Tag Archives: vigilantes

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: 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.

Kass – Risk Happens Fast

  • Risk happens fast – Trump trade policy whacks futures this morning
  • We remain in a trading sardine market – not an eating sardine market
  • Hastily crafted policy that conflates politics is dangerous in a flat and networked world
  • The return of an untethered Orange Swan is market unfriendly … brace yourselves
  • The Supreme Tweeter will likely “Make Uncertainty and Volatility Great Again” (#MUVGA)

The First Half of 2018

The first half of 2018 has been a tale of two markets. Maybe three markets.

January brought a market fervor – in which global equities rose dramatically, likely in response to the expected stimulative contribution and impact of the Administration’s reduction in statutory tax rates.

As interest rates began to climb in January, bullish investor sentiment crested and the risk parity trade went array.

Stocks fell violently in February and the new regime of volatility commenced – in a market revealed as increasingly illiquid.

The S&P Index fell from nearly 2900 and successfully tested the 2550 level twice. Several meek rallies commenced but the S&P had 2-3 more successful tests at about 2600 and stocks recently closed in on 2800 (S&P Index).

1Q-2018 corporate revenues and profits didn’t disappoint but the complexion of the market had clearly changed – and valuations (the S&P Index’s price earnings ratio expanded by almost 3 points in 2017) began to contract. Wall Street, which outperformed Main Street in 2017 – reversed roles in the first six months of 2018.

While the stock market reeled with volatility since January 1, the FAANG stocks generally stood tall throughout the year as the market narrowed and investor interest focused on the 5-10 anointed stocks.

The first half of 2018 was also characterized by a series of questionable and controversial presidential policies (the most recent being trade/tariff decisions) at the same time the Federal Reserve was pivoting on monetary policy. By overtly playing to his base, having little sense of economic history, Trump has contributed to even greater volatility in a market without memory from day to day.

Finally, during the second quarter the European Union’s economic instability and weak banking foundation (read: Deutsche Bank (DB) ) contributed further to the new regime of volatility.

Despite these intrusions — up until a week ago — stocks climbed steadily higher. I shorted into that rise.

Since my marshalling assignment at the US Open at Shinnecock, the markets have declined for six consecutive trading sessions. (It also has been a bad time for six others: Jordan Spieth, Rory McIlroy, Phil Mickelson, Tiger Woods, Jon Rahm and Jason Day).

Trade War

President Trump’s aggressive negotiating strategies with regard to trade is a crude tool and is clearly disruptive and destabilizing to the markets. That policy and those negotiating tactics hold the risk that business confidence could be jeopardized and supply chains may be disrupted.

In turn, the real economy is vulnerable.

The Administration is trying to get a “better deal” for America but the way to get a better deal is to make us more competitive and the Trump strategy, rooted in the past and not the present, is not the way to do it.

The Second Half of 2018

My concerns are multiple over the balance of the year:

  • The possibilities of policy errors (fiscal and monetary) are multiplying.
  • The Fed is tightening. If the global economic foundation is as weak as I believe, our central bank may go too far in raising rates.
  • A poorly and hastily crafted trade policy, though not having a large direct impact on the domestic economy, could deliver a big psychological drain to business confidence.
  • In a flat and interconnected world economy, global cooperation is at an all time low.
  • The corporate tax reduction will likely trickle up and not down.
  • Debt is out of control and politicians are paralyzed.
  • Both the Democrats and Republicans are guilty of fiscal irresponsibility. With rates rising, ‘the judgment day” is nearing.
  • With over $50 trillion in non financial domestic debt, every 100 basis point increase in rates produces a $500 billion economic drag.
  • The Global Citigroup Economic Surprise Index is weakening (even China is slowing) — worldwide growth is becoming more ambiguous, less steady and less reliable.
  • Short dated Treasuries now yield more than the S&P dividend yield.
  • The yield curve continues to flatten – underscoring the fragility of domestic economic growth.
  • Technicals are deteriorating: (1) The market is narrowing (see my repost of Bob Farrell’s Ten Rules of Investing), (2) New highs are contracting, new lows are expanding, and (3) Valuations of the median stock on the NYSE is already contracting. More contraction may lie ahead.
  • The markets are growing more illiquid and with so many market participants worshiping at the altar of price momentum – market structure is a risk (with so many on one side of the boat).
  • With strength in the US dollar and emerging weakness in the EU and elsewhere, US denominated debt concerns could continue to raise issues regarding the emerging markets.

I have long argued, in my 15 Surprises for 2017 and for 2018 and in my Diary, that the “Orange Swan” would ultimately be market unfriendly – that an untethered Trump would “Make Uncertainty and Volatility (in the markets) Great Again.” (#MUVGA)

And, I have recently argued over the last few months, that the President’s behavior is now beginning to impact the capital markets.

Acting upon his impulses, growing more isolated and becoming more unhinged — the Supreme Tweeter is now an Orange Swan headwind. In my view, this is market unfriendly and one of the reasons the markets may continue to act poorly.

Past is indeed prologue as Trump’s White House is now replicating The Trump Organization – both are built on a small body of personnel with policy developed on “gut instincts” (and without thoughtful planning). We witnessed this during the campaign and we now see it in the government of the U.S.

As I wrote in “A Presidency of One” a few months ago:

  • Trump’s behavior may finally matter to the capital markets
  • The Administration’s disorganization, revolving door and impulsive policy actions may soon intersect with market valuations
  • Investors should consider taking C.I.T.A. (“cash is the alternative”) to the prom and should consider avoiding a dance with T.I.N.A. (“there is no alternative”)

“Rex, eat your salad…” – President Trump

Since 2017 year-end, the White House has been a poster child of turnover and disorganization.

After the recent multiple changes (of senior government officials) in the first months of this year, impulsive policy decisions/statements, the lack of shared policy conviction, a seeming Administration agenda of fear (rather than hope) and given potential legal problems, the President has likely seriously cut off his ability to hire capable people for White House assignments.

Without counsel, the President’s decision making process poses a threat to the markets.

Nowhere is it as clear as in the trade tariffs being levied towards China and other nations.

Meanwhile, the sounds and pictures of recent immigration policy grow move vivid and a potential Blue Wave may loom only four months from now – creating the potential for even more uncertainty. It is looking increasing likely that the November mid-term elections could result in important changes in the majorities and point to the increased likelihood that little meaningful legislation may be forthcoming over the balance of the Trump Presidency. As I put it in my Surprise #1 in my 15 Surprises for 2018:

Surprise #1: President Trump’s Behavior Finally Does Matter

“The tax reform bill becomes the sole landmark piece of legislation of his presidency.”

