Category: Nugget of the Day

As any market follower knows, there has been an abundance of news over the past 3 months essentially telling market participants that a trade deal is imminent. It is tough to say why such obvious market jawboning was dismissed, but the time is here to wake up to reality. I also want to bring up that these past 3 months have made me wonder if news algorithmic trading programs have the ability to exhibit headline skepticism, but that’s another conversation.

Below, you will find the tweet that has caught market participants off guard. It is now apparent that the trade war is in fact not coming to an end any coming Friday, but in fact getting taken to the next level.

So why did this happen and what are the ramifications?

One can speculate that Trump was not getting all he asked for in the deal room with Xi. I think what is important to remember is that Trump is up for reelection in 2020 and Xi is a lifetime leader. If Xi is unsatisfied, then he can simply wait for the next President.

Forecasts for the 2020 election become key in understanding the dynamics of the situation. We know that Trump is largely running on the use of an economic scorecard. If the scorecard looks good by 2020, then Trump is likely going to win and vice versa. The economic scorecard basically consists of the stock market, GDP, and unemployment.

Please view an overly simplistic decision tree below.

Trade Deal-Market Rally-Trump Wins 2020 Election

Trade War Intensifies-Market Sells Off-Trump Loses 2020 Election

The point is that Xi has the luxury of time and will use that to his advantage to basically choose who opposes him in the deal room.

Moving on. Why did this really happen?

Is Trump performing some sort of “Art of the Deal?” Maybe in his mind.

But perhaps, he is aware that GDP is due to come in weaker in quarters to come with the huge inventory builds. He does not appear able to get Powell to cut rates in order to pull demand forward, so maybe he has decided to attempt to influence the GDP number. One thing that I think is fairly straight forward is that if we are in an official recession by 2020, then Trump has no chance of winning the election. So, let’s assume that Trump knows that future GDP may be under threat, and he understands that he does not have monetary policy in his arsenal at the moment, then what does he do?

He tariffs (taxes) domestic producers’ imports in order to influence them to build inventories again. Theoretically, this could short-term boost GDP as it did with the last round of tariffs. From the chart below, it is apparent that the level of contribution of inventory to GDP mean reverts around 0%. This should make sense intuitively as businesses build inventories one period, they are less likely to need to build inventories in the next period as well.

I will wrap this up with some things to watch out for.

Will the yuan depreciate against the dollar again to offset the tariff?

Will tariffs of this magnitude spur inflation as producers have to pass tariff costs to consumers?

Will producers who are already sitting on large inventory hordes build again?

At what level on the major indexes will Powell announce that QT will end before the expected September 30 date?

When fundamentals no longer support markets, the only answer to continued rising asset prices must be liquidity.

Liquidity in my mind can be broken down into direct and potential liquidity.

I would like to define direct liquidity as central bank open market purchases a.k.a. expanding their balance sheets. Below you will find a chart that is the most up to date aggregate of central bank assets that I can find. I am unsure why the PBOC is not included, but this chart is still a useful proxy.

The main point is that there is a clear correlation between growth in central bank balance sheets and rising equity prices, and it appears that the contraction has resumed its course.

Next, we can touch on potential liquidity. Companies have the option to either buyback their stock with the money they earn or accumulate via debt issuance. Should the company choose to allocate their capital towards buybacks, then it should be fairly straightforward that this is a form of a liquidity injection to the price that will help to support or to boost prices. Below, you will see the trend in stock buybacks over time.

The reason I called this potential liquidity was not just due to the fact that it was the companies’ choice of how to allocate their funds, but that during earnings season some companies will go into what is called a buyback blackout period. The “potential” ceases temporarily as these companies are restricted from purchasing their own stock via buyback. Below, you will see that one is approaching now.

At the cusp of a liquidity drag, it should come as no surprise to the contrarian investor that investors are possibly jumping in at one of the worst times. This can be seen in the below tweet, which displays that investors are piling into a growth equity ETF at the fastest pace ever.

At times like these, prices can always get a lot crazier before they return to “normal,” but it is imperative to proceed with caution.

A unique opportunity is upon us. The FED has signaled to the market that it will not raise rates in 2019 and they say there will only be one hike in 2020.

Anyone who has been in the game long enough will tell you that the bond market precedes the equity market. I would just like to expand that it precedes all markets including the Federal Funds Rate “market.”

