Wednesday, June 11, 2014

Two Sigma Is Upon Us

Credit to Brad Palatiello of Chapel Hill Research for the below commentary...  Click Here to read his full article


  • Two sigma events are a rarity and have coincided with periods that have produced poor long term returns.
  • Utilizing two standardized values, CAPE and trailing 5-year returns, these metrics have captured all significant equity market bubbles. We are currently in two sigma territory.
  • Markets can endure beyond the two sigma signals and, with unusual Fed policy, it can continue to do so.
  • However, it is important to be aware that 10-year risk adjusted returns have been negative beyond these signals and long term investors should plan accordingly.
  • Also, aggregate profits have suffered a significant decline in Q1, and the historical implications are poor moving forward.
Jeremy Grantham designates a bubble, using various metrics, as two standard deviations from their respective means. We have created our own metric in the graph below, which is the adjusted, standardized CAPE plus standardized trailing 5-year return.
(click to enlarge)
These events occurred in '29, '37, '65, '87, '95-'00, '07, and now '14. As you would presume, it never ends well. The average 10-year return in excess of Treasuries of similar duration after these two-sigma events is -2.02% a year. This is including '87 when the market plummeted abruptly and then proceeded to march higher. Surely, as validated by the '65 and '00 bubble, the market can endure and move to the upside in the short term. However, for us long term investors, this is dispiriting information.
Also, aggregate corporate profitability plummeted -6.8% year-over-year in the first quarter of this year.

Wednesday, May 7, 2014

Weakness in Small Caps

In 35 years of history, this is only the third time that the NYSE Composite Index was sitting at a 52-week high one day, and the next day the Russell 2000 had fallen below both its 50-day and 200-day moving averages. The two precedents occurred on 3/12/99 and 11/1/07, which is disturbing as it preceded the last two bear markets. It's tenuous (!) to place a lot of weight on a sample size of two, though this is another warning that the divergences we've been seeing lately have not had positive outcomes the majority of the time.

Tuesday, May 6, 2014

Research Brief from 361 Capital

Below are some excerpts from Blaine Rollins, CFA excellent research briefing...

Something else you don't see every day... Stocks and Bonds both moving toward highs...

Russia is still a thorn in the world which benefits Bond prices, but remove the Ukraine and there remains a disconnect...
With U.S. stocks near record highs and Treasury bond yields near multi-month lows, the disconnect between equity and debt investors has rarely been as stark. Over the coming months, the economy is likely to show one of the groups has bet wrong. The S&P 500 sits less than one percent below an all-time high. After a wintry first quarter, stock investors are betting that economic growth is picking up, as evidenced by stronger spending figures and business demand. That's boosted the cyclical stocks which react to rising demand, particularly energy shares... Bond investors are reacting to a different story. Yields on the 10-year note hit a five-month low on Friday and the 30-year note's yield fell to its lowest since June after the April jobs report, which showed strong growth in payrolls but no growth in earnings and a decline in the labor force. That data points to the conclusion that overall economic demand will remain tepid and that inflation won't materialize as the Federal Reserve continues to pull back on monetary stimulus, analysts said.

Transportation stocks moving back to highs favor the strengthening economy...

ISI Group's Weekly Economic Surveys also told you that the data points would be moving higher...
ISI's company surveys and bank loans both correctly suggested the recent run of strong monthly U.S. data, e.g., employment and consumer spending. They now suggest another run of strong data. Improvements in the U.S. and Europe are driving a global reacceleration (e.g., global IP), and lifting earnings for S&P companies (over the past three weeks, 1Q estimates have surged from -1% to +5%, and further increases are likely). Around the world, money is pouring into everything --- deals, real estate, equities, corporate bonds, Spanish bonds, and U.S. bonds. Cumulatively, Fed and BoJ balance sheets have surged +$495b ytd.
(ISI Group)


But some excellent discussion on the state of the Financing and M&A markets from the Carlyle Group conference call last week...
...“given recent geopolitical and macroeconomic events we are surprised at how well credit markets have been in 2014. The world continues to be awash in liquidity and investors are chasing yield seemingly regardless of risk. Leverage levels in the United States are increasing and rose by almost a full third over the past year while spreads between IG and HY are ~250 basis points below the 20 year average. Thus, the market is not assigning a significant premium to riskier assets. We continually ask whether the fundamentals in the global credit markets are healthy and sustainable. Frankly, we don't think so. What does this mean for global investments? On the positive side we are locking in low interest rates for new investments and continuing to refinance existing debt. At the same time historically low interest rates and a high appetite for risk are pushing up leverage levels and contributing to rising asset prices. This is good news if you are a seller, but bad news if you are a buyer. Given these dynamics good deal judgment is paramount”.