It took a while but I believe the weight of the Trump Administration has now become an influence on the markets (but not in a good way) – as also carved out in my 15 Surprises for 2018:

Surprise #2: Politics is Upended in 2018 as the U.S. Electorate Pushes Left in Mid-Term Elections

  • The tax cut for the rich is election manna for the Democrats.
  • The U.S. economy falters next year, more due to monetary tightening, but everyone blames Trump and the ineffective tax reform initiatives put in place in late 2017 that do little to encourage capital expenditures and feather the bed of corporate executives.
  • With a malfunctioning and disorganized administration, almost nothing gets done in Washington, D.C.
  • The House falls to the Democrats in the November mid-term election, but the Senate remains barely (by one seat) in control of the Republicans.
  • Establishment Republicans — seeing an intermediate and longer-term threat because of large losses in voters who are minorities, females and those under age 35 — panic and begin to reconstitute the party’s leadership toward a more youthful profile and try to expand the party’s tent in order to survive the reduced support seen for the Trump administration.
  • House Speaker Paul Ryan, recognizing the need for party change, resigns.

Bottom Line

* Price momentum and hope float but fundamentals propel.” – Kass Diary

My S&P forecast remains unchanged:

Market Downside: 2400 to 2450
‘Fair Market Value’: 2500
Trading Range: 2550- 2750 to 2800
Monday Close: 2775

So, according to my calculus, downside risk remains far greater than upside reward and I remain net short.

The market’s reaction to news over the last few months indicates that there is not a lot of conviction out there.
While I remain concerned about the monetary pivot of the world’s central bankers, higher interest rates, fiscal irresponsibility (on both sides of the political pew), too optimistic consensus on corporate profits and domestic economic growth, a potential trade war with China, and other possible headwinds – the Presidency (and his actions) will now likely continue to weigh on the markets (and on the Republican Party over the balance of the year).

When we superimpose the market structure (with so many in one side of the investment boat), the secondary market implication of all this is a continuation of a new regime of heightened volatility and a wide trading range – which favors trading sardines over eating sardines.

Moreover, if we are 12-18 months from a recession – we will blow out our deficit to more than $1.5 trillion – which I can’t imagine the bond market will like very much.

Finally, I don’t see, given the above concerns, that the FAANG stock price rises are sustainable. I feel like a lot of people are waiting for the moment to jump off the train – it could be a hard fall.

Investors should consider taking C.I.T.A. (“cash is the alternative”) to the prom and should consider avoiding a dance with T.I.N.A. (“there is no alternative”).

Kass – An Italian Job?

“What should have happened? First, I think it would have helped to have some perspective on Italy. The country’s gotten pretty dysfunctional, with almost no growth whatsoever. There’s also that aforementioned 11% unemployment rate, plus an immigrant population that all parties concede will cost more than the country can currently afford.

At the same time, Europe’s recent history of chaos has provided multiple opportunities to invest here in America, because you can count on some people panicking over the “black swan theory.” Finally, you can be sure that what happens in Italy won’t be related to any individual companies, as all anyone cares about now are the indices. Those trade both here or abroad as if they’re their own beasts these days, unrelated to anything corporate at all like earnings, or dividends, or prospects.

Now, I concede you can’t not report these things in the media. But I also think that the Italian crisis should have been reported in the light of what it really was — an oddity that produced a quick spike in Italian bonds as a product of a government changeover. Nothing more.

But on a slow news day with almost no earnings and the usual Trumpian trade tensions growing less and less newsworthy, it was something new and exciting to report. And it was easily framed as frightening and worrisome, because there are no consequences whatsoever for it not to be framed that way. If it turned out to be terrible for our markets, the dread would be warranted. But if it turned out to have a positive resolution (which was the case), well, nobody pays for the scare stories.

It’s an asymmetrical standard at work, and the only two things you can do are 1) expect it and 2) exploit it. Otherwise, shame on you for selling given how often these European “woe-is-me” stories burst onto the scene, explode and then recede within a few weeks’ time. Or even less in the case with this particular Italian job”.

– Jim “El Capitan” Cramer  – “Rome’s Political “Crisis’ Was Just an Italian Job” discusses the past week in review – particularly from his vantage point of the Italian “debt crisis.”

I agree with some elements of Jim’s missive and disagree with others.

I agree that the market downdraft provided a short term opportunity in the U.S. – that is about history and about the passive strategies and products that dominate our markets and tend to exaggerate short term moves.

My tactical response, as described in a series of columns last Tuesday was to cover my Spyder shorts for a nice profit, and I went net long in exposure. Seeing the market with no memory from day to day emerge (Tuesday – down big, Wednesday – up big, Thursday – down big) I went on to (incorrectly) scale into a short as stocks rallied after a few days of inconsistent price action later in the week – and I incurred modest losses on my Spyder hedge which I covered in premarket trading.

But more importantly I believe the Italian debt crisis is not an oddity – it lies at the epicenter of a world (private and public) immersed in debt as the global economic recovery ages. It is an example of the systemic financial problems and risks in Europe that have been swept under the rug – and that, over the intermediate term, should not be dismissed as a “one off.” This is particularly true if the ECB, as planned, moves away from a “money for nothing” policy.

Indeed as I remarked, while that Italian indigestion could elongate our domestic economic expansion – as the risk of a short term shock in higher inflation and interest rates abate – we should not lose sight that the synchronized economic expansion is growing more ambiguous and that the world, like never before, is flat and interconnected.

Mark Grant touches on this alternative view in is his commentary this morning:

I honestly believe that the markets, and most investors, do not understand exactly what is happening in Italy. Of course, the boys in Brussels, and Berlin, will claim that nothing of significance is happening, at all, in Italy, but then what else is new? I have the sense that these people understand, well enough, but they are following the time worn German playbook, “Deny, Deny and Deny.”

Mr. Salvini has stated, “As Italians, not as slaves of Berlin or Brussels.” It is a different time, as history echoes, once again, but I recall the rather famous words of Seneca the Younger (4 BCE-65 CE), “The master eats more than he can hold; his inordinate greed loads his distended belly, which has unlearned the belly’s function, and the digestion of all this food requires more ado than its ingestion. But the unhappy slaves may not move their lips for so much as a word. Any murmur is checked by a rod; not even involuntary sounds – a cough, a sneeze, a choke – are exempted from the lash. If a word breaks the silence the penalty is severe. Hungry and mute, they stand through the whole night.”

Mr. Salvini, rightly or wrongly, feels that Italy has been enslaved and he has bound with the Five Star Movement in his fight against the European Union. That much is clear to me. Did you expect him, in his first few days in office, to try to overthrow the European Masters? I believe that he, and the newly elected Italian government, have other tactics in mind. I also believe that they will begin to be effectuated in the not too distant future.