The Federal Funds Rate (FFR) is what the FED uses to “fight” recessions.

The rest of the yield curve (2-year, 10-year, 30-year bonds) has many pricing mechanisms, but if the FFR is moving then they will move with it.

The smart money sees that the FED has ceased rate hikes, and that the next logical step will be rate cuts. With this in mind, they will begin to front run the FED’s move.

We do not know exactly when the FED will go to zero again with the FFR, but what we do have is a strong conviction towards that it will cut rates when bear market and recession talks heighten.

Pay attention to the beginning of the smart money forecasting the inevitability of the FED going to zero again. Once the FOMC release occurred on Wednesday at 2PM, the 10-year and 30-year tanked.

For historical reference, you will notice that the 10-year and 30-year tend to initially lower in anticipation of the cut to zero. This usually occurs during the pause phase. Then, the rest of the move occurs once the rate cut announcement is made or becomes fully baked into expectations.

You may say well why would I want to buy a 30-year for a 2.87% interest rate. The answer is not that you will hold it to maturity, but you will sell it when the market yield for 30s is 2-2.5%, thus locking in a capital gain.

Do you own research. This is not trade advice.

Today, March 20, 2019, a FOMC rate hike decision was made. It is official-the FED can’t keep its spoiled child in check.

First, you will find below the FED’s dot plots from December and today. The dot plot is a tool that the FED uses to convey to the market what the Federal Funds Rate will be in the future.

Using the upper range of the current Federal Fund’s Rate of 2.5%, we can analyze the swing in the projection. On December 19, 2018, 15 of the 17 dots were above the 2.5% line for 2019 projection. Today, only 6 of the 17 dots are above the line for 2019 projection.

So, why did this happen?

Below, you will find a graph of the FED Funds Futures. The first one is for what the market was predicting the FED Funds Rate would be on March 20, 2019 over time. After the December stock market meltdown, the market began projecting that the FED would be close to capitulating, employing the “Powell Put,” or saving the market…whatever you want to refer to it as.

Think of the market as a spoiled child and the FED as its parent. In December, the market sold off violently. Essentially, the market threw a tantrum and the FED came in and said it would be less hawkish going forward like a parent getting its child to shut up by buying it a present. The child liked this and as you can see by the chart below, the probability of the FED Funds Rate being 2.75% by the March meeting plunged from around 40% to 0% and the probability of it remaining at 2.5% skyrocketed from around 50% to 100%. This led to the market appreciating by roughly 20% since the December lows!

So what’s the issue? Below, you will find that the FED Funds Futures chart for January 20, 2020. The market expects the FED Funds rate to be 2.5% with a probability of over 60%. In short time, I expect this number to reach near 100%.

Each time the market throws a tantrum, the FED has less presents to give. The next present that will be given is most likely a rate cut. Once that game begins, the FED only has presents for the market from 2.5% to 0%.

I leave you with two questions.

Do you think that the buffer zone to cut from 2.5% to 0% is enough to levitate markets indefinitely?

What happens if inflation shows up in the CPI and the FED is forced to raise rates without the market’s blessing?

When a bear and a bull meet at a crossroads, a debate ensues. In the amateur world, the debate will end with the bull saying something along the lines of “the market always comes back.”

The first issue with this statement is that the time it takes for the market to come back is not specified.

Let me clarify that I am assuming that the bull would claim anytime is a good time to buy stocks, since the bull says, “The market always goes up over time.” This clarification allows me to illustrate some times the bull should have kept his or her mouth shut without the hindsight dismissal of “You cherrypicked the worst times.”

The best current example is the Nikkei 225. This is one of the headline indexes out of Japan. Immediately, those with the home bias of the US will say, “This is irrelevant. That is Japan.” Anyways, this illustrates that in the modern era a country’s major stock market index can exhibit an inability to “always come back.” If you invested in the Nikkei 225 in 1989, you are still underwater. It is now 30 years later.

Below, is a historical Log scale chart of the S&P 500. If you had invested in 1929, it would have taken you 25 years to get back to even. If you had invested in 2000, and did not sell for a minuscule gain in 2007, then you would have been underwater for approximately 12.5 years. Also, I have attached the standard scale chart of the S&P 500 just to demonstrate the parabolic nature of the recent move and its similarity to Japan years ago.

