By the end of last week we took profits on our stocks and
stock options within our portfolio and replaced them with general market ETF’s.
We bought SPY’s and QQQ’s and added UPRO and TQQQ to capitalize on what is a
traditionally strong week for the stock market (Thanksgiving week). We have
decided on this “block and tackle” defensive approach as the latest trade from
last week puts us up 20% in the Fishbone Portfolio for the year before fees.
For more information on the Fishbone Model please click here.
We’re fairly certain that the market will remain in an
uptrend through the end of the year and quite possibly reach new highs. That
said we are extremely cautious about the intermediate and longer-term prospects
for U.S. equities. It would seem the market is exhibiting topping
characteristics similar to 1999 - 2000 and 2007 – 2008. We will continue to
attempt to capitalize on high probability trades but are keeping a tight leash
on positions knowing that the market can turn drastically at any time. Hoping
for the best and preparing for the worst.
Lack of Conviction
Research from FBN Securities (via Business
Insider) show the latest rebound in equities has not had stellar
participation as measured by volume. This is perhaps a double-edged sword. On
the one hand it may indicate that a significant portion of market participants
are not buying into the market rally as economic and policy measures seem to be
providing a headwind into 2016. On the other hand, if the negative assumptions
of a continued slowing of the economy, softer corporate earnings & revenues
and detrimental monetary policy decisions prove to be false, then there will be
significant bullish torque to slingshot the market ever higher. We are in the
camp of expected market weakness but not so stubborn to concede analytical
error and nimble enough to make appropriate adjustments to our investment
thesis.
Research out of BofA Merrill Lynch (via Business
Insider) indicates investors have been making shifts into economically
defensive sectors of late, abandoning the high flying cyclical sectors that
have outperformed over the past several years. The chart below tracks client
fund flows within the firm.
We have also been speaking about retail sales lately.
Results seem to be all over the map. At first glance it seems apparel and mall
outlets are struggling, i.e. Nordstrom, Gap Stores, Macy’s but home improvement
still has positive momentum, i.e Home Depot, TJ Max (Home Goods), Lowes and
Wal-Mart. We consider retail sales an important function and leading indicator
of economic growth and the headline numbers are at best alarming.
Taken from Economy
& Markets Daily, “But the real
story comes from looking at growth rates in retail sales over the long
term…Retail sales excluding automobiles have been slowing since 2012. In 2015,
they’ve been approaching zero-percent growth. Bad news.
They’re now lower than
in the worst of the 2001 recession… and much lower than when the Great
Recession began in January 2008.
More bad news!
This sort of indicator
is important because it tells you how the economy is doing right now.
Economists revel over
lagging indicators like jobs growth that tell the story after the fact (because
they’re idiots). Ideally we’d focus on leading indicators, but most of those
don’t work in an artificial QE- and ZIRP-driven economy. But retail sales
correlate directly with consumer spending and therefore the economy. That makes
them the ultimate consumer-focused coincident indicator that you should focus
on near a top.
And as you can see –
they stink!”
“The trends are very
consistent with what we’ve been forecasting – a slowing economy in the second
half of the year – and reveal why, amidst rising geopolitical challenges, the
Fed may still keep interest rates at zero in December, despite the “strong”
October jobs report compelling them to do otherwise.
To understand this,
there’s two numbers you need to remember: 46, and 54.
46 is the age when
people on average reach peak spending, after which it plateaus for a few years.
We conducted a 10-year analysis many years ago that reached this conclusion.
54 is the year that
plateau ends. It’s also the year when the affluent – a smaller, more impactful
subset of the overall group – reach their peak, and they’re doing so today.
So it’s no coincidence
that we saw a recession after late 2007 when the average baby boomer turned 46.
Now, eight years later, they’re turning 54, when they come off that plateau and
the affluent peak in spending. This is also when auto sales – one of the few
remaining bright spots in our economy – finally declines sharply. But it’s the
affluent sector that I’m most concerned about because they control so much of
the spending – 50%!
This was not the case
in generation cycles before. But that changed heading into the bubbly late
1990s when they racketed up so much of the wealth, and wealth and income
inequality became as severe as in the late 1920s bubble boom. In 1989, spending
by age in five-year cohorts (the best we had back then) saw the biggest dropoff
come between age 50 to 54. Now, it comes between age 55 to 59. And that’s the
age they reach as we step into 2016, when the real demographic cliff hits.”