The New Yorker Magazine joins me in my contrarian corner. “Looking further ahead, however, there is great uncertainty surrounding not just Italy but the entire nineteen-nation eurozone. For the first time since it was formed, in 1999, the monetary union will be confronting a government in one of its core member countries that is implacably opposed to many of its rules and policies.” You see, I may hold the minority view on what is about to happen in the European Union, by way of Italy, but I am not totally alone in my sentiment.

The new government has a very distinctive policy agenda, which includes the establishment of a state-provided universal basic income. The League coalition also supports higher spending in various areas and it is also calling for a flat tax of fifteen per cent. Both parties want to roll back the quite unpopular pension reforms, that the E.U. regards as essential.

The E.U., it should be noted, doesn’t prohibit specific policies, but it does enforce broad fiscal targets that limit how much member countries can tax and spend. If the new government in Rome flouts these policies, Brussels will demand changes and most likely threaten it with fines. Brussels will shove, and Rome will shove back and that is when the real rebellion will occur, in my estimation.

Depending on how antagonistic the situation becomes, the European Central Bank could even threaten to withdraw its support for Italian government bonds, which it has been purchasing in large quantities, as part of its quantitative-easing program. The number is approximately $400 billion of Italian bonds, to date. One caveat of the ECB’s program is that any member government has to formally agree, in writing, to the policies and regulations of the European Union, before they will buy bonds and provide financial support. I just do not see the new Italian government signing up for what is going to be demanded.

I recall the words of Yanis Varoufakis, during the Greek crisis, “If you insist on policies that condemn whole populations to a combination of permanent stagnation and humiliation, you will soon have to deal not with Europeanist leftists like us but, instead, with anti-Europeanist xenophobes who see it as their vocation to disintegrate the European Union.” A decent prediction and a coming reality, in my view.

In any event, regardless of your personal view, what cannot be dismissed is that there is now a formidable amount of “risk” on the table for the European Union as it confronts the demands of the new Italian government. If you can honestly deny that, then you have been wooed by the political comments rolling out from Brussels and Berlin almost non-stop. “Do not be taken in,” I say, “because this is a very dangerous situation.”

Play the Great Game as you will but when I see Grant’s first ten rules, “Preservation of Capital,” under threat, then I am no longer willing to enter the arena. I am out of Italy. I am out Italian banks. I am out of European banks, in general, because of counterparty risks. I am also out of the European Union, as a general theme, because of the upcoming Italian revolt, which I believe will be taking place.

Spartacus has returned!

Bottom Line

Italy’s debt crisis isn’t a “one off.” It is symptomatic of the potential emerging risks – in an aging global recovery – in an increasingly flat world that is immersed in historically high debtloads (in both the private and public sectors).

2017 was a year of hope (and too little second level thinking) – that corporate tax reform would catalyze growth (and “trickle down”) – as multiples on the S&P Index expanded by three points. Wall Street prospered over Main Street.

2018 is a year of reality setting in (and too much first level thinking) – with a compression in price earnings ratios. With all the earnings excitement consider that stocks are basically flat for the year. Main Street is prospering over Wall Street.

The global expansion is aging. Note that employment, in particular, is a reliable indicator of a late economic cycle. (Consider the last time we were at 3.8% unemployment was April, 2000 – which marked the top and end of a 10 year “up” economic cycle). That was the lowest unemployment rate in a half a century, exactly the same unemployment rate (3.8%) that exists today.

While it “appears” that we are moving back to the upper end of a trading range, the market remains one without any memory – one that is dominated by products and strategies that frequently provide false signals.

Be skeptical of what the market is saying (over the near term), stay opportunistic, consider the emerging risks (which almost always appear when interest rates climb in a leveraged backdrop) and be flexible and impassioned in your trading — in the new regime of volatility that is upon us.

Kass – Welcome To Hotel Europa

  • The Italian crisis is not all negative to our markets
  • While the global economic cycle will be slightly downgraded, it will be elongated
  • Lower rates and inflation represent a valuation positive
  • Lowering Market Risks: Pessimistic Case Reduced (-10%), “Fair Market Value” Increases (+4%) and Upper End of Trading Range Lifted (+2%)

“Welcome to the Hotel California
Such a lovely place (such a lovely place)
Such a lovely face.
Plenty of room at the Hotel California
Any time of year (any time of year) you can find it here” – Eagles, Hotel California

While the Italian debt crisis exposes investors to the reality of a structurally unsound economic region – which principally grew due to negative interest rates – and will almost certainly serve to slow down Italy’s economy, with collateral damage in other parts of Europe, leading to slower global economic growth, modestly slower domestic economic growth and a more tepid rise in US corporate profits – there are market and economic upsides to the crisis:

  • Interest rates and inflation in the U.S. will moderate (look at the quick drop in the price of crude oil in the last week after Saudi Arabia detailed supply increases for the second half of this year) relative to previous expectations
  • Reflecting rising global economic concerns (see my notes on growing economic ambiguity), our Federal Reserve should be less restrictive and more measured in 2018-19 than the general consensus believes
  • Lower than expected interest rates will sustain the housing market (producing a more positive multiplier effect) – which was beginning to disappoint in the months of April and May under the weight of higher mortgage rates (that pressure, was only going to intensify as rates recently moved higher)
  • Moderating interest rates (relative to previous expectations) and a lengthier economic up cycle will contain corporate loan default risks over the near term (particularly given covenant lite terms)
  • Though economic growth will be slower than consensus, the threat of a swift profit margin contraction has been lessened

The bottom line is that the US economic cycle will probably be elongated – deferring my concern that rising rates and inflation would define the end of the current and nearly decade long domestic economic up cycle and negating the risks incorporated and leading to my pessimistic case for the S&P Index.

Moreover, as recently written – with so much stock locked up in Central Banks and Sovereign Wealth Funds, and with fewer companies listed and a marked reduction of outstanding shares (due to buybacks) of the existing listed companies — the market is structurally inflated to higher values.

That is not to say that global economic growth, while being sustained for longer, will be improving. It will not, and forecasts for the economy and profits will be tilted somewhat lower now. But, my view , is that the cycle’s lengthening (even though the overall growth rate will be moderating) will result in modestly higher valuations and negates the bust brought on by higher interest rates and rising inflation.

Finally, it is important to note that while contagion risk still exists – unlike previous and similar incidents in the past, so much Euro debt is held by the ECB, that the effects of a selloff of that debt will be buffered.