Next, I would like to stress an important point that is misunderstood by many. This point is the proper use of opportunity costs. Those who say you cannot take your money out of “the market” due to giving up on gains are confused. Opportunity cost is not a function of…

[Returns you could have had in the market-ZERO]

This function would be correct if the money that comes out of the market does not re-allocate towards anything at all. Cash is an allocation. If cash returns 2% (1.8% in 2018), and if the S&P 500 returns 10%, your opportunity cost is not 10% for being “out of the market.” Your opportunity cost is actually 8%. Also, I will not get into it, but cash is not the only alternative when getting out of “the market” as many seem to think.

The other camp that understands the market can take very large amounts of time to come back, may say “you can’t time the market.” This statement is said with so little backing. To those who make such a statement, have you ever even calculated the amount of time you have to time the market? I am simply going to use the past 2 cycles as precedent in the US for market timing abilities. I think this is fair, since if the bulls can extrapolate into the forever future, shouldn’t a bear be able to?

If you determined that the tech bubble of 2000 was a bubble, then you had a nearly a 6 year window to time it right. For example, if you exited “the market” in May 1997, then you could have bought in at February 2003 with no opportunity loss via “market” investments. Theoretically, you could have never invested in the housing bubble cycle, since the subsequent trough in the housing bubble cycle was lower than that of the trough of the tech bubble cycle. You could have even exited “the market” in December of 1996 and entered in February 2009 with no opportunity loss via “market” investments. That is a little over 12 years. If past is prologue, and the S&P 500 falls the average of the past two bubble cycles, then the S&P 500 will fall 48.6% (44.6% in 2000 and 52.6% in 2008). If the S&P 500 fell 48.6% from an assumed peak in September 2018, then it would land at about 1506. With that in mind, you could have theoretically sold in February 2013, with no opportunity loss via “market” investments.

I would like to leave those in the camp of the market always comes back with one last thought. Have you considered the risk that nominal “market” values come back, but real “market” values do not?

The situation the market currently resides in is one where market participants cannot decide which force is stronger…

“Powell/Mnuchin/Trump Put” + China Trade Deal Prospects

vs.

Fundamental overvaluation of equities + “U.S. Earnings Recession” + “Synchronized Global Economic Slowdown”

Let’s first look at the technicals on the U.S. equity market (S&P 500) in tandem with the VIX. We know that the S&P 500 has 3 prior failed breakout attempts above the 200-day moving average on 10/17/18, 11/17/18, and 12/3/18. We also know that we currently reside just above this powerful line in the sand once again.

Now, let’s take a look at the VIX. I have circled the prior instances that the S&P 500 was above the 200-day moving average on the VIX chart. These circles all occurred pre-VIX spikes.

From 10/17/18-10/24/18, the VIX jumped from 17.40 to 25.23 in a 45% move. From 11/17/18-11/20/18, the VIX jumped from 18.14 to 22.48 in a 24% move. From 12/3/18-12/24/18, the VIX jumped from 16.44 to 36.07 in a 119% move.

Today, 2/22/19, the VIX is flirting with the 14 mark, which is below the 10-day moving average as other pre-VIX spikes had been prior to their moves.

Some technicals are certainly in play, but now we must ask if we have any catalysts coming to fruition. The answer is yes. On 2/28/19, the long awaited Q4 2019 GDP results will be released. The market already ignored the downward revision of the Atlanta Fed’s potentially lofty estimate. We shall wait and see if confirmation of a downward revision, or a further downside surprise, will have an effect on the market.

Bullion

The classic way to own gold is through bullion (the actual physical metal). Not only is the classic way, but it is arguably the least risky. If you own gold that is in your hand, then you do not run the risk of any counter party failing to fulfill its obligation. This will make sense in the examples to come as trust in this “counter party” with your gold exposure becomes necessary. Since, gold is viewed by many as an insurance asset against the financial system, I question those who hold all of their allocation in the financial system. Don’t plug your back up generator to your house.

Gold ETFs

An ETF is an exchange traded fund, and it trades on the stock market with its own ticker symbol. Gold bullion ETFs typically hold quantities of gold in a vault based on how many people purchase the ETF. The common gold bullion ETF is GLD. There are other options of tickers that one can use that track the spot price of gold, but this is the most notable. Read prospectuses if you want to know the exact details of how the gold spot price is tracked, if bullion is redeemable for shares, and if there is potential force majeure language. It should go without saying that you do not physically possess the bullion, so in a worst case scenario your insurance may not work. On the other hand, you relinquish the risk of misplacing the gold or having it stolen.