If we take a journey to the high yield market, it seems that
market is casting doubts on the robust U.S. economy and bull market. Taken from
analysis from Deutsche Bank (via Business
Insider), “Another interesting and unusual development is taking place on a
high-level across asset classes, where US [high-yield] is now underperforming
all major related markets, Including loans (-1.2%), [investment grade bonds]
(-0.5%), equities (-2.1%), Treasuries (-6%), [European high-yield] (-3.7%) and
even external [emerging market] sovereigns (-4.3%). The most intriguing detail here, in our view, is that [high-yield] is
underperforming both [investment grade bonds] and equities at the same time.
Think about how unusual this is for a moment. If [high-yield] is an asset class
that sits somewhere in the middle on a risk scale between high quality bonds
and equities, then normally we would expect it to be underperforming one and
not the other, as they would normally move in opposite directions. Figure 2
confirms this intuition – plotted here are the trailing 12mo differentials
between [high-yield] and [investment grade bonds] (blue line) and [high-yield]
and equities (red line), and most of the time these two lines are on the
opposite sides of the x-axis. In fact,
the only two times we had both of them being negative were, again, early 2000
and late 2007. Even 2011 did not create an exception here.” (emphasis
added).
DoubleLine Capital's Jeffrey Gundlach pointed out this
following metric (via Business
Insider). “One area of the market
that does a nice job of offering a leading indication of financial conditions
is the high-yield bond market. Also known as junk bonds, high-yield bonds are
ones issued to companies with speculative-grade credit ratings. These companies
are at higher risk of default than investment-grade companies.
Junk-bond spreads have
been elevated, signaling stress in that area of lending.
During a public
webcast on Tuesday, DoubleLine Capital's Jeffrey Gundlach observed that
credit-rating downgrades were outpacing credit-rating upgrades. Gundlach noted
that, in the past, a tick below the blue line was "the beginning of
something big." Now, while Gundlach wasn't forecasting the market to tank,
he did say that this was reason for caution from a monetary-policy standpoint.”
Fed Policy
The futures market now places a 68% chance that the Fed will
raise rates in December. The debate rages as to the impact and economic
wherewithal of such a rate increase. We came across an interesting study that
monitors monetary policy beyond the traditional tracking of interest rates. In
this study found on Euro Pacific Capital site entitled, The Shadow Rate Casts Gloom, they argue that monetary policy is a
function of interest (fed funds) rate, quantitative easing and Fed
forward guidance.
“Another big input is
Fed “forward guidance.” This comes in the form of official and unofficial
pronouncements from top Fed policy makers as to the possible trajectory of
rates in the future. If the Fed communicates that rates will stay low, or QE
will remain in place, for some time, then policy becomes looser still. Such
assurances effectively remove near term interest rate risk, which stimulates
financial activity. Ever since the Financial Crisis of 2008, the Fed has
engaged in unprecedented forward guidance, without which monetary conditions
could have been expected to be tighter.
To account for these
important factors, University of Chicago professors Cynthia Wu and Fan Dora
Xia, constructed a model for the “Shadow Rate.” While the fed funds rate has
remained between 0.0% and 0.25% ever since November of 2008 (Federal Reserve
Board), the Shadow Rate moved much lower, factoring in the effects of QE and
forward guidance. That rate got as low as -2.99% in May of 2014. (Federal
Reserve Bank of Atlanta, CQER, Shadow Rate)”
They go on to conclude, “Each
of the last three easing cycles took rates lower than where they were at the
end of the prior easing cycle. Given that the fed funds rate is at zero (and
the Shadow Rate got to as low as -2.99%), one shudders to think how low the Fed
is prepared to go the next time around. As a result, investors may want to
consider re-positioning their assets for another period of possible monetary
easing not a period of tightening, which I believe, in fact, is already well
underway and will soon be a thing of the past. December is far less significant
than what almost everyone has been led to believe.”
We have said for quite some time that the Fed risks losing all
credibility if they don’t at least make an attempt at policy normalization.