New Trading Range and 2018 Price Targets for the S&P Index

“Well when events change, I change my mind. What do you do?” – John Maynard Keynes

Late in the day yesterday I removed my large (SPY) short and moved from a medium sized net short exposure to a medium sized net long exposure.

For those that follow me closely this is a rare move for me – but there are a number of stocks with favorable reward versus risk in my portfolio.

So, when the facts change, I change.

This is not to say that I am bullish (as I wrote yesterday I plan to be reshorting strength and moving my invested position back down) – I am not (see rewards vs risk in my closing notes in this missive).

I still believe that the price peak in the S&P Index for the year was reached in late January, 2018.

A somewhat elongated cycle (caused by less interest rate stress) reduces the market’s downside target by 10%, slightly improves (+4%) the “fair market value” and modestly increases the top end of the anticipated trading range.

I am changing my 2018 price targets for the S&P Index:

Previous S&P Forecast:

Market Downside: 2200
‘Fair Market Value’: 2400
Trading Range: 2550-2725 to 2750

New S&P Forecast:

Market Downside: 2400 to 2450
‘Fair Market Value’: 2500
Trading Range: 2550- 2750 to 2800

Bottom Line

Most of my market concerns, expressed in yesterday’s opening missive, “The Circular Debt ‘Doom Loop’ and the End of the Epic Bond Bubble in Europe ” remain intact.

Importantly, the ECB is still ending QE by year end so Italy might be just a dress rehearsal of what’s to come as junky credit exists everywhere in the EU. And in one month, QT (over here) ramps to $120 billion in 3Q2018.

The market continues to have limited upside, but an elongated economic cycle (and less interest rate stress) likely means my pessimistic scenario (S&P 2200) has been negated for 2018.

Here are the current reward versus risk parameters (based upon the +13 handle rise in S&P futures, 2705 S&P equivalent):

1. There is 280 points of downside risk against 95 points of upside reward (compared to the top of the expected trading range) in my new pessimistic case (2400-2450)

2. Compared to “fair market value,” (2500) there is 205 points of downside risk versus 95 points of upside reward.

3. Against the expected trading range, there are 155 handles of downside risk and only 70 points of upside reward.

As you can see – all the ratios of risk are negative. The rationale for my current net long exposure (given the above risk/reward ratios) – is that I believe I have found individual stocks and sectors (like banks) with favorable reward vs risk.

Kass – The World Is Flat

  • In a paperless and cloudy world, are investors and citizens as safe as the markets assume we are?
  • In a flat, networked and interconnected world, is it even possible for America to be an “oasis of prosperity” and a driver or engine of global economic growth?
  • With the G-8’s geopolitical coordination at an all-time low, how slow and inept will the reaction be if the wheels do come off?

The “we have seen this before” crowd is predictably unperturbed by the Italian debt crisis and the possible contagion from it.

Rather they continue to look through the rear view mirror and are excited about the (one-time) tax reform influenced improvement in corporate profits.

And they seem to believe that a never ending deluge of monetary easing is the solution to the problem in Italy and elsewhere in Europe.

As it is said, past results may not be predictive the future – in charts or in policy. If it was, librarians would be the richest investors in the world.

And masking over structural problems by throwing money (QE, NIRP) is also not the solution. (It is first level thinking, at best – from my perch).

What I believe they don’t understand is how interconnected the global economy is today compared to the past. As each year progresses, the role of world trade increases and the role of non US operations in our largest multinationals multiply. Just look at the ever expanding role of exports (and non US sales) in the S&P Index – it’s increased as a percentage of total revenues by 2.5x in the last few decades.

What does the Italian debt crisis have to do with Bristol-Myers (h/t Jim “El Capitan” Cramer)?

My answer is…Plenty!

Remember, a year or so ago, when the smart money confidently found more value in European investments than investments in the U.S.?

In The Bull Market of Complacency even the most deep rooted problems are often ignored. Indeed, it took a full fledged crisis in Italy to finally fully expose the extent of the Italian debt crisis to global investors.

While the Bullish cabal will no doubt dismiss the Italian debt crisis – as they have multiple other sovereign debt issues – the paper overing by the ECB of the EU’s debt laden and structurally unsound economies are most real and have grown so large that a European contagion seems inevitable.

The collateral risks to Europe are large – most notably to ECB and to Germany. In it’s extreme it could mean Italy separates from the rest of the EU. To me, as I have written in the past, Deutsche Bank (DB) is particularly exposed.

Deutsche Bank is Likely the Next Black Swan

But, to this observer [who has consistently warned about Deutsche Bank being the next Black Swan and the imbalances in the European banking system (particularly in Italy)], the risks of a possible negative multiplier effect on other European financial intermediaries and on the region’s economic prospects is profoundly real.

As I have also warned, while Italy represents an extreme, US public and private debt is at record levels.

The circular debt “doom loop” is upon us.

Recap Of The 10-Biggest Risks

1. A tug of war between fiscal expansion and monetary contraction seems likely to be won by Central Bankers in the year ahead. History proves that the monetary typically wins out of the fiscal particularly since there are legitimate concerns whether the tax cuts will “trickle down” to the consumer. Moreover, we are at a tipping point towards higher rates (in the U.S. and elsewhere) after nine years of interest rate repression in which the accumulation of debt in both the private and public sectors are at record levels. Not only has the Fed turned, but each day gets us a day closer to the end of ECB QE. (The Italian 2 year yield went from -.265% to -.10% in one day). So, risk happens fast when a massive bubble has been created.

2. There is a growing ambiguity in domestic and non US high frequency economic data. Citigroup’s Global Surprise Economic Index has turned down and Citigroup’s EU Surprise Index is at a two year low. U.S. data (ISM, PMI and others) have often failed to meet expectations. Reports are that retail started the quarter weakly and, this morning, retailer Home Depot (HD) missed consensus comp views.

A flattening yield curve is endorsing the notion of late cycle economic growth. And, according to my calculus, the yield on the ten year U.S. note (given current inflation breakevens) implies U.S. Real GDP growth below +1.70%/year.

3 . The rise in global interest rates may continue – providing a reduced value to equities (on a discounted dividend model) and serving as a governor to global economic and US corporate profit growth. C.I.T.A. (“cash is the alternative) is getting busy while T.I.N.A. (“there is no alternative”) seems to be without a date to the prom this spring.

For the first time in 12 years the yield on the three month U.S. Treasury note now exceeds the dividend yield of the S&P Index:

Source: Zero Hedge

Meanwhile, the six month Treasury bill yields over 2% (2.09% this morning) and the two year Treasury bill’s yield is over 2.55%.

Inflation, too, is likely at a multi-year infection point.

