## Minsky and the Levy/Kalecki Profit Equation

I want to talk Minsky and the Levy/Kalecki Profit Equation

This may sound a bit heady, but don’t worry. We’re going to break it all down Barney style and then walk you through how you can use the frameworks for understanding the current environment in order to better assess the probabilities of potential outcomes (ie, gauge the general conditions).

I still had much to learn but I knew what to do. No more floundering, no more half-right methods. Tape reading was an important part of the game; so was beginning at the right time; so was sticking to your position. But my greatest discovery was that a man must study general conditions, to size them so as to be able to anticipate probabilities.  ~ Jesse Livermore

Let’s kick things off with the Levy/Kalecki Profit Equation.

The Profit Equation is just a macroeconomic accounting identity for how the global economy actually operates. Specifically, it answers the question as to where “Profits” come from and thus, growth.

If you’ve ever heard of The Jerome Levy Forecasting Center where a number of talented economists work. Well, that’s the same Levy. The center performs analysis using the Profits Equation framework developed by Jerome Levy in 1908 (side note: Kalecki was a renowned economist who developed the same framework as Levy years later and received credit initially for it because Levy was a relatively unknown name).

Now, you can read the full white paper on the equation here, which I highly suggest you do so. We’re just going to cover the gist of it today, because it’s relevant to potential macro risks and constraints we’ll be facing in the coming year(s).

The actual accounting identity looks like this:

Profits before tax = + Investment – Nonbusiness saving + Dividends + Corporate profits taxes

This accounting identity, which like any identity holds true under any circumstance, is just saying that corporate profits are the direct result of net investment minus nonbusiness (Households + Government + rest of world) saving before dividends and corporate taxes are paid out.

Confused? Don’t worry. I’ll break it down even more.

We all know where profits come from at the individual level, right? A company earns more in revenue than its costs and the excess is profit.

Well, if you pull back and look at the global economy as a whole, it’s a closed system. Its closed in the sense that profits aren’t magically appearing from anywhere outside of the global economy. But profits obviously aren’t a zero sum game. If one company earns profits it doesn’t necessarily mean that another company somewhere has to be operating at a loss. There wouldn’t be any growth if that was the case. So, where do profits come from then?

The answer is in net investment, which is a positive sum game. If we divide the economy into our four aggregate entities (1) US Corporations (2) Households (3) All levels of US Government and (4) the Rest of the World (RoW) and look at them as a whole, there needs to be net positive investment as a whole for their to be profits.

This means that an economy’s ability to produce profits comes down to the net expansion of the aggregate balance sheet in the macro accounting identity. For instance, if the US Government is running a budget surplus (shrinking its balance sheet), like it did in the late 90’s. Then either the Household, Corporate, or the RoW needs to take up the slack and expand their balance sheets to make up for the fall in demand. Or else demand will fall and profits will contract.

In the late 90’s, US Corporates made up for the government’s demand deficit by expanding their balance sheet. In the 2000s it was Households and the RoW (led by China) who borrowed money and invested — US Households in homes and China in building entire cities.

Understanding that profits are essentially the residual of the net balance sheet expansion/contraction of the entire global economy is helpful because (1) we can look at the trends in the balance sheets of our four macro aggregates to see if net demand (profit) is being created and (2) we know that their are natural limits to how much balance sheets can expand and therefore whether the global economy may be headed for a contraction in profits.

This is essentially a more nuanced framework for understanding how the debt cycle (as put forth by Bridgewater) works. Profits are essentially the result of expanding balance sheets (increases in debt). The more balance sheets expand the lower interest rates need to drop in order to decrease debt servicing costs and keep the cost of capital down for marginally profitable firms — essentially keep the economy from going into free fall.

Enough with the theory… How does this apply to the present day?

Well, think about what’s been the source of profits in the US economy the last couple of years.

The Household sector has been deleveraging since the Great Financial Crisis (GFC). They’ve been contracting their balance sheets and thus have been a negative source of profits/demand in the economy. The demand then has come from both the Federal Government and the Private Sector, both of which have been rapidly expanding their debt.

The RoW, primarily the Eurozone and China being the two economies large enough to matter, have been either a wash or net drag on global demand over the last few years.

China has pretty much maxed out its balance sheet limits where it now takes extraordinary injections of credit from the government to produce a relatively modest and short-lived economic impulse — the whole “pushing on a string” thing. And European consumers and corporates are fairly weighed down by debt and haven’t been helped much at all by their governments, who unlike the US decided to go with German imposed austerity following the GFC (though this may be starting to change, which we’ll discuss soon).

And this brings us to a growing concern of mine. Where is net demand going to come from in the future?

The fiscal impulse from the US tax cuts and increased budget deficit is starting to wear off. And on the corporate side, with corporate debt to GDP at all-time highs, how much more credit driven demand can we expect?

Things actually look worse when you disaggregate the corporate data. Taking a look under the hood we find that debt is actually much higher and there are a number of “zombie” firms that aren’t profitable even in such a low cost financing environment which means its going to take just a small tightening of financial conditions to cause these firms to go belly up, potentially kick starting a chain reaction of defaults.

Check out the following notes from Financial & Insurance Firm, Euler Hermes (emphasis by me):

• Between 2009 and Q3 18 the US total debt has declined from a peak representing 350% of GDP in Q1 09 to 311.5% in Q3 18. While the US as a whole has been deleveraging, the business sector (corporate and non-corporate) has re-leveraged, standing at 72.6% of GDP or USD 15tn today. This represents a 2pp deviation to trend. Past recessions in the US have coincided with positive deviations ranging from 2-8pp of GDP.
• According to our calculations, the true level of non financial corporate debt in the US may be 30% or USD 3.9tn higher than officially reported, primarily because of leveraged loans bought by non-banks. We estimate that the debt-to-EBITDA ratio would thus be close to 4.6 instead of 3.9. As a consequence, the BAA-Treasuries’ spread (to AAA) should be about 120bps higher than currently observed (~ 230bps today) if hidden debt were factored in.
• The Trump Administration’s fiscal stimulus has boosted demand in the US over the past couple of years. According to our model, a correction of this excess demand, back to potential output growth, could trigger an increase of the corporate delinquency rate from 1% in Q3 18 to 2.32% (highest level since Q2 11). This adjustment could follow strong disagreement about fiscal policy as we enter 2019-20 budget discussions. Corporate spreads will thus continue to hover around 230-250bps as seen today, still underestimating hidden debt, but aware of looming risks in the corporate sector. In a stress scenario (likelihood to switch estimated at 35%), which could correspond to a series of defaults for instance, the delinquency rate would jump to 3% and credit spreads would very quickly increase by 70bps higher than today.
• The bottom line is that be it from scoping (hidden debt) or for cyclical reasons, we believe that corporate spreads are underestimated today, and that unfortunate events (rapid downturn, market defaults) could end up pushing up spread by 70-190bps, by sheer realization by market actors of intrinsic risks in that segment.