Recently it appears their dual mandate has been tossed aside in favor of day
trading tactics. This ongoing support of the stock market has tarnished their
reputation in my opinion. Read this blog post entitled Mollycoddled by Slope of
Hope blog for an entertaining viewpoint of Fed dependency where Tim Knight
writes, “Thus, after the Paris attacks,
the knee-jerk reaction (which lasted only moments, and was actually quite
sensible in a normal world) was to sell everything except gold, which itself
got bid up nicely. The collective mind, however, knew that the succubus Janet
Yellen and her kind would swoop in and let equity investors suckle at the
dangling teats of fiscal accommodation, thus eradicating any true price
discovery and any risk for the soft-as-downy-fur traders out there.”
Charlie Bilello, Director of Research at Pension Partners, LLC, put
it best. “It’s also time to start
acknowledging that there are unintended consequences of 0% and the longer the
Fed waits, the worse the effect it will have on long-term economic growth. I
have argued over the past year that 0% policy has actually become a headwind
for growth as it: 1) is a tax on savings and therefore investing, 2) is leading
to a gross misallocation of resources and capital, 3) is encouraging financial
engineering (buybacks/mergers) over investments in capital/labor, 4) has
already created the third financial bubble in the past fifteen years, 5) is
putting less money into the hands of consumers, 6) is not helping real wages as
asset price inflation (and rents) outpaces income gains, and 7) has only
widened the wealth gap…The Fed needs to send a clear message to the markets
that they are no longer going to be pushed around by the easy money addicts
wanting 0% rates forever. If the stock market goes down a few percent in the
short-run as a result, so be it. It’s a small price to pay for improved
long-term growth and stability in the economy.
But I would not be
surprised if the opposite occurs, and the market actually rallies on a clear
rate hike message from the Fed, putting an end to this endless period of
uncertainty over when they’re going to move. The incessant delaying of
normalization has became a source of instability in the markets.”
Quite honestly at this point I wouldn’t be surprised to see
the market rally in the near-term in news of a dovish rate hike. Nor would I be
shocked to find the U.S. dollar sell-off and gold and other precious metals
rally in the face of an initial tightening.
Gold Bug Emergence
Speaking of gold prices, I’m reading quite a bit about a
bottoming process in the commodity space. We’ve never invested in gold and
certainly will not try to catch that falling knife now, but it’s worth
commenting on in the face of tighter monetary policy.
From Pipczar
blog, “As you know, gold, silver and
copper have been under tremendous pressure as of late. The Strong USD as of
late has been an added thorn to their side as well in the last year. Frankly, I
am not too sure how much lower they can go, or when they will bottom. But the
charts you see here, could argue we are at levels that may provoke a bounce.
Take a look:”
“As you can see with
gold, we are trading very close to a 50% retracement near the 1070 level. We
have probing above and below this level the last couple weeks.”
“Silver shows we are
sitting on a multiyear trend line, which suggests that the $14 level is a very
big support.”
Also from The Short Side of Long, “However, do consider that from a contrarian
point of view sentiment is ridiculously low, while prices are very deeply
oversold. Raw materials represented by the famous CRB Index, are now trading at
levels last seen in 2001 of 184 points. Furthermore, the price range between
175 to 185 is a major support zone dating all the way back to 1973. Will
commodities be able to bounce from this important memory zone, which buyers
have defended for generations? Even if we told you there is an above average
chance, you probably wouldn’t believe us.”
To be fair to both writers, they never once recommend buying
gold or commodities and are just pointing to possible support levels within the
space and we certainly appreciate the heads-up. My view on gold continues to be
bearish until prices prove otherwise. The herd behavior around gold is
exceptionally strong and it will take quite a bit to influence direction. For
gold we need to look at long-term trends for analysis. This is what would
incentivize me to purchase gold as an investment or trade.
1 – Monthly RSI (14) will need to cross above 50 and stay
there through a retracement.
2 – Prices will need to break above the 20 month moving
average and retest it as support. The 20 month moving average is currently
$1198 and this level has been key for pricing in the past for both the bullish
and bearish cycle.
3 – Monthly MACD (20,35,10) needs to break above the signal
line and hold.
My business partner Mr. Parker has continually asked when is
the appropriate time to purchase gold. These three criteria should act as an
excellent starting point.
PGM
A large part of our business is trading against physical
delivery of PGM group metals, in particular platinum, palladium and rhodium.
These metals are a key component in removing harmful emissions from engines.
The automobile catalyst converter market is a key source of demand for these
metals thus I have always considered them an industrial metal priced as a
precious metal. I have long written about the favorable supply and demand
dynamics of PGM.