While Treasury Prices move to highs, Junk Bond prices have stopped gaining. This should be a bit worrisome for RISK investors. The ramp in supply from the above mentioned M&A does not help.

And still worrisome to RISK investors is the under performance in Small Cap versus Large Cap equities...

But working in RISK investors favor is the continued buying in the Emerging Markets. In Brazil the Real currency is helping. And as Barron's noted over the weekend, political changes in India are helping those Equities...


But for Portfolio Managers, 2014 has been BRUTAL...
Calendar year 2014 is now 1/3 behind us and for many equity portfolio managers the calendar is turning into an annus horribilis to use the phrase immortalized by Queen Elizabeth II. Nearly 90% of large-cap growth mutual funds, 90% of value funds, and 2/3 of core funds are trailing their style return benchmarks YTD (1%, 4%, and 2%, respectively).
Stock-picking has been extraordinarily challenging this year. The typical hedge fund had a YTD return slightly below zero as of April 30. Dispersion of S&P 500 stock returns for the last three months ranks at the 1st percentile compared with the past 30 years. Within Consumer Discretionary, where hedge funds have nearly 25% of their net exposure, the return dispersion also ranks in the 1st percentile. Simply put, 2/3 of consumer stocks usually have a three-month return within a 29 percentage point span. However, the range is currently just 16 percentage points which makes both long and short security selection extremely difficult compared with prior periods.
(Goldman Sachs)

For the week, there was a bounce in RISK as Technology outperformed and Utilities underperformed...

More broadly, International Equities were also snapped up across Emerging and Developed markets...

Friday, November 1, 2013

JP Morgan sees "most extreme excess" of global liquidity ever!

In an article in the UK's The Telegraph, the author highlights a research report published by the global asset allocation team at JP Morgan that say's the bank's measure of excess global money supply has reached an all-time high.  The implications, of course, is that previous periods of excess liquidity provided to global markets have all been coincident with the inflation of unstable asset bubbles.

The latest surge in liquidity has surpassed the last three episodes of excess liquidity: 1993-1995, 2001-2006, and during the emergency response to the financial crisis between October 2008 - September 2010.

The flood of excess liquidity has sparked another asset boom, while the global economy continues to sputter along.  This disconnect between asset prices and fundamentals is a dangerous game of chicken being played by global central bankers, as the hangover of recent asset booms has been devastating for many investors.

With returns from safe assets near zero, investors this year have chased higher risk investments like stocks - fund flows into stock funds have been 10 times the level of inflows to bond funds.

Global stock markets are now responding daily to whispers about the Federal Reserve's intentions.  When Chairman Bernanke announced in early summer that the Fed was looking to begin tapering QE as early as this fall, stocks immediately corrected 5%.  This also caused a mild panic around the globe with emerging market stocks dropping 15% and gold tumbling 20% as currency volatility spiked.

Interest rates on government debt rose from 1.6% to 3.0%, causing bond prices to drop sharply.  The Fed's decision to delay tapering when it was widely expected at their September meeting caused risk assets to surge.

But we now know what is likely to be the reaction to a reduction in monetary accommodation in the months to come and some "smart money" investors are beginning to position their portfolios accordingly. Blackstone, the world's largest private equity fund, said in the Spring that they are selling everything that is not bolted down.  Norway's sovereign wealth fund reportedly stopped buying stocks in the third quarter and is now a net seller.

Monday, October 21, 2013

Forget Fundamentals?

The Financial Times ran an interesting article this morning titled Forget Fundamentals, Fed Liquidity is King.  The article highlights many of the same issues that I've been struggling with in 2013.