The Bank for International Settlements (BIS) put out a research paper last Fall, titled “The rise of zombie firms: causes and consequences”, where they discuss the pervasive rot in the developed market corporate sector, especially here in the US.

Here’s a few of the notable highlights from the paper.

• 12% of all companies globally are now “zombie firms,” meaning that they can barely pay the interest on their debts. The number is 16% in the US, which is an eight-fold increase since the 90s.
• These zombie firms have been kept alive by low interest rates along with investor demand for “leveraged loans”.
• The leveraged loan market is now in the trillions (the exact number is unknown) and consists of low-quality corporate debt that’s at risk of being downgraded — which would cause forced liquidation — should interest rates rise too much.

It seems we’re on a clear course of transition from what Minsky would call the “speculative financing” stage to the “Ponzi Financing” stage of the financial cycle.

For those of you not familiar with Hyman Minsky, here’s a brief summary of one of his more popular theories, which applies to our discussion today.

Minsky came up with the “financial-instability hypothesis” which stated that long stretches of prosperity sow the seeds for an eventual crisis. Economic stability breeds instability.

Minsky understood that recency bias drives myopia in the human decision making process. Economic actors end up extrapolating low volatility into the future which leads to more risk taking in the present through the use of leverage (credit).

The theory was established by defining what investment is, and its role in an economy. Which, put simply, investment is the exchange of money today for money in the future. That money (investment) can come from one of two sources: the economic actors’ (consumer, company, government) own cash flows, or from the cash flows of others (lenders). And it’s the balance between these two sources of investment that comprises the stability of the financial system.

According to Minsky, the financial cycle typically follows three stages of financing; these are:

1. Hedge financing
2. Speculative financing
3. Ponzi financing

Hedge financing is the most stable of the three. It’s when the economic actor relies on its own stable cash flows to repay any borrowings. It’s when the actor’s earnings far outweigh its limited borrowings.

Speculative financing is when the actor uses its own cash flow to pay the interest on its debt, but must assume more debt to repay the principal; thus rolling its debt over. This stage of financing is less stable than hedge financing.

And lastly, there’s Ponzi financing, which is the most unstable of the three stages of financing. Ponzi financing is where the actor’s cash flows do not cover either the principal or interest payments on its debts. The actor is completely reliant on the appreciation of the underlying asset in the hopes that it’ll be enough to cover its liabilities.

Minsky argued that financial cycles naturally progress from each stage of financing to the latter; driven by human greed and carelessness. When economies enter the Ponzi stage, they become increasingly unstable and eventually experience a “Minsky Moment” which is a sudden collapse in asset values, leaving both lenders and borrowers exposed. This is the deleveraging phase of the debt cycle as put forth by Bridgewater.

So we have a diminishing US fiscal impulse, a nearly tapped out corporate sector riddled with zombie firms in an economy transitioning from speculative to ponzi finance, all which sits atop a leveraged loan market that measures in the trillions. Great…

The Game Masters (Policy Makers) are well aware of this threat. Former Fed chair Janet Yellen remarked in an interview with the FT last Fall that “I am worried about the systemic risks associated with these loans. There has been a huge deterioration in standards; covenants have been loosened in leveraged lending… There are a lot of holds. We should not feel the financial stability glass is full.”

I believe it was the market’s concern (rightfully so) that drove the large selloff at the end of last year. With the Fed acting as if they were on rate hiking autopilot, a painful recession and zombie killing field was all but assured if they had not changed course. But, they did, and here we are. The game is still going and may very likely go on for a while longer.

This is all rather big picture stuff. It may or may not be actionable in the near future. But it’s certainly something we need to be aware of because it will eventually matter and be actionable.

I’m still bullish the market but I do think the longer-term risk/reward is less positively skewed than it was just a few months ago.

There’s some deteriorating data that’s linked to the leveraged loan market as well as our zombie firms that will eventually cause a domino effect of economic pain should the data not reverse following the Fed’s easier stance. The two charts below are evidence front and center for this. We have the Fed Senior Lending Officer (SLO) survey showing banks are increasing the spreads on loan rates to large and medium firms (a reading above zero means lending conditions are tightening).

And the BAA/AA corporate bond spread has failed to reverse with our other indicators of financial/liquidity conditions. This tells me the market is finally starting to sniff out the brewing trouble we just discussed.

## A Tactical Short in Bonds

I was going to send out a note today where I dissect one of my favorite Bruce Kovner quotes and then get into how we can use Brier scores to make better probabilistically weighted market bets and combat two of our worst enemies, overconfidence and confirmation bias — the recent Invest Like The Best podcast with Michael Mauboussin dives into this (I highly recommend you give it a listen).

But, there’s a highly actionable setup triggering in the market so I figured I’ll put that note out to the Collective later this week and talk bonds and utes today.

The setup is for a swing trade. Specifically, for going short bonds (long bonds) and short utes (XLU). I’m neutral on US rates longer term. Actually, that’s not true. I think they’re probably headed lower (bonds higher) in the quarters ahead. Regardless, they’ve set up for a decent tactical short opportunity.

Starting with the 10-year. We can see that it’s pierced its upper weekly Bollinger Band near its 200-weekly moving average and then reversed. The highlighted bars show each time this has occurred over the last 3 ½ years.

Here’s a look at the same chart but on a daily. It’s also pierced its upper Bollinger Band on the daily timeframe and has completed a Demark 8-count.

Not only are bonds extended here but the copper/gold ratio is failing to confirm the recent trend. And as I wrote in Emergent Properties of the Market Collective the metals market tends to be the smarter of the two…

The technical setup looks even better on utes (XLU) — utilities tend to track bonds as the sector is extremely sensitive to interest rates. Check out the following weekly chart of XLU. It pierced its upper Bollinger Band then reversed and completed a weekly Demark 9 count last week.

The setup on the daily timeframe is similar.