Based on the chart below, an investment in PGM in 2015 was a
mistake.
Our metals business fortunately isolates us from commodity
risk. We work with a large network of auto scrap recyclers and processors that
accumulate platinum, palladium and rhodium from spent catalytic converters,
process them and resell them to primary mines and original equipment manufacturers.
Running the hedging strategy for our processing and collection customers allows
us to keep our margins consistent so our metals desk has done well in spite of
the commodity rut.
That said there were two interesting events last week that
would significantly increase our revenues and profitability were they come to
fruition.
As we mentioned, our margins remain consistent but any
increase in metals prices and/or volume provide an exponential boost to our
hedging business.
The first news item came out of Johnson Matthey. They are
projecting total demand for PGM to outpace primary supply for the fifth year in
a row. Auto sales continue unabated while primary mining supply continues to
have trouble keeping pace. Johnson Matthey believes that a larger than average
number of ounces will come from the secondary recycled market to meet the
excess demand. According to BloombergBusiness,
“Platinum demand will probably beat
supply for a fifth year in 2016 on more industrial usage, even as recycling
rebounds, according to Johnson Matthey Plc. Palladium’s deficit may narrow…While
slumping platinum and steel prices have reduced the incentive to scrap older
cars this year, there may be a
“double-digit” increase in the amount of metal recycled from vehicles in 2016,
it said.” (emphasis added).
Demand estimates for palladium are also set out outpace
supply next year and JM also thinks there will be a major boost in ounces
supplied from the secondary recycling market, “Demand from car companies, which probably increased 0.8 percent to a
record this year, will rise “modestly” in 2016, the report showed. Scrap supply should climb “strongly”
(emphasis added).
This bodes well for our processing and collection partners
as well as volume through our hedging desk.
The second item talks to metals prices, palladium in
particular. We came across this intriguing bit of news, End
of Russian palladium exports may result in world market shortage from
Investor Intel. In the article they write, “Russia
may significantly reduce exports of strategic rare earth elements to foreign
markets during the next several years, despite the recently announced state
plans for a significant expansion of their domestic production.” As the
leading primary source of palladium as a by-product of their nickel mining
activity, any withholding on the part of Russia can have a significant impact
of palladium prices. They go on to state, “The
official volume of palladium reserves in Russia is a state secret. According to
the British research company GFMS, during the period of 2005-2009 Russia
exported in an average of 34 tonnes of palladium per year, while in recent
years these figures have significantly declined.
The end of supplies
may result in a sharp rise of prices for palladium in the global market and
will lead to the fact that Russia will no longer have a major impact on the
world palladium market.
The end of exports of
Russian palladium may result in a shortage of the metal in the world market. At
present palladium is mostly used in the production of automotive catalysts,
while its shortage may result in a significant increase of the costs of
automakers.”
Bottom line for
equities: We have reduced our holdings and now hold ETF’s and levered ETF’s
that track the broader indices. We anticipate a strong market next week and
will take profits on our levered instruments into strength and remain in our 1
to 1 index ETF’s SPY and QQQ into the end of the year. We anticipate possible
new highs for the market into the end of the year, quite possibly on a fed
interest rate raise…buy the rumor sell the news. We remain cautious on equities
in the intermediate and long term and are prepared for another severe
correction.
We don’t think at
this time we are in for a 2016 recession and bear market but are watching the
data closely.
Bottom line for gold:
There are grumblings of a possible bottom in commodities and gold in
particular. We will not be purchasing gold as an investment but are watching
several metrics. Should these metrics improve, it is quite possible that gold
may outperform equities in 2016. We will monitor appropriately.
Bottom line for PGM:
We continue to believe the supply/demand dynamics are favorable for PGM. We do
anticipate prices to improve and more importantly volume from the secondary
recycling market to increase dramatically. This will offer us an outstanding profit
opportunity as secondary market hedge book managers. It is our belief that 2016
may offer the greatest profit opportunities since we launched this business
line several years ago.
I’d like to take this opportunity to wish all my friends,
partners and associates a very happy, healthy and safe Thanksgiving. I will be
spending some much needed quality time with my wonderful wife and two beautiful
children with the rest of our family. I certainly have much to be thankful for.
Joseph S. Kalinowski, CFA
Additional Reading
On Commodities
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