I continue to view June/July 2016 as The Generational Low In Yields. Non US yields are at even more unjustified levels and will lead to large mark to market losses over the next few years – imperiling retail and institutional investors and banks in Europe that have leveraged positions in over-priced fixed income. (Just look at Argentina, a country that has defaulted on its sovereign debt on eight separate occasions – most recently in 2001. As a measure of lameness, investors scooped up 100-year Argentina bonds last June).

Bonds are in year two of a major Bear Market – fixed income (of all types) are overvalued (and I remain short bonds).

4 . The Orange Swan represents clear risks for the equity markets and for the real economy. As I have written in my Diary and stated on Fox News yesterday afternoon, hastily crafted tweets by the White House are dangerous in a flat, networked and interconnected world. The inconsistency of policy (which seems to be designed and conflated with politics as we approach the mid-term elections) seems to be weighing on business fixed investment plans which, I have learned through many of my corporate contacts, are being deferred (and even derailed) in the face of uncertainty and lack of orthodoxy and inconsistency of the delivering policy by “The Supreme Tweeter” who resides in Washington, D.C.

5 . Investor sentiment has grown more optimistic and fears of a large drop in stocks has been all but disappeared.

6 . Technicals and resistance points mark a short term threat to stocks. Not only has the market risen for eight consecutive days but an important Fibonacci point has been been met (from the January highs). As well, the S&P Index is now at the 2725-2750 resistance level – the upper end of the recent trading range. Yesterday, the lynx-eyed David Rosenberg remarked, on CNBC, that on breadth and volume the rally has been less powerful than recent rallies.

7 . The dominance of passive and price momentum based strategies are exaggerating short term market runs– contributing to a false sense of investor security. Though our investment world exists as buyers live buyer and sellers live lower, beware of a change in momentum that can turn the market’s tide.

8 . After nearly a decade, both the market advance and a sustained period of domestic economic growth have grown long in the tooth.

9. Though market valuations are high they are not too stretched – but other classical market metrics (equity capitalization to GDP, price to book, price to sales) are very stretched.

10. A new regime of volatility, seen recently, might signal a change in market complexion.

The world is flat and interconnected.

Kass – There Is No Special Sauce

* There is no quick answer to capture the holy grail of investment results.
* The only certainty is the lack of certainty.

If this morning’s downturn in futures holds up, the S&P (-20) and the Nasdaq (-72) Indices will have been down four days in the last five.

I moved back to a net short position late Friday/early Monday and I have been consistently expanding my shorts and reducing my longs since then (I now stand at medium size net short) – based on the recent move into the top end of my projected trading range and predicated on my (mostly) fundamental assessment of reward versus risk (which has turned quite negative).

Yesterday’s market decline was particularly hard felt in retail (where I recently sold off most of my longs) and defense (where I took a pass) – a possible signpost of more sector problems ahead.

I continue to see a new regime of volatility and the possibility of an expanded trading range.

More Lessons

Another lesson may be learned today and possibly over the next few months: Be fearful of the merchants of attention (particularly in the business media) that almost universally parade in a bullish costume. In their world and in the world of Twitter (TWTR) and other social media platforms – they never lose money. “First level thinking,” the absence of rigorous analysis and “group stink” are all – in the long and intermediate run – often harmful to your investment well being.

Stay independent and rigorous in approach and avoid generally useless (independent) indicators (e.g., unusual call activity that is typically quite usual and/or a quick/superficial look at a chart) that are used to hook retail investors (to buy a service) and make things seem easier than they are in selecting equities.

Always think second level and read Howard Mark’s book.
The investment mosaic is complicated and the past (trend(s)) or random factoids are not the sole factor to making investment/trading decisions – it involves the interaction of fundamental, technical, sentiment, psychology, valuation and a host of other known and unknown factors. If simply looking at past history was the route, librarians would be the wealthiest investors in the world.

As an aside, the primary reason I posited that President Trump would “make economic uncertainty and market volatility great again” #muvga is that superficial, untethered, non-researched, first level and hastily crafted policy is dangerous in a flat, networked and interconnected world. So it is with our trading and investment decisions – they are complex and require deep and time consumptive research.

In late 2012 I wrote a column entitled “There is No Secret Sauce.” Here is an abridged version:

Yesterday Tim “Not Phil or Judy” Collins and I went back and forth on the merits of technical analysis. (Here are my comments, and here are Tim’s.)

Let me start today with an expansion of my statement made on Tuesday that there is no secret investment sauce or elixir that will deliver traders and investors a recipe for investment success. There is no quick answer to capture the holy grail of investment results — not in charts, algorithms or historical patterns or pattern-recognition formulas.

On the latter point, Jim “El Capitan” Cramer appropriately and roundly criticized pattern-recognition observations on “Mad Money” last night — he called them worthless, incorrectly authoritative, a pernicious and a lazy exercise that serves as nothing more than a “lovey blanket” (i.e., a piece of cloth that makes you secure but provides, in reality, little security).

And I agree strongly with Jim.

But I understand why many want to believe. Taken by themselves, charts, algorithms and/or historical patterns provide a veneer of authenticity in just the sort of easy and quick sound bite conclusion that traders and investors are drawn to. I frequently see blind faith in the effectiveness in some of these exercises in our comments section every day, and, frankly, it concerns me. These approaches (and others) provide an attempt to simplify an awfully complex investment mosaic. Similar to Jim’s “lovey blanket,” they provide a false sense of security.

Investment selection is not as simple as interpreting a chart (through technical analysis); it is a complicated combination of macroeconomic factors, the level of interest rates, individual stock analysis, sentiment, valuation and many other factors. Technical analysis, in particular, should be used in conjunction with the above, not as a means unto itself. Again, there is no secret sauce in analyzing a stock’s price chart — a chart simply tells us where a stock has been, not where it is going.

Though I am a fundamentalist, I am not attempting to say that the answer is found either through fundamental or technical analysis.

I utilize and incorporate valuation, sentiment, macroeconomic factors, interest rates and many other factors in my investment process, but fundamental research is the foundation of all my decisions.
Fundamental research, when done properly is hard work — done well, it takes time. I research companies (and you see my conclusions in my diary) hopefully in a hard-hitting analytical way, and I often look to develop variant views from consensus (on both shorts and longs).

I choose not to utilize technical analysis in a meaningful way in my stock selection and decision-making process, however, as fundamental analysis (as a dominant determinant) just works for me. Technical analysts feel the same way in not adopting fundamental analysis, and I respect their views but deeply question decisions that are made solely on a technical basis or that are based on algortihms and/or pattern recognition.