A recent report by Sentiment Trader shows that just recently, more than 80% of utility stocks hit new 52-week highs. This is one of the sector’s most extreme momentum readings in three decades and tied for its second highest since 1990.

The following table from that same report shows just how hard it is for a defensive sector like utes to maintain this kind of momentum.

Here’s the following summary via Sentiment Trader (emphasis by me):

Across all time frames, utilities struggled to gain any amount, much less hold onto any gains that might pop up. Over the next 2-3 months, only two of the dates managed to show a positive return, and those gains were brief and ultimately erased.

The risk/reward ratio for the sector is one the worst for any study we’ve seen in 20 years. In a generally rising asset like stocks, it’s awfully rare to see a negative risk/reward ratio over a multi-month period, much less one shows as limited upside as this one, and such severe downside.

Bonds compete with stocks for capital flows. When stocks selloff, capital diverts to bonds in search of safety and vice-versa. The fundamental and technical picture still favors higher US equities, imo. A move up here in stocks should drive a reversal of some of the recent move in rates. This makes short utes/bonds a pretty good tactical short opportunity.

On an unrelated note, I’m currently working on the MIR (our monthly Market Intelligence Report). We’ll be focusing on two areas of the market that I’m most excited about; Ag and energy. There’s a number of trades to be made off these two macro themes. But there’s one that is actually a unique play on both. It’s an equity trading at low multiples of cash flow with a rock solid balance sheet and massive upside potential. I’m looking forward to sharing it with you and hearing your thoughts.

Only Macro Ops Collective members will receive access to my ag and energy trades. If you’re interested in checking them out be sure to sign up for the Macro Ops Collective by this Friday at midnight!

## A Golden Macro Opportunity

Yesterday, I talked about the massive vol compression I’m seeing across a number of major macro instruments —  most notably FX dollar pairs and gold — along with how these compression regimes set the stage for expansionary ones (i.e., Giant Macro Trends).

Here’s the chart of gold again which shows its volatility (as measured by the width of its monthly Bollinger Bands) recently hit ALL-TIME lows. The last time gold vol was anywhere close to being this contracted was in 2002, right before the yellow metal busted out the gates and ran for a decades-long bull market.

Now, compressed vol isn’t a bullish or bearish signal. It just means a big move is coming.

But one of the great things about compression regimes is that we can be directionally agnostic. A tight coiling market is the epitome of an inflection point. This means that we don’t have to discern any big macro narrative to try and guess where things are headed. We can just wait for the market to tip its hand and then play the cards…

With that said, let’s take a look at the gold market anyways and see what our data and indicators are telling us to see if we can get a jump on the trend.

We’ll start with another excerpt from Bigg’s Hedghogging. This time from his chapter on “Peter”. An investor that Bigg’s refers to as “the most knowledgeable gold analyst in the world”. Bigg’s writes (emphasis by me).

As he studied the literature, Peter focused on a long scholarly piece written in 1988 by Lawrence Summers (later secretary of the treasury and now president of Harvard) and Robert Barsky entitled “Gibson’s Paradox and the Gold Standard.” Summars and Barsky argued that the relative price of gold is driven by (and is the reciprocal of) the real rate of return from capital markets and that this relationship has strengthened since the price of gold was floated.

“Gold is a highly durable asset, and thus, as stressed by levhari and Pindyck (1981), it is the demand for the existing stock, as opposed to the new flow, that must be modeled. The willingness to hold the stock of gold depends on the rate of return of available assets. We assume the alternative assets are physical capital and bonds.” ~ “The Pricing of Durable Exhaustible Resources” The Quarterly Journal of Economics

Since 1988 the price of gold has had a negative 0.85 coefficient of correlation with the S&P 500 and an R2 of 72%. As things got crazier since 1994, the negative correlation rose to 0.94, with an R2 of 88%. In other words, the stock market explains 88% of the weekly price fluctuations of gold over the past eight years. The long-term correlation with Treasury bonds is not as high but still very significant.

As Peter explains it, the so-called problem with gold, which causes its erratic price behavior, is that “the elasticity of a positively sloped investment demand function overwhelms the inelasticity of supply.” I didn’t understand it either until he explained. You see, only 18% of the gold mined throughout history is held in investment form, or slightly more than \$200 billion. The investable capital markets of the world are estimated to be about \$60 trillion.

In a low return cycle for stocks and bonds, monetary and investment demand for gold turns positive, and there is a dramatic shortage of available metal. This large differential can only be solved by much higher prices. The point is that it is not inflation or deflation that is the principal driver of gold, but the return from other long-term financial assets, particularly equities. Peter’s model of this relationship is shown in Figure 19.1. As you can see, in times of bleak returns, gold beats everything else.

There are two key points to take from Peter (1) is that over the long run (and this is one of Dalio’s “principles” regarding gold, as well) the price of gold will approximate the total amount of money in circulation divided by the size of the gold stock and (2) it’s not “inflation or deflation that is the principal driver of gold, but the return from other long-term financial assets, particular equities.”

With that in mind let’s think about the world we’re in.

Is the total amount of money in circulation set to expand or contract in the coming years?

Well, the major central banks appear to be cornered into continuing easy monetary policy. The ECB effectively can’t reverse course and the Fed just announced they’re ending QT prematurely, are ready to cut rates soon if needed, and are willing to let inflation materially overshoot their target of 2%.

Then we have China who has the centenary anniversary for their glorious communist party coming up in 2021. This raises the odds that we’ll see them ease significantly in the second half of this year in order to pull their economy out of the doldrums and get things running hot in time for the celebrations.

Oh… Then we have the US running its largest non-recessionary fiscal deficit in peacetime plus Europe who’s about to see their biggest fiscal impulse in a decade. I, of course, could also mention the popular rise in MMT amongst Western policymakers, which essentially gives politicians the license to print. But I’ll save that discussion for another day.

Markets and their respective Game Masters (Central Banks and Governments) are still very much being influenced by the Event Echo of the GFC. An event echo is a:

Powerful psychological event (think crypto boom/bust or the GFC) that echos through time and affects the thinking and actions of the market for years. The 08’ financial crisis created a collective disaster myopia that is still prevalent today, 10-years on. This is not only noticeable in the psychology of market participants but also in the policymakers who pull the levers on the economy (ie, central bankers).

There’s a deep-seated fear around experiencing another deflationary “liquidity crisis” like the GFC. This fear will continue to drive the impulsive reaction function of creating ever more liquidity. This is bullish for gold.