As an unapologetic fundamental analyst, it has been difficult to watch markets continually shrug off poor or weak data, both from the broad economy as well as individual companies to trade dramatically higher on any hint that the Federal Reserve will continue to flood markets with unprecedented liquidity. While it is not at all uncommon for the market to ignore short-term fundamental noise, historically, these divergences haven't lasted.

The article asks...

"Earnings per share are falling, but the stock market continues to move up due to quantitative easing. The Fed’s policies continue to have little impact on the real economy but a large impact on financial asset prices. Given the continuing gap between the economy and markets, what is the rational investor to do?

A massive downward revision to bottom-up analysts’ expectations had no market impact at all,” JPMorgan concluded. (Hedge fund manager) Mr Einhorn notes that third-quarter S&P index earnings growth is expected to be half of what was forecast in June"

The author goes on to lament that net margin debt, funds that investors borrow to buy stocks, has surged to all-time highs.  Further, lower quality stocks have outperformed the overall market.  Both are traditional signs of excessive speculation.

The concern of course is that the market gets so stretched in terms of valuation, that the inevitable snap-back will be more and more painful.  This is why our strategy has been to slowly reduce overall exposure through the course of the year for some clients and remain on the sidelines for others.  I believe it is clear that stock investors will not be happy when the Fed finally decides to begin scaling back on their grand monetary experiment.    

The following chart, courtesy of Bianco Research, illustrates the declining growth rate of corporate profits for the S&P 500 over the last ten quarters.  

Tuesday, October 8, 2013

Weekly Update

Below are excerpts from Blaine Rollins' of 361 Capital Weekly Research Update...

Maybe Mark Twain said it best... 
"No man's life, liberty, or property are safe while the legislature is in session."

Washington would also like to pressure the financial markets to increase the intensity on negotiations...
President Barack Obama and his top economic officials appear to be pushing for some market unrest to exert pressure on the GOP to throw in the towel. Asked in his CNBC interview Wednesday whether Wall Street is right to remain calm over the standoff, Mr. Obama replied: “No.”
“I think this time’s different,” he said. “I think they should be concerned... When you have a situation in which a faction is willing potentially to default on U.S. government obligations then we are in trouble. And if they’re willing to do it now, they’ll be willing to do it later.”

Not sure who is winning the cat fight in D.C., but the raw data shows that Equity Bulls would side with Samuel Clemens...
We find a strong link between Congressional activity and stock market returns that persists even after controlling for known daily return anomalies. Stock returns are lower and volatility is higher when Congress is in session. This “Congressional Effect” can be quite large—more than 90% of the capital gains over the life of the DJIA have come on days when Congress is out of session. The Effect varies systematically with the public's opinion of Congress: returns are lower and volatility higher when a relatively unpopular Congress is active. Public opinion appears to play a fundamental role in market prices. This is consistent with a mood-based explanation that sees Congress as ‘depressing’ the average investor. Alternatively, our results can also be reconciled with rational explanations that view Congressional activity as a proxy for regulatory uncertainty or rent-seeking behavior.

Portfolio Returns When Congress is In-Session vs. Out-of-Session for the Dow Jones Industrial Average: The “Out-of-Session” strategy is the cumulative return to a strategy that invests $1 in the DJIA on days Congress is not in session and in cash (earning 1 basis point per day) when Congress is in session. Conversely, the “In-Session” strategy invests in the market index on days Congress is in session and in cash on days Congress is out of session.

For the week, the S&P500 was flat with plenty of daily moves and some sector rotations...

Among global equities, a RISK appetite was still present with weak Europe, Brazil, Small Caps gaining while Japan, Gold & Bonds fell...

Another look at the monthly historicals as we enter the best quarter of the year to be invested in equities...


Even more interesting is to note that previous global equity strength leads to even further Q4 gains...