Though technical analysis is only a small part of my investment decision process, I do refer to the charts, and when I do, I want to hear from someone like Tim Collins, as few do it better than him. Tim is in the class of my favorites, which also includes the Divine Ms. M., Rev Shark, Justin Mamis, “Uncle” Bob Farrell, Jeff Hirsch and Walt Deemer. (In fact, I have endorsed books on technical analysis by Jeff Hirsch and Walt Deemer.)

I keep charts, algorithms and historical pattern recognition in their proper perspective — and so should all of you.

I shortly followed this column with the next one:

As a rejoinder to my last post and to my recent “There Is No Secret Sauce” post, I see too many in our comments section (and elsewhere in the business media) confident and assured in their near-term market outlooks, and I see too many in our comments section (and elsewhere in the business media) confident and assured in directing others toward their personal views.

When wrong, many will say never mind — and where are you then left if you took their advice?

I will repeat for emphasis: Rarely has there been so much uncertainty. Indeed, as I have written, the only thing certain is the lack of certainty.

This is especially true with the avalanche of liquidity by the world’s central bankers (which dulls natural price discovery) and the large advance in the averages (over the last few years) being threatened by balance sheet deleveraging, political uncertainty, the worrisome trend in corporate profits and structural headwinds.

As my Grandma Koufax used to say, “Dougie, my there is a lot of moving parts in this game.”

This renders near-term market forecasts as no better than a coin flip.

But as I have written repeatedly, the market is not static; it is constantly changing based on fundamentals (principally) but also sentiment, interest rates, valuations and fund flows (among other factors).

The investment mosaic is complicated and there is no secret sauce — not algos, charts or opinions — that can deliver with confidence the short-term direction in stocks.

I always worry that subscribers react to a special algo or the simplicity of charts and opinions.

If you do, you will likely be disappointed.

In fact, I have found that the stronger the conviction, the more likely the data will reveal a lousy idea or market view.
I wish Mr. Market was that easy to outsmart, but he isn’t. Mr. Market is always in a state of flux — more so today than in the past.

I always worry that subscribers react to the simplicity of charts or any other secret sauce.

Before you make a move in this environment, be sure you do your own research, take a few deep breaths and consider risk and reward.

Doing so takes time and hard work – because there is no special sauce that can be quickly heated up.

Kass: Rising Costs And Suffering Profit Margins

A combination of so-called “demand pull” and “cost-push inflation” is sending up feedstock costs and interest expenses to levels that I believe will soon lead to a marked contraction in U.S. corporate profit margins.

In fact, we already saw this phenomenon in first-quarter earnings reports across a host of industries, from consumer-packaged goods to social media. While the cut in U.S. corporate-tax rates has mostly masked these drags and headwinds, the rising cost of everything will likely worsen in the year(s) to come.

For example:

  • Interest Costs Are Climbing. The Federal Reserve is raising interest rates and reducing its balance sheet’s size The European Central Bank will soon follow as it tapers its own quantitative-easing program.
  • Energy Costs Are Making New Highs. Rising oil prices are a tax on consumption.
  • Commodity Prices Are Rising. Lumber and steel are just two of the commodities that are bolting higher.
  • Labor Costs Are Growing. A November midterm-election “blue wave” of Democratic congressional victories might only accelerate the trend.
  • Trucking/Transportation Costs are Exploding. Every single good that’s transported is costing much more to deliver.
  • A Strengthening U.S. Dollar. This weighs on U.S. trade, as well as on multinationals who export products.
  • Regulatory Expenses Are a New Threat to Technology/Social Media. There’s little doubt that Alphabet/Google (GOOG) , (GOOGL) , Facebook (FB) , Twitter (TWTR) et al. will have to accelerate hiring of compliance people and others who monitor and supervise the dissemination of personal data. This will place a new drag to profits.

These influences are occurring at a time when U.S. and global economic figures growing more and more ambiguous, earnings-per-share comparisons are becoming more challenging and the U.S. deficit is swelling (see here and here).

Valuation Worries

Valuations are higher than most recognize when measured against feeble economic growth and too-optimistic EPS forecasts

Gluskin Sheff’s David Rosenberg last week delivered an interesting report with the chart below, which shows that investors are paying more for less U.S. economic growth. He concluded that U.S. stocks have only been so expensive only 9% of the time in history:

Here’s a good take on Rosenberg’s analysis from my pal Lance Robert’s Real Investment Advice

“The market is currently overpriced and overvalued by about a third. While investors can certainly bid up prices in the short-term, the long-term fundamentals will eventually come to play.

With households more exposed to financial assets currently than at any other point in history, the next downturn will be greatly exacerbated by the “panic” that ensues. As you can see in the chart above, the last two peaks in this ratio almost perfectly coincided with the dot-com crash and the 2008 financial crisis.

David [Rosenberg’s] most salient point came from a quote from Federal Reserve Bank of San Francisco. He pointed out that, having access to tons of research, they themselves admit that equity valuations are so stretched that there will be no returns in the next decade: “Current valuation ratios for households and businesses are high relative to historical benchmarks … We find that the current price-to-earnings ratio predicts approximately zero growth in real equity prices over the next 10 years.”

Basically, the Fed is giving investors an explicit warning that the market will ‘mean revert.’ But revert, doesn’t mean stop at the mean.

According to David’s calculations, if the household net worth/GDP ratio reverted to the mean, savings rates would go from 2% to 6%. As a result, GDP would go down 3%, which would have nasty consequences for the economy and, in turn, stocks. Just something to think about.”

With a moderating trajectory of economic growth and rising cost pressures, I believe that 2018-19 consensus EPS forecasts are too optimistic.

Edward Yardeni’s post: What Are Stock Industry Analysts Smoking? further illustrates the risk that companies might not realize current profit forecasts. Here, the difference between Yardeni and the consensus comes closer into focus:

The Bottom Line

Valuations are high, particularly in light of how much (or how little) economic growth that we’re seeing. The end of global quantitative easing is also at hand, while feedstock costs of all breeds are rising.

Add it all up and this might be a good time to derisk, as the possibility of stagflation looms ever closer. The bottom line: Investors are paying too much for stocks given slowing economic and corporate-profit growth, coupled with the pressure of rising costs of all kinds.

Quick Take: Kass – Beware Chasing Momentum

I am beginning to think, these days, that with the exception of Warren Buffett, nearly everyone worships at the altar of price momentum.

Seemingly, more than ever, commentators today are citing “levels”, charts, flows and my least favorite indicator (and one that has never been documented as a plausible and profitable endeavour)“unusual” call activity that is really quite usual. (As I have written in the past I am respectful of those that earn a living by utilizing some of the more thoughtful and disciplined methods of technical analysis.)