What about the expected returns from other asset classes?

Here’s the 7-year asset class real return forecasts from GMO. US large cap stocks, which comprise the vast majority of global equity total market cap, have a projected real return  of -3.7% over the next 7-years. That’s not good…

It seems we have the two necessary ingredients for a major bull market in gold. These are (1) low expected returns for long-term financial assets and (2) a global money stock that is likely to keep growing (potentially by A LOT).

When we combine this with the current low vol regime + the textbook long-term inverted H&S bottom pattern forming, we get a clear trading opportunity.

There’s also positioning which remains relatively neutral considering the recent run up in price.

And TIPs, which had bearishly diverged from gold last year, have now completely reversed course and are now confirming the trend upwards in gold.

And finally, the gold/silver ratio has risen to levels that have marked significant bottoms every time over the last 20-years.

Looking at the tapes of a number of gold miners I can’t help but salivate. There’s a few stocks here that look ready to explode (I’ll share my preferred ones in a Trade Alert going out to Collective Members tomorrow).

One of my favorite historical figures, Miyamoto Musashi (the deadliest Ronin Samurai to have ever lived), wrote this about the importance of timing:

There is timing in the whole life of the warrior, in his thriving and declining, in his harmony and discord. Similarly, there is timing in the Way of the merchant, in the rise and fall of capital. All things entail rising and falling timing. You must be able to discern this. In strategy, there are various timing considerations. From the outset, you must know the applicable timing and the inapplicable timing, and from among the large and small things and the fast and slow timings find the relevant timing, first seeing the distance timing and the background timing. This is the main thing in strategy. It is especially important to know the background timing, otherwise, your strategy will become uncertain.

The background timing of the current macro environment tells us something big is coming, something that’s not yet fully known or fully discounted by the market…

This means some major trends are on the horizon. And along with major trends come major opportunities to profit.

Gold is just one area I see that’s ripe for exploitation. There are others which I’ll cover later this week.

If you want to see the exact gold stocks my team and I are interested in buying then check out the Macro Ops Collective.

## There’s a BIG Macro Move Brewing in Markets

A favorite market-related book of mine is Hedgehogging by Barton Biggs. If you haven’t read it, I highly recommend you do so. It’s excellent.

One of the many entertaining stories Biggs shares in the book is a conversation he has with a very successful Macro Fund Manager, named “Tim”.Tim shares with Biggs a key pillar of his approach to markets, which I’ve included below (emphasis by me).

Tim works out of a quiet, spacious office filled with antique furniture, exquisite oriental rugs, and porcelain in a leafy suburb of London with only a secretary. My guess is he runs more than \$1 billion, probably half of which is his. On his beautiful Chippendale desk sits a small plaque, which says totis porcis—the whole hog. There is also a small porcelain pig, which reads, It takes Courage to be a Pig.” I think Stan Druckenmiller, who coined the phrase, gave him the pig.

To get really big long-term returns, you have to be a pig and ride your winners… When he lacks conviction, he reduces his leverage and takes off his bets. He describes this as “staying close to shore… When I asked him how he got his investment ideas, at first he was at a loss. Then, after thinking about it, he said that the trick was to accumulate over time a knowledge base. Then, out of the blue, some event or new piece of information triggers a thought process, and suddenly you have discovered an investment opportunity. You can’t force it. You have to be patient and wait for the light to go on. If it doesn’t go on, “Stay close to shore.”

The last few weeks I’ve been writing about the abnormally low volatility we’re seeing across a number of major macro instruments.

Implied volatility in the major FX pairs (ex. GBP) is near ALL-TIME lows.

Volatility in gold as measured by the width of its monthly Bollinger Band is at levels last seen over 17-years ago, in 02’ right before the barbarous relic began its decade-plus run.

Markets tend to work like rubber bands in a way. The tighter they’re wound up, the more explosive they unravel. In other words, compression regimes lead to ones of expansion. And the size and velocity of the move often mirror the preceeding level of contraction in vol. There are logical reasons for why this occurs (it has to do with positioning and narrative cascades).

The current level of compression suggests something big is coming around the corner. As macro traders, it’s regimes like these where we need to be at the ready. An explosive macro trend is about to be born. Quite likely, multiple ones…

It might soon be time to go Totis Porcis.

Tomorrow I’ll be sharing a write-up on one of these potential major macro trends I’m looking at.

If you want to trade right alongside me when I go whole hog later this year then check out the Macro Ops Collective. I’m extending the enrollment period until this Friday because a number of you missed the deadline and still wanted in. There’s a TON of opportunity on the horizon and I don’t want anyone to miss out.

## Yield Curve Inversion: Why This Time is Different

It’s happened…

The 10yr/3m yield curve has inverted. The party is over folks. Sell your stocks, horde your cash, pack your bags and go home. Recession is imminent…

The mainstream financial news and twitter “market experts” have nailed it. The top is in.

It’s nice knowing that calling a recession is this easy. There’s really nothing to this game. Buy the dip when the curve is positive and sell when it inverts, sidestepping a recession and bear market. It’s so easy your grandmother could do it.

Alright, enough of the sarcasm.

You can probably tell that I don’t quite agree with the above sentiment. Last time I checked, investing and calling macro tops isn’t quite so simple.

Let me give you a different interpretation.

First, I’ll explain what an inverted yield curve actually means. Then I’ll lay out why there’s almost certainly more upside in stocks (much more). And then I’m going to use the four dirtiest words in finance to explain why context matters in this game, especially now.

So what does an inverting yield curve actually mean? And why is it an excellent predictor of recession (though not omnipotent)?

I’ll tell you.

The yield curve reflects the pricing of bonds (and inversely their yields) from the front end rate which is set by the Fed all the way out to the long end of the curve, which is set by the market. Obvious, I know.

The yield curve shows us how interest rates are being discounted through time; from the present to decades out into the future.

It’s important because all assets are priced off this curve.

When the front end interest rate, which is set by the Fed, rises faster than what the long end is pricing in (ie, it flattens and/or inverts), it impacts markets and the economy in two ways (1) it has a negative present value effect on asset prices and (2) the flatter/negative curve causes a constraint on lending as well as the broader economy.

The first one is simple. When front end rates become equal to or exceed those of longer end interest rates, moving out of duration assets and into cash/cash-like instruments makes sense (why take on duration risk when you don’t receive compensation for doing so). This applies to stocks as well, as stocks are essentially long-duration assets.