Gold Miners

This option is not for your everyday individual. I consider the gold miners to be a leveraged play on the spot price of gold. The idea behind the leverage is that a gold mining company’s cost of good sold is relatively constant, so a rise in gold should lead to a more rapid rise in earnings per share. On average, gold company share prices move 2-3 times the spot price of gold in both directions. The enterprising investor may seek out the best gold mining company to try to maximize the leverage, but this is no easy task. For the investor who wants to put on an extra level of risk to potentially maximize their returns, an ETF that is a basket of gold miners should be used. The most common one is GDX.

To those of you that read Part 1 within the thesis category, you may have been aware that I believed that GDP had a higher than anticipated probability to weaken due to the difficulty in quantifying behavioral variables within the economy. The timestamp on the article is less than perfect due to a need to recategorize within the website. Anyways, as anticipated the sobering reality is upon us. Below, you will notice that the Atlanta Fed GDPNow estimate has plummeted from its 2.6%-2.8% range to 1.5%.

Also, below you will notice that the Q1 2019 GDP forecast out of the New York Fed has fallen from about 2% to 1.08%.

These moves may seem small in nominal terms, but the point is always to consider the move in percentage terms. The forecast cut out of the Atlanta Fed means that Q4 2018 GDP will be about 44% lower than previously expected. The forecast cut out of the New York Fed means that Q1 2019 GDP will be about 5o% lower than previously expected. It continues to perplex me that the market can be so complacent on the news. Despite the news, the U.S. equity market remains up about 2-3% in February. The official release for Q4 2018 GDP will be on the 28th of this month. The release was delayed due to the government shutdown. This is quite the learning experience for how the markets react ahead of what can very well be tough times ahead.

An interesting debate in the world of finance is what drives markets? Some say fundamentals and some say liquidity.

This is a relatively advanced topic, but let’s dive in. Fundamentals are the characteristics of the securities within the markets. These characteristics for example could be PE ratios, which can be used to suggest valuation relative to other markets and historical precedent. The idea is that if stocks are cheap, then they will go up and vice versa. On the other hand of the debate is liquidity. Liquidity is like the Brita filter in your kitchen and everyone’s cups are different markets. If the Brita filter has water in it, then markets can rise.

The tough question for me has been defining and quantifying liquidity beyond that abstract definition. The first definition you learn on liquidity is the ease at which you can get in and out of a market. Essentially, this is the idea that there is another buyer when you want to sell. If there is no next buyer, then the market price for the asset will go down to create a buyer.

The original question devolves to what causes markets to have a next buyer so that prices do not descend in search of the next buyer? Is it fundamentals or liquidity?

The question I propose to the audience is when fundamentals no longer support stock prices, how can fundamentals continue to drive markets higher? This is where I believe the debate takes a decisive turn. I believe both stances are correct under specific market conditions. If liquidity is overabundant, then I believe that liquidity overpowers fundamentals and drives markets. If liquidity is not filling everyone’s cups, then I believe fundamentals drive markets. There are nuances to this, but this is the main point.

I will now use this mental framework to discuss current market conditions. Being a fan of mean reversion and a skeptic of “this time is different,” I will use the Shiller PE ratio to discuss fundamentals. The fundamentals show us that the Shiller PE ratio is at its third highest level, which suggests third highest level of overvaluation in history. For you to believe that fundamentals drive markets you would have to believe that earnings will move up in order to compress PE ratios to normal levels. I have created a graph of S&P 500 earnings by year since 1950 in blue with a moving average line in orange. This graph is particularly interesting because it suggests that over time earnings revert to the mean. Earnings are currently at all time highs, so for fundamentals to drive markets it means you place a higher likelihood on further record earnings than the eventual reversion to the mean that has happened time and time again.

So where does liquidity come from? The main source is the central banks. Quantitative easing is a complex term, but it really just means central bank asset purchases. This means that the central bank enters the markets, buys assets, and electronically creates currency to give to the previous owner of the asset. This expands the money supply. We operate under a system called fractional reserve banking. The reserve requirement is 10%. This means that when a bank eventually receives this new liquid currency, they have the ability to lend 90% of it out. This 90% eventually finds itself in another bank that can lend out 81% of it and so on. What you need to understand is the vast power global quantitative easing has on supporting and boosting asset prices like stocks.