Meanwhile, the market heads into the October earnings reporting season. Did the global powerhouse, Nike, already set the mood for what the season has in store?
The bad news is that analysts aren't expecting growth to pick up too much in the third quarter. Thomson Reuters estimates that earnings will increase just 4.9% in the third quarter, which would be the 10th consecutive quarter of sub-10% growth. "It will be difficult to generate interest from investors with growth so low," notes Pierre Lapointe, head of global strategy and research at Pavilion Global Markets. The good news is that expectations are low. Management has spent the previous three months telling analysts that their profit forecasts were too high—there have been more than three times as many companies guiding estimates lower than higher, and now the predictions are far more plausible, says Adam Parker, chief U.S. equity strategist at Morgan Stanley. In fact, an early preview from companies releasing before Tuesday has been surprisingly good. Of the 17 companies that reported through Sept. 27, six beat earnings, eight met expectations and just three missed. And earnings have topped forecasts by 3.3%, the largest for this group since the fourth quarter of 2012. "Earnings should be OK and remind people U.S. companies are in good shape," Parker says. "That should be supportive for stocks."

Speaking of growth... Twitter files its IPO...

If you are looking for help in valuing the company, Prof. Damodaran has built you a model framework with his thoughts...
Having learned from the Facebook fiasco, I expect the bankers and the company to make the Twitter IPO a smoother offering. That process will of course start with the road show, where they will package the company like a shiny new present, and unwrap their “offering” price. I am sure that Goldman’s bankers, working on this deal, are a capable lot and will price the stock well, with just enough bounce to make those who receive a share of the initial offering feel special. As I watch the frenzy, I have to remind myself of two realities. The first is that there will be lots of distractions (like this one) during the IPO, most designed to take my eye off the ball. The second is that the bankers have their own agenda, and I cannot make the mistake of assuming that it matches mine. Watching out for my interests, here is how I see Twitter: at a $6 billion market cap ($10/share), I think it is a very good deal, at $10 billion ($17.5/share), I am indifferent to it, and at $20 billion ($35/share), it is a moon shot. Could I be wrong? Of course, but I would rather be transparently wrong (hence the long blog post detailing every assumption that I made) than opaquely right.

Speaking of non-tech growth, the 10 year rise of gambling in Macau has been incredible...
Macau has grown at light speed since the former Portuguese territory in 2002 abandoned a monopoly system that gave one concession to the tycoon Stanley Ho. Last year, gaming revenues from the six companies with casino licenses – Sheldon Adelson’s Sands China; Wynn Macau; James Packer’s Melco Crown; Mr. Ho’s SJM, Galaxy; and MGM China – reached $38bn, making Macau six times bigger than Las Vegas. CLSA expects that number to double to $77bn by 2017...
Macau’s gambling industry has been propelled by an influx of Chinese tourists. China bans gambling on the mainland, but allows its citizens to visit Macau every three months under a special visa program. Gamblers can also bypass visa restrictions by joining special tour groups. According to the Macau government, the number of mainland Chinese tourists increased 45 percent from 11.6m in 2008 to 17m last year.

Sports geek story of the week...
Bet me. No QB in the NFL is more accurate, goes deeper or is more effective than the Colts' Andrew Luck. And that's just his vocabulary. Wednesday, for instance, in a single half hour, he got in "vociferous" (re: loudmouth, loud-playing Seattle cornerback Richard Sherman, who brings undefeated Seattle to Indy Sunday), "cognizant" (was he aware of big moments as he's making them? no, he wasn't), and "implemented" (he was glad to see some more running plays being "implemented" into the Colts' game plan.)
A 3.48 GPA at Stanford in environmental engineering will do that to a person. "The other day he used 'paucity' on us," says his backup, Matt Hasselbeck. "And 'chutzpah.' How many people in this locker room even know what chutzpah is?" "The guy just comes at you all day long with the SAT words," punter Pat McAfee complains. "I tell him, 'You know I'm dumber than you. You don't have to rub it in all the time.'"

An incredible stat to challenge your kids with this week...
@Alcoa: ~75% of aluminum ever produced since 1888 (when Alcoa invented the industry) still in use today.

In the event that you missed a past Research Briefing, here is the archive...
361 Capital Research Briefing Archive

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Monday, September 23, 2013

Economic Template by Ray Dalio

The following 30-minute video is probably the best "easy-to-understand" template for how the economy works that I have come across.  Ray Dalio is the founder and head of Bridgewater Associates, the world's largest hedge fund with $122 billion in assets under management.