The second part refers to how the curve — the spread between front end and long end rates — sets the price of money, and therefore incentivizes or de-incentivizes lending in the real economy. Here’s the following from Hedge Fund manager Ray Dalio, writing in his book Big Debt Crisis on the subject:

Typically, in the early stages of the top, the rise in short rates narrows or eliminates the spread with long rates (i.e., the extra interest rate earned for lending long term rather than short term), lessening the incentive to lend relative to the incentive to hold cash. As a result of the yield curve being flat or inverted (i.e.. Long-term interest rates are at their lowest relative to short-term interest rates), people are incentivized to move to cash just before the bubble pops, slowing credit growth and causing the previously described dynamic.

Early on in the top, some parts of the credit system suffer, but others remain robust, so it isn’t clear that the economy is weakening. So while the central bank is still raising interest rates and tightening credit, the seeds of the recession are being sown.

The fastest rate of tightening typically comes about five months prior to the top of the stock market. The economy is then operating at a high rate, with demand pressing up against the capacity to produce. Unemployment is normally at cyclical lows and inflation rates are rising. The increase in short-term interest rates are rising. The increase in short-term interest rates makes holding cash more attractive, and it raises the interest rate used to discount the future cash flows of assets, weakening riskier asset prices and slowing lending. It also makes items bought on credit de facto more expensive, slowing demand. Short rates typically peak just a few months before the top in the stock market.

There’s also a market/Fed disagreement component to a flattening/inverting yield curve which is where the signaling comes from.

When front end interest rates (which are set by the Fed) rise above long end rates (which are set by the market) it essentially means that the market disagrees with the central bank. The market is saying that the Fed has gotten ahead of itself and will soon have to reverse course (cut interest rates) due to slower growth and inflation in the future. That’s why investors take on duration even when it’s offering an equal or lower yield than the front end; they expect yields to continue to trend downwards.

I’ll explain in a bit why the dynamics of this have changed and why the signaling quality of the curve has deteriorated due to some very explainable reasons.

Before we get to that though, I want to show you quickly why even if the recession signaling value of an inverted yield-curve hasn’t been distorted, it’s still no reason to panic over the short-to-intermediate term.

The reason being is that the curve tends to invert well before a recession and depending on which specific curve you’re using, long before a market top as well. See the 10yr/3m curve chart at the top. It inverted years before the last two market tops.

The graph below shows that the standard 10yr/2yr yield curve has inverted on average 19-months before a recession, going back to 1968, whereas a top in the SPX has preceded recession by only an average of 7-months.

The 10/2yr curve hasn’t even inverted yet.

This chart via Sentiment Trader shows that the return picture following curve inversions is on balance positive going out to two years.

Okay, so maybe take the rising calls for recessionary doom and gloom with a shaker of salt.

More importantly, let’s talk context, which is something that so many market commentators seem to not care about.

There have been two very important changes this cycle that make present-day conditions unique and the signaling value of the yield curve diminished. Yes… I’m saying This Time is Different.

I know, I know, you’re never supposed to utter those words in finance. But excuse me if I think that’s the most overused lazy and abused adage in this game. The truth is, it’s always different this time. No two cycles are exactly alike. So, yes, we still have to use our little monkey brains to try and understand what things like yield curve inversions mean in the context of present-day reality.

Following the GFC new financial regulations (ie, Dodd-Frank & Basel III-IV) were enacted to ensure a more robust and resilient banking system during times of significant market stress. One of the many byproducts of this new regulation is the liquidity coverage requirement (LCR) which requires financial institutions to hold a certain amount of high-quality liquid assets (HQLA) that’s sufficient enough to withstand a significant stress scenario.

What this means in practice is that banks have to hold a higher level of HQLAs (ie, sovereign bonds) than before. When you couple this with the need for duration matched assets from pension funds and insurance companies in a world where there’s \$10trn+ in negative yielding developed market debt, we get price blind buyers for bonds. And when you have price-insensitive buyers (institutions who buy because they have to) well, the impact on that market’s signaling value should be obvious.

This has never been the case before in past cycles. This is why the yield curve may not serve as much of a valuable recessionary signal as it used to in the past. This is why THIS TIME IS DIFFERENT.

Then there’s the second and more recent change, which is within the Fed itself.

Fed Watch Tim Duy wrote in Bloomberg about the Fed’s recent and total about-face, writing (emphasis by me):

It is hard to understate the importance of this shift. The Fed’s models haven’t worked this way in the past. In previous iterations of the forecasts, the expectation of unemployment remaining below its natural rate would trigger inflationary pressures. To stave off those pressures, the Fed perceived the need to raise rates above neutral to slow the economy enough to nudge unemployment upwards. Now the Fed believes it can let unemployment hold persistently below the natural rate without triggering inflation and without Fed policy becoming restrictive.

Duy goes on to note that, “The Fed apparently has finally realized that persistently low inflation remains a problem.” And “to avoid the problems of the zero lower bound for as long as possible, the Fed needs to ensure that inflation stays sufficiently high to hold expectations at its target and that they act to avoid a recession. The policy implication is that they need to err on the dovish side.”

In practical terms, this means that the Fed has essentially thrown out the models that it’s relied on in past to help make interest rate decisions. Jerome Powell and team are making it clear that they need to see an actual and sustained spike in inflation before raising interest rates. And they’re willing to cut rates and even resume QE to get there, even at near full employment and stable growth.

This is a BIG deal. The Fed has learned some lessons from past cycles and doesn’t want to kill the party. So why fight the Fed?

I sure don’t want to.

Okay, so far I’ve explained what an inverted yield curve typically means along with why things are different this time. I’ve also laid out why context always matters and why one should never just lock onto a single input and form a market view. We want to put as many pieces together in our market puzzle. And most importantly, we need to be weighing the data we see against what’s already being priced in.

We need to always be asking ourselves: What’s part of the common narrative and what is the market blind to?

So let’s play the common knowledge game.

Everybody knows that the yield curve is inverting. And everybody knows what this historically has meant (hint: the news headlines at the start of this piece).

Everybody also knows that global growth has been slowing, for a while now. NDR’s Global Recession Probability Model (via CMG Wealth) shows that much of the world has been in recession since the latter part of last year.

Most global markets are already reflecting this. Take Europe for example where German equities are trading at 50-year lows relative to the US. And emerging market stocks spent all of 18’ in a gut-wrenching bear market.

It seems to me that there remains a pretty low bar for the global economy to clear in order to cause a shift in the popular market expectations.