Below, you will find a chart of quantitative easing since 2003 by the Fed (US central bank), ECB (European Central Bank), BOJ (Bank of Japan), and China. Further below, I have created a chart of the S&P 500 that highlights, to the best of visual ability, time periods where global QE went from extremes to near zero. You can see that markets struggled in these time periods until Global QE returned.

So do fundamentals or liquidity drive markets? I think prior to 2006, I would have said fundamentals. Since 2008 though, we have entered the global quantitative easing experiment, and it is tough to dismiss the power of liquidity.

People are way to quick to assume that cash is an enormous mistake of a position in a portfolio. I am about to have a fun time debunking this one as it is complete and utter conventional wisdom nonsense. It may have been a tad more difficult to make this argument a couple years ago, but now many money market funds are returning over 2%, and the old saying Cash is King is being remembered.

The time for cash to be a prominent portfolio position is specific. Cash is not always King, but when valuations are at extremes, it is a wise position. The term “extremes” is subjective, but I will let you be the judge. Below you will find a chart of the Shiller PE ratio. The Shiller PE ratio is a special kind of PE ratio. First, a PE ratio is a price to earnings ratio. It is a valuation metric, and it tells you the multiple that each share of stock costs in relation to earnings. The significance is that if a company makes $1/share and you pay $50 for the share, then the company is priced at 50x earnings. Earnings can be volatile so PEs can be subject to short term volatility that should not affect the valuation of the company, but due to the way the PE ratio is calculated it may unfairly signal that a company is overvalued or undervalued. The beauty of the Shiller PE ratio is that instead of just using recent earnings, it uses the average earnings of the past 10 years in the denominator. This smooths out the ratio from any arguably insignificant volatility. The current Shiller PE ratio resides at levels only seen around the time of the 1929 stock market crash, which preceded the Great Depression, and the dot-com bust of 2000. Also, note that before the prior selloff the Shiller PE ratio for this cycle was higher than that of the 1929 cycle peak making it by historic Shiller PE ratio standards the second most overvalued stock market in US history.

The focus of this post is not how such irrational company valuations occur, but what they signify. Ever hear of buy low sell high? Well simplistically, this could serve as a guide for a novice investor. As one can see when stocks are overvalued, they are due for correction. Let me provide you with some downside risk reference. Peak to trough, the crash of 1929 cost investors in the Dow Jones Industrial Average 89%. Peak to trough, the dot-com bust of 2000 cost investors in the Dow Jones Industrial Average 34%, but more relevant is what was lost in the Nasdaq 100. The Nasdaq 100 is a composite of the 100 largest tech companies in the US, and this index lost 81%.

I am not saying that because valuations are on par with these past disasters that north of 80% losses are in the cards. What I am saying though is that the market is just like a casino, and if you do not step away from the table when you still have chips, then those past “gains” may be nothing but a memory.

Let us now consider the naysayers. They will say things along the lines of look at all the gains that you are missing out on as overvaluation extends into even more ridiculous territory. They may ask you, “When will you get back in the market?” I would propose the question, “When will you get out?”

I do not anticipate a continuation of this trend, but it is certainly noteworthy that cash was even the best performing asset in 2018 per the above figure.

So in holding an allocation towards cash, not only will you be relatively defended versus adverse market conditions, but you will even be compensated for it. Let us not forget the last benefit. When stock markets crash, investor sentiment tends to sway to a state of over panic, which creates fire sales.

Warren Buffett famously said, “Be fearful when others are greedy and greedy when others are fearful.”

You cannot take advantage of the fire sales and the fear unless you have dry gun powder (cash) at the ready. It should come as no surprise in such cyclical times that the legend is preparing.

At the beginning of 2018, Buffett and Berkshire Hathaway sat on $116 billion in reserve. This cash is crisis ready. In line with what the Shiller PE ratio was telling us, Buffet has yet to see value opportunities arise. The difficulty with cash is that people will constantly tell you that you are a fool for holding it. I presume that Buffett made a few mistakes during the year due to shareholder pressure, but nevertheless he still has over $100 billion in reserves, and is ready for what may be coming based on history.