I, too, have caught a bit of that “technical” infliction as I try to complement my long term investments in a new regime of volatility – as, in recognition of a machine/algo dominated world that exaggerates short term price moves, I am trying to adopt to an investing world that is more reactionary and less anticipatory.

I am so old that I still remember fundamental investing — recognizing that in the short run the market is a voting machines, it is a weighing machine over time (again, Buffett).

My experience is that fundamentals nearly always win in the end and it is that approach that I champion.
Bottom Line

Near term I continue to view the market as at or near the upper end of a defined trading range – 2550 downside and 2725-2750 upside (reflected in S&P terms). Technically, this is an obvious level of resistance as well as an important Fibanocci level.

Some other short term concerns:

* Crude and energy stocks are market leaders – often a signpost of a late cycle market move.
* Bullish investor sentiment is rising. (See Divine’s comments this morning.)
* Concentrated and narrow leadership in ” MANA”

I see a bumpy market road in the second half of the year.

As expressed in “The Madness of (Investing) Crowds”; I outlined the pillars of my bearish views (the growing ambiguity of global growth trajectory, rising interest rates, the inconsistency of policy, etc.).

My core trading and investment strategy is based on the notion of upside reward vs downside risk (the difference between current prices and my calculation of “intrinsic value”) – expressed by the calculation of a list of fundamental outcomes and the probabilities of those outcomes.

While many see higher lows and higher highs – since the early February drubbing, I view today as a good time to derisk.

At least based on my perception of the fundamentals.

Kass: The Madness Of (Investing) Crowds

“Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”  – Charles Mackay, Extraordinary Popular Delusions and The Madness of Crowds

The Bull Market in Complacency has resurfaced. Reject it and consider derisking, now.

I find myself, after a period of being long of equities, back in the bearish minority again – and I moved back into a net short exposure late in the day on Friday.

And, I observe, that many of the same investors who were bearish at the February lows are now bullish at the recent mid-May highs.

Fear of a large drawdown seems to have been all but eliminated in the eyes and thoughts of market participants as the Bull Market of Complacency seems to have reappeared.

2017 was a year of hope and anticipation (in large measure because of the optimism surrounding lower corporate tax rates) as price earnings ratios expanded by almost three multiple points. Interest rates were still suppressed and volatility was at historic lows. Last year was one in which Wall Street recovered and prospered better than Main Street.

In 2018, markets are more or less unchanged as the reality of instability and inconsistency of policy and economic uncertainty have reemerged. This year, unlike last year, Main Street has thrived and Wall Street has stagnated. And a new regime of volatility has emerged, coincident with a general rise in interest rates – particularly in maturities of ten years or less.

Let me summarize my top ten, current market concerns:

1. A tug of war between fiscal expansion and monetary contraction seems likely to be won by Central Bankers in the year ahead. History proves that the monetary typically wins out of the fiscal particularly since there are legitimate concerns whether the tax cuts will “trickle down” to the consumer. Moreover, we are at a tipping point towards higher rates (in the U.S. and elsewhere) after nine years of interest rate repression in which the accumulation of debt in both the private and public sectors are at record levels. Not only has the Fed turned, but each day gets us a day closer to the end of ECB QE. (The Italian 2 year yield went from -.265% to -.10% in one day). So, risk happens fast when a massive bubble has been created.

2. There is a growing ambiguity in domestic and non US high frequency economic data. Citigroup’s Global Surprise Economic Index has turned down and Citigroup’s EU Surprise Index is at a two year low. U.S. data (ISM, PMI and others) have often failed to meet expectations. Reports are that retail started the quarter weakly and, this morning, retailer Home Depot (HD) missed consensus comp views.

A flattening yield curve is endorsing the notion of late cycle economic growth. And, according to my calculus, the yield on the ten year U.S. note (given current inflation breakevens) implies U.S. Real GDP growth below +1.70%/year.

3 . The rise in global interest rates may continue – providing a reduced value to equities (on a discounted dividend model) and serving as a governor to global economic and US corporate profit growth. C.I.T.A. (“cash is the alternative) is getting busy while T.I.N.A. (“there is no alternative”) seems to be without a date to the prom this spring.

For the first time in 12 years the yield on the three month U.S. Treasury note now exceeds the dividend yield of the S&P Index:

Source: Zero Hedge

Meanwhile, the six month Treasury bill yields over 2% (2.09% this morning) and the two year Treasury bill’s yield is over 2.55%.

Inflation, too, is likely at a multi-year infection point.

I continue to view June/July 2016 as The Generational Low In Yields. Non US yields are at even more unjustified levels and will lead to large mark to market losses over the next few years – imperiling retail and institutional investors and banks in Europe that have leveraged positions in over-priced fixed income. (Just look at Argentina, a country that has defaulted on its sovereign debt on eight separate occasions – most recently in 2001. As a measure of lameness, investors scooped up 100-year Argentina bonds last June).

Bonds are in year two of a major Bear Market – fixed income (of all types) are overvalued (and I remain short bonds).

4 . The Orange Swan represents clear risks for the equity markets and for the real economy. As I have written in my Diary and stated on Fox News yesterday afternoon, hastily crafted tweets by the White House are dangerous in a flat, networked and interconnected world. The inconsistency of policy (which seems to be designed and conflated with politics as we approach the mid-term elections) seems to be weighing on business fixed investment plans which, I have learned through many of my corporate contacts, are being deferred (and even derailed) in the face of uncertainty and lack of orthodoxy and inconsistency of the delivering policy by “The Supreme Tweeter” who resides in Washington, D.C.

5 . Investor sentiment has grown more optimistic and fears of a large drop in stocks has been all but disappeared.

6 . Technicals and resistance points mark a short term threat to stocks. Not only has the market risen for eight consecutive days but an important Fibonacci point has been been met (from the January highs). As well, the S&P Index is now at the 2725-2750 resistance level – the upper end of the recent trading range. Yesterday, the lynx-eyed David Rosenberg remarked, on CNBC, that on breadth and volume the rally has been less powerful than recent rallies.

7 . The dominance of passive and price momentum based strategies are exaggerating short term market runs – contributing to a false sense of investor security. Though our investment world exists as buyers live buyer and sellers live lower, beware of a change in momentum that can turn the market’s tide.

8 . After nearly a decade, both the market advance and a sustained period of domestic economic growth have grown long in the tooth.

9. Though market valuations are high they are not too stretched – but other classical market metrics (equity capitalization to GDP, price to book, price to sales) are very stretched.