There are a number of catalysts which could this.

We have the coming 100-year anniversary of the Chinese Communist Party which we believe the CCP will want a strong economy for. In which case, they’d likely have to start easing significantly in the second half of this year.

There’s also a potential for the trade war to get settled. We are entering election season after all and the President has made it pretty clear how important the stock market’s performance is to him.

And then there’s also the little-noticed changes going on at the margins which I’ve been discussing recently.

There’s the possibility that the atrocious econ data in Europe bottoms soon. At least for a while. After all, we are about to see the biggest fiscal boost our of Europe in a decade (charts via MS).

And European dataflow is already beginning to slowly improve.

Turning to the US, we are seeing some slowing growth. But our confluence of recession indicators are not flashing red, as of yet.

The labor market is still strong and signs of financial stress remain mum. Our liquidity indicators are all miles away from indicating recession and in fact, are very supportive of risk-assets moving higher.

NDR’s Credit Conditions Index (via CMG Wealth) shows that credit conditions are near cycle highs and a loooong ways off from signaling recession.

I understand that this may not be a very popular take — which means it’s more likely to be true — but I think the current macro conditions continue to set up to be extremely bullish for stocks. Note that I say stocks and not the economy. Remember, the two are not the same.

Trading legend Bruce Kovner once remarked that “As an alternative approach, one of the traders I know does very well in the stock index markets by trying to figure out how the stock market can hurt the most traders.”

Fund manager cash holdings are the highest they’ve been since January 09’.

Their allocation to equities are at some of the lowest levels this cycle.

So, let me ask you… Where is the pain trade? Higher or lower?

I think it’s pretty clear where I think it is.

On December 18th of last year. When the market was in total panic. I wrote the following.

The following week, on December 24th. The day before the very low of the selloff was reached, I sent this out in a note.

I’m not trying to gloat here. I get things wrong ALL the time and don’t mind doing so. That’s not the game I’m playing. I’m playing the game of making money, not being right.

But I show this to prove a point. When I wrote the above I was ridiculed. I got emails and comments from readers saying what a “sheep” I am and how I was about to get steamrolled and yada yada yada…

I personally love this kind of feedback to my work. It means I’m onto something. I have a feeling this piece will invoke similar cries of hysteria. Especially when the market moves a little lower in the week(s) ahead.

The market will be talking about the yield curve inversion, collapsing growth, and a coming recession. But I’ll be focusing on flush liquidity, a solid Fed put, and a normal technical pullback that was easy to spot (see chart below showing semis on the weekly piercing their upper BB. A move back down to around the orange line is expected).

While most will be selling into the hole, we’ll be looking to add to our risk in a number of areas of the market where we see extraordinary asymmetric opportunities.

So, yeah… This time IS different and the world probably isn’t coming to an end. If you’ve been offsides on this year’s face-ripping rally then you may want to use the coming small pullback as a chance to get back in.

Everybody else will be shorting into the hole…

I’ll be updating this yield curve narrative weekly inside of the Macro Ops Collective. If you would like to see how my team and I are positioning into the summer click the link below to join our premium community.

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I hope to see you in the Collective. Just click the link below, and scroll down to the bottom of the page to join our amazing community of macro traders from all around the world.

## Shippers: The Most Bombed Out Sector of the Market

Sir John Templeton used to quip that “People are always asking me where the outlook is good, but that’s the wrong question… The right question is: Where is the outlook the most miserable? Invest at the point of maximum pessimism.”

If you want deep value and a wide margin of safety then you have to be willing to venture where others won’t. Maximum pessimism is what creates the asymmetric bets where the risk then becomes time and not price, as Richard Chandler puts it.

Looking across global markets today there is perhaps only one industry that fits this bill. Where the outlook is beyond miserable and the stocks within it have either been dismissed by investors or just outright forgotten all-together.

I’m of course talking about marijuana stocks…

Just kidding. No. I’m talking about the shipping sector.

Take a look at the following charts showing the prolonged grinding drop in shipping rates.

The Harpex Shipping Index has been in a steep rolling bear market for nearly a decade and a half.

The Baltic Dry Index is down to 645. It’s only been lower three other times in the past 35-years for which we have data. Once in 1985, then in 2015 and again in 2016.

Price action drives sentiment which in turn drives price action in a perpetual feedback loop. A decade plus of falling prices and negative investment returns has created a pretty fatalistic consensus towards the industry — which has, in turn, led to some pretty amazing prices…

Many shipping stocks now trade for less than half their liquidation value. And that’s using sale prices in the fairly active second hand purchase market.

This means that companies could liquidate their fleets and after paying off debt there’d be enough leftover cash that equity holders would more than double their money.

So to sum things up, we have (1) maximum pessimism which has driven (2) bargain prices which creates (3) a large margin of safety.

That’s pretty good, but now we need a catalyst.

The shipping industry is a notoriously cyclical industry which follows the classic Capital Cycle. Martin Stopford’s excellent book, “Maritime Economics”, notes that there’s been 23 shipping cycles going all the way back to 1743. Timing here is key. We don’t want to sit in a dead money trade for another 5-years when our capital could be going towards something that’s actually working for us.

Luckily, there’s a number of potential catalysts lining up that could make 2019 the year that the trend finally changes. These are:

• A one-two regulatory punch
• New banking regs leading to tighter financing and thus lower supply
• Capital Cycle: supply and demand in deficit
• China/India starting to buckle down on fighting pollution which means they need to import cleaner industrial fuel imports (ie, more shipping demand)

Last year shipping companies were forced to begin installing costly ballast-water treatment systems, thus raising the operating costs on an already struggling industry. And by next year, shippers will have to adhere to IMO 2020.

IMO 2020 is a new global regulation aimed at reducing airborne sulfur pollution by requiring shippers to reduce the sulphur limits in their fuel from 3.5% to 0.5%. There’s a number of ways for companies to reduce their sulphur output and all of them are bullish for the shipping industries’ supply and demand dynamics.

For instance, shipping companies can install scrubbers that will reduce the sulphur from burning bunker fuel. But, these scrubbers are expensive, which means less capital to deploy towards ordering new ships and paying down debt. Also, installation will require significant dock time which means there’ll be less ships on the water, which means a tighter supply market.

Another option, and this is likely to be the more popular one, at least initially, is for shippers to switch to low-sulfur marine gasoil.

