish/Intermediate Term Bearish

How can one be negative in view and at the same time move into a net long position?

  • Unemotionally trading around a “view” in a period of much more heightened volatility is a key component of my tactical approach to the markets in which passive strategies, products that worship at the altar of price momentum and strategies that allocate to risk (e.g., ETFs, risk parity and volatility trending)
  • These products and strategies exaggerate short term market moves – often artificially extending bouts of depression and elation.
  • If one has a view of “fair market value” in the indices, sectors or individual stocks – this is one heckuva opportunity to deliver exceptional trading profits (by moving contra to the moves) when the difference between that “fair market value” calculation and the current share price widens.
  • Investors and traders have differing time frames. Even traders have differing time frames. Some trade hourly, others trade with positions (often held for several weeks) – and in times in between.

For me, given the new regime of volatility, it is consistent to have a bullish and very short term long exposure at the same time being intermediate term bearish. (Indeed throughout the first half of 2018 I have often been net long in exposure though holding to an intermediate ursine market view).

Depending on my calculus of the downside risk versus upside reward — that condition can continue for “some time.”

However, given my calculation of the bearish skew of risk versus reward it is not likely that I will even be small net long in exposure for very long!

I ended yesterday in a small net long exposure.

Downside Risk Dwarfs Upside Reward Now

Here are my reward/risk parameters:

Market Downside: 2400 to 2450
‘Fair Market Value’: 2500
Trading Range: 2550-2750 to 2800
Current S&P Cash (Adjusted for this morning’s future rise): 2775

Here are the current reward versus risk parameters (based upon the +5 handle rise in S&P futures, 2750 S&P equivalent):

  1. There are 350 points of downside risk against only 25 points of upside reward (compared to the top of the expected trading range) in my new pessimistic case (2400-2450). This is an overwhelmingly negative reward vs risk ratio (14:1).
  2. Compared to ‘fair market value,’ (2500) there are 275 points of downside risk versus only 25 points of upside reward. That’s a negative 11:1 ratio.
  3. Against the expected trading range, there are 225 handles of downside risk and only 25 points of upside reward (to the top end of the anticipated trading range). That’s a 10:1 adverse ratio.

I Remain a Pajama Trader and I am Proud of it!

Investment opportunities take multiple forms and for the life of me I cant see missing market opportunities – whether they arise at 1pm or 1am.

If I blanketly rejected such an opportunity, some of my investors would no doubt reject me as an investment manager!

Some commentators on this subject – though I can’t understand the logic – reject non market hours trading. Here is that view by one of our contributors.

By contrast, as expressed in my March, 2018 post, I am a pajama trader and proud of it – as it routinely yields exceptional opportunities:

“Markets evolve — and, to me, it is the responsibility of market participants to change with it.

I am a “pajama trader” (during outside of market hours) and I am proud of it!

I don’t understand the objection, in some circles, to trading stock futures (and securities) opportunistically whenever the market is open — whether it is 2 pm or at 2 am.

Does this mean the trades/markets are not real in the after hours? Trust me, they are real — these trades importantly impacted by P&L.

Does this mean I shouldn’t capitalize on extreme reactions to news (like the after hours Gary Cohn resignation)? That would be an extremely poor decision, in my judgment.

I try to capitalize on the inefficiencies or quick interpretations to news (and other factors) outside normal trading hours — and so do many others.

It’s an opportunity that Mr. Market affords market participants.

At least I try to exploit the opportunities — with increased activity, particularly in a period of rising volatility.

That said, I now trade at least 40% outside normal trading hours, as I see expanding opportunities flourishing in these periods.

Do I care if the futures go to extremes in the after hours and may not be indicative of the next day and may not follow thru?

Who really cares if an opportunity is being presented in the after hours for me and other pajama traders!” – Kass Diary, I am A Pajama Trader and Proud of It!

Bottom Line

Mr. Market has rallied from yesterday morning’s lows and is now back in the middle of the upper end of my projected 2018 trading range.

While I am small net long in exposure I will likely cut back and move back into a net short exposure over the next few days given my calculation of risk over reward.

Be flexible in approach and avoid dogma as the market’s structure is providing unimpassioned traders with exceptional opportunities in a new regime of volatility.

Finally, never limit your trading opportunities based on the time of the day or any other factor.