10. A new regime of volatility, seen recently, might signal a change in market complexion.

 

Kass: A Market Without Leadership

* More volatility lies ahead

“Our experience tells us that these leaderless periods typically occur during important transitions in the market. So what is that transition today and how can we harness it to make money? Sticking with our original thesis for 2018, we think the market is digesting the fact that the tax cut last year has created a lower quality increase in US earnings growth that almost guarantees a peak rate of change by 3Q. Furthermore, the second order effects of said tax cuts are not all positive.

Specifically, while an increase in capital spending and wages creates a revenue opportunity for some, it also creates higher costs for most. The net result is lower margins, particularly since the tax benefit is 100 percent ‘below the line.’ Now, with the pricing mechanism for every long duration asset- 10-year Treasury yields-rising beyond 3 percent, we have yet another headwind for risk assets.

Perhaps most importantly for US equity indices, these higher rates are calling into question the leadership of the big tech platform companies-the stocks that may have benefited from the QE era of negative real interest rates more than any area of the market. When capital is free, growth is scarce, and the discount rate is negative in real terms, market participants reward business models that can use that capital to grow. Dividends and returns on that capital today are less important with the discount rate so low. But, with real interest rates rising toward 1 percent, that reward structure may be getting challenged…2018 will mark an important cyclical top for US and global equities, led by a deterioration in credit. Narrowness of breadth and a lack of leadership suggest that this topping process is in the works and will ultimately lead to a fully defensive posture in the market later this year.” – Morgan Stanley

The market lacks clarity and trend – likely remaining in a broadly defined near term trading range of (S&P) 2550-2725.

For the full year I continue to expect a 2200-2850 trading range for the S&P Index in 2018, with a “fair market value” of about 2400.

With cash now at 2680 – adjusted for the 8 handle rise in the S&P Index – currently, there is about 480 S&P points of downside risk (to the low end of my full year trading range) and approximately 280 S&P points of risk to “fair market value” — as compared to the upside of only approximately 170 S&P points to the high end of my forecasted trading range.

Accordingly, the current S&P cash level has about 2.8x more risk compared to reward against the low end of my full year trading range and S&P cash provides 1.6x more risk relative to reward when compared against “fair market value.”

I remain cautious on the markets over the near- and intermediate-term.

That said, I am giving the current market advance (from the recent lows) a wider berth given the dominance of risk parity, volatility trending and passive strategies (ETFs) that tend to exaggerate short term market moves.

Continued Volatility Lies Ahead

We remain in a Bull Market for Volatility – if not in an absolute sense, certainly relative to recent history.

The roller coaster market, with no memory from day to day is likely in place for the balance of the year – ideal for traders but problematic for longer term investors.

I am a scale short-seller now as investor confidence will likely build over the near term in the face of some spectacular EPS reports – but substantive market headwinds (often delineated in my Diary) remain in place in a cycle that is beginning to exhibit late cycle characteristics (in inflation, growth, etc.).

Tread carefully and consider raising cash on strength.

Kass: The Return Of The Bond Vigilantes

  • With mounting private and public debt, the U.S. economy is poorly positioned to reach consensus economic growth expectations
  • The Bond Vigilantes are saddled up and ready to make a comeback – and it’s market unfriendly

“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
– James Carville

In “The Great Bond Massacre” from late 1993 to late 1994, the yield on the US ten year note rose from 5.2% to 8.0% as investors grew fearful about the implications of large federal spending increases.

For the first time in years the bond vigilantes, “a self-appointed group of citizens – the bond vigilantes – who undertake law enforcement in their community without legal authority, typically because the legal agencies are thought to be inadequate” have surfaced – with the ten year U.S. note yield now approaching three percent.

This morning the yield on the ten year U.S. note has hit a new four year high of 2.99%.

As I see, though rates still appear low by historic standards – the sizable climb in debt loads (in both the private and public sectors) and the continued fiscal profligacy – will likely exacerbate the impact on the recent rise in yields by providing a governor to economic growth and by stirring a number of other adverse outcomes:

* Ballooning Deficits and A Large Supply of Treasuries Loom: A $1.2 trillion 2018 U.S. deficit (and borrowing requirement) coupled with $600 billion of the Fed’s Quantitative Tightening means that there will be, according to David Stockman’s most visual phrase, “the bond pits will be flooded with $1.8 trillion of ‘homeless’ government paper.”

Never in the history of modern finance has a near decade old domestic economic recovery faced a financing hurdle that represents almost nine percent of GDP. How large is this hurdle relative to history? At the top of the last U.S. economic expansion, the Federal Deficit was 87% lower (at $160 billion) – which represented only one percent of U.S. GDP at a time that the Fed was still buying Treasuries (in 2007 the Fed purchased $15 billion of Treasuries) and not selling them (or letting them rollover without replacing). So, this time around, the flow of Treasuries will represent supply that is nine times larger (relative to GDP) than was the case in 2007.

* Protectionism and The Chinese Debt Bomb Threaten The U.S. Treasury Markets: The Administration’s assault on China and its trade policy threaten the demand/supply for U.S. treasuries, as the possibility that China sells down their U.S. Treasury holdings looms as a potential Chinese tool in the latest trade war with America. As well, the large stated and shadow debt in China when coupled with the capital flight issues suggest more selling of U.S. Treasuries is probable.

* The ECB Also is a Source of Treasury Supply: The ECB is also pivoting away from monetary ease in late 2018 and towards quantitative tightening in 2019. It’s balance sheet of $5.5 trillion compares to only $1.5 trillion eleven years ago. This means the ECB, like the Bank of China, will not be soaking up anywhere the amount of Treasuries that it has in the past.

* Total Public Debt as a Percent of GDP is Near An All Time High: Back in 2007, when the debt load was well under $10 trillion, government debt service was about $350 billion/year. With debt of about $21 trillion today, a rise in interest rates could take debt service to nearly $1 trillion in the next 1-2 years. See, here.

* Non Financial Corporate Debt is At an All Time High: See, here.

* “Borrowed Prosperity”: In looking at the last two charts (above) it should be clear that we are borrowing more to produce less output. In the last decade, credit market debt, at $69 trillion, has risen to 3.5x GDP, and has increased by almost $16 trillion. Unfortunately that $16 trillion has only produced about $5 trillion of GDP. In other words it is taking more and more debt to move the US economy:

Bottom Line

Given rising private and public debt to levels never seen, an imminent pivot by global central bankers away from easing, the threat and possible consequences of trade policy and the poor demand/supply balance for Treasuries, among other factors – the return of The Bond Vigilantes will have an outsized and negative impact on the trajectory of domestic economic growth.

Despite protestations from the bullish cabal that interest rates are still low (by historic standards), the return of The Bond Vigilantes (who are now saddled up and ready for a comeback) is another threat to the decade old Bull Market in stocks.