But the issue here is that even with no change to the current pricing conditions, switching to marine gasoil will represent a substantial increase in fuel costs and fuel costs already make up the largest portion of a shipper’s operating costs.

According to Wood Mackenzie, shipping industry fuel costs could increase by \$60bn next year. This would represent a jump in fuel expenses of around 50%.

In order to economize on fuel costs, ship charterers are likely to begin slow-steaming ships. Here’s the following on what this will mean from S&P Global Platts (emphasis by me):

The simplest way to curtail costs would be to reduce consumption via reducing speed.

Reducing speed from 12 knots to 10 knots would effectively remove 17% of dry bulk shipping supply overnight,” it said.

Ships older than 15 years of age, comprising about 142 million dwt or 17% of the existing fleet would come under maximum pressure and would become ideal candidates for scrapping, as their older engines are not able to burn LSFO.

In 2020, you are going to have a supply shock either through slow steaming of the entire fleet or a combination of scrapping of some of the older ships and the balance of the existing fleet slow steaming,” it said.

Then we have new banking regs.

Basel IV bank regulations mean that the traditional sources of financing for the shipping industry (ie, the credit they use to order more ships) are no longer available.

Under Basel IV, bank’s have to account for the volatility of the asset being loaned against. And, well, shipping is pretty volatile. This means that shipping loans are becoming more capital intensive. Gone are the days of 90%+ loan-to-value construction finance which led to the glut of yore. Now, many new vessel orders require over 30% in equity financing.

European banks, which have long been the primary lenders to the industry for the last 100-years or so, are either drastically reducing their loan books or exiting shipping finance all together.

Bear markets are always the authors of bulls. And it’s for reasons like the above as to why tight financing effectively means tight future supply and tight future supply means higher prices.

And this brings us to our next catalyst: The Capital Cycle.

Dry bulk shipping is an extremely capital-intensive business. With over 10,000 ships, each with an average 25-year lifespan, somewhere between 300-500 new vessels need to be built each year just to counteract natural attrition. That’s not even accounting for growth in demand.

According to Clarksons Research, the global bulk fleet is expected to grow by just 2.2% this year.

This will make 2019 the third consecutive year in which demand growth outpaced the growth in supply, putting the market in deficit.

And by the looks of the current orderbook, this deficit looks set to continue. The current orderbook at just 11% of the fleet, is at its lowest levels since the early 2000s. It takes approximately 2-years from the time of order for a ship to be delivered. So this means that a supply constrained market is practically guaranteed going forward.

And lastly, we have the growing importance of combating pollution in emerging markets.

Following China’s recent “Two Sessions”, Li Ganjie, the Minister of Environment and Ecology, declared that “It is necessary to maintain the strength of ecological and environmental protection” and there must be “no wavering, no relaxing” according to Trivium China. Li went on to say that four sources account for over 90% of particulates, with industrial emissions and coal burning the two worst offenders.

The industrial emissions are largely attributed to China’s dirty steel mills. These mills use iron ore that has a high sulphur and ash content. Recent changes in policy will require mills to use less pollutive materials going forward. This means that China will have to import “cleaner” industrial fuel sources (ie, iron ore and coal) from far away places, such as Brazil and Australia.

This is important because iron ore and coal account for over half of the global dry bulk trade (29% and 24% respectively). According to shipbroker Banchero Costa, “China remains very much at the centre of the action, estimated to account for 70 percent of global iron ore imports and 41% of the dry-bulk market all-together”.

Just to show you the outsized impact China has on the shipping market, see the chart below showing Chinese iron ore imports (orange line) and the Baltic Dry Index (blue line).

So the requirement for cleaner industrial fuels is a positive. But this chart also reveals the shipping industries’ achilles heel. China.

Where Chinese iron ore imports go, so too will the shipping industry.

And that’s where the near future for shipping stocks becomes less certain.

I’ve been writing for the last year about how China is slowing down. This slower growth is clearly visible in the data.

And this is putting downward pressure on global trade; hence the recent collapse in the Baltic Dry Index.

But I’m also expecting China to begin pump-priming its economy for the 2021 centenary anniversary of the Communist Party in the second half of this year.

If that happens, then we should get a buoyed global market combined with a structurally tight shipping industry; one that appears to be rising from the trough of the capital cycle.

Throw in the secular rising demand from India crossing the Wealth S-curve and brighter days should be ahead for the industry.

If this ends up being the case then there’ll be oodles of money to be made. Not only do we have bargain bin prices currently but these companies also benefit from high operational gearing.

Shipping companies have extremely high fixed costs, so even a tiny uptick in charter rates flows directly through to their bottom lines. Plus, any upturn in the cycle will raise the value of the underlying fleets which are trading at depressed values. This kind of operational gearing combined with the currently low stock prices means that some of these shipping companies could earn their entire market cap in a single year once cash flows mean-revert.

This is why bull markets in shipping tend to be incredibly explosive.

Shakespeare once wrote that:

There is a tide in the affairs of men, Which taken at the flood, leads on to fortune. Omitted, all the voyage of their life is bound in shallows and in miseries. On such a full sea are we now afloat. And we must take the current when it serves, or lose our ventures.

Shippers undoubtedly have the most miserable outlook. Over a decade of falling charter rates has birthed maximum pessimism, which has led to depressed prices (read: amazing values). Now we have a tight supply market and a turning capital cycle, with a number of structural changes that will ensure it stays this way. China is the big unknown, but it always is. Buying positive FCF producing shippers for less than half of NAV gives us a reasonable margin of safety where our only risk is time, not price.

We’re going to put on a starter position in a basket of shippers. Look for a trade alert with further info soon.

Time to leave the shallows and take the current

## Bear Markets and Liquidity Conditions

Credit spreads have narrowed significantly since the beginning of the year. Check out the graph below via Citi Bank.

Credit spreads and stocks move together because all market moves are governed by liquidity conditions. When liquidity conditions tighten (credit spreads widen) the cost of capital goes up, and therefore the returns investors receive in equities relative to other assets looks less attractive.

It’s important to stay in tune with liquidity conditions because that’s how you give yourself a chance to actually time the market. Stanley Druckenmiller earned his breathtaking track record by paying close attention to liquidity in the financial system. (Quote below)

I never use valuation to time the market. I use liquidity considerations and technical analysis for timing. Valuation only tells me how far the market can go once a catalyst enters the picture to change the market direction.

Central banks around the world have been easing significantly since the start of the year, injecting liquidity into what was a panicked market back in December.

And because of this the Dow has rallied almost 4000 points this year! Until liquidity conditions tighten up again we remain bullish and in sync with liquidity flows. Shorts must use extreme caution until liquidity conditions deteriorate again.

## The Fed Put Is Real and China Stimulates

In our December MIR titled Genghis John and Building Snowmobiles during the midst of the market rout I wrote the following noting the key macro variables we didn’t and couldn’t know at the time:

• We can’t predict with high certainty exactly how the Fed will react to slowing global data ex. US
• We can’t predict if/when China will attempt to reflate its economy with another massive credit injection
• Rising geopolitical tensions bring greater risks and unknowns. We don’t know if the trade war will escalate significantly (though recent signs indicate it will) or if other events will conspire (such as a Russian invasion of Ukraine).

Here’s a chart of the Russell small-caps index I included in the report along with our thoughts on where the market was headed.

Much has happened since those early volatile December days. The market sold off and bounced off key support as we expected.

And we’ve received some answers to two of our three previous ‘unknowns’ (1) The Fed’s response to slowing global growth and (2) if/when China would stimulate.

The answer to our question of if/when China would stimulate and by how much ended up being “now and by A LOT”.

Chinese credit data for the month of January just hit and the numbers are… how do you say… impressive?

January was a gargantuan month for credit creation in China.

Total Social Financing in January was the largest monthly liquidity injection as a % of GDP on record. That one month is equal to nearly a quarter of the total credit creation for ALL of last year and makes for a 51% increase over the year prior.

Here’s another look at the data. The orange line shows that credit growth in the shadow banking sector is still contracting (though, the contraction even seems to have stalled somewhat). The red line shows the recent hockey stick turn in total credit creation.

I’ve been writing for the last few years about how China is THE most important macro variable this cycle. The reason why is shown in the chart below.

China has undeniably been the global growth workhorse this cycle having helped staved off crushing global deflation with its incredibly large and reliable injections of credit at the nearest hint of slowing growth.

The last time China injected anywhere close to this amount of credit was at the start of 16’. That shot to the arm defibrillated the global economy back to life and sent markets on a 2-year near volatility-free money printing uptrend.

Should we expect the same thing again? Are we about to embark on another emerging market (EM) led bull? Is it time to mortgage the house and dump the proceeds into some EM high-fliers and then just kick back and wait to cash out?

Not so fast Kemosabe…

We have to look under the hood of this credit data to get a better grasp on what’s really going on. And when we do that, we find that the stimulus is not all it’s cracked up to be.

First, the January numbers were inflated due to seasonal issues. The Chinese New Year fell earlier in the month of February than the previous year which meant banks were giving out more loans in the weeks of January leading up to the holiday.

Secondly, the financial derisking campaign began in earnest at the end of 17’. Because of this, last year’s new credit numbers were abnormally low which means there was a very low base effect for this year.

Thirdly, the PBoC pointed out themselves that the credit growth numbers for the month were aided by a slowing pace of contraction in the shadow banking sector. Authorities are still very much focusing on dismantling the off-balance sheet Godzilla they’ve spawned, so it’s unlikely January will mark a major turning point in the trend in shadow banking credit growth.

And fourthly, it appears the vast majority of January’s credit growth was due to a one-off jump in banker’s acceptances and bill financing (short-term loans). This is not indicative of a shift to long-term credit growth. In fact, Premier Li Keqiang went out of his way this past week to drill home the fact that the party isn’t going to repeat the massive credit stimulus playbook of times past. Li said (via Trivium China):

I reiterate that the prudent monetary policy has not changed and will not change. We are determined not to engage in ‘flood-like’ stimulus.”

So while January’s credit data isn’t nothing. It’s notable. it’s just not quite ‘flood-like’ and certainly not as impressive as many market participants seem to be thinking it is.

There’s typically a 6 to 9 month lag between stimulus and its effects being felt throughout the real economy. As of now, there’s no sign of the data improving.

The current extent of China’s slowing may surprise some given the number of other stimulative measures the CCP has enacted over the last year (ie, tax and rate cuts). But this should be expected when you have an economy like China’s that’s hit the end of the Gerschenkron Growth Model, is straining under its debt burden, and is riddled with unproductive assets.

If the latest round of credit growth is enough to right the ship or is a precursor to a continued ‘flood-like’ stimulus then we should soon see it reflected in the data. The primary one being M1 money supply growth (new net credit growth should lead to deposit growth). See the big jump in M1 in 2016 during the last credit injection? Well, nothing similar yet. M1 growth is still sitting at multi-decade lows…

Before moving on, I’d just like to reiterate that we should expect China to continue to slow — at least until they really hit the classic stimulus button leading up to the Party Centennial in 2021 which I expect will happen in the second half of this year — but we shouldn’t expect a crisis. Here’s one of my favorite economists, Michael Pettis, explaining why:

Paradoxically, too much debt doesn’t always lead to a crisis. Historical precedents clearly demonstrate that what sets off a debt crisis is not excessive debt but rather severe balance sheet mismatches. For that reason, countries with too much debt don’t suffer debt crises if they can successfully manage these balance sheet mismatches through a forced restructuring of liabilities. China’s balance sheets, for example, may seem horribly mismatched on paper, but I have long argued that China is unlikely to suffer a debt crisis, even though Chinese debt has been excessively high for years and has been rising rapidly, as long as the country’s banking system is largely closed and its regulators continue to be powerful and highly credible. With a closed banking system and powerful regulators, Beijing can restructure liabilities at will.

Of course, this doesn’t mean that China has found the secret to defying the basic laws of economics and can just continue to stimulate its way to perpetual prosperity. There’s a cost to everything and a crisis is only one way the bill comes due. And in fact, the other payment method can be much more costly. Here’s Pettis again:

Contrary to conventional wisdom, however, even if a country can avoid a crisis, this doesn’t mean that it will manage to avoid paying the costs of having too much debt. In fact, the cost may be worse: excessively indebted countries that do not suffer debt crises seem inevitably to end up suffering from lost decades of economic stagnation; these periods, in the medium to long term, have much more harmful economic effects than debt crises do (although such stagnation can be much less politically harmful and sometimes less socially harmful). Debt crises, in other words, are simply one way that excessive debt can be resolved; while they are usually more costly in political and social terms, they tend to be less costly in economic terms.

It’s likely that China will go the way of Japan in the 90s and Russia in the 70s. This means decades of stagnation and low single-digit growth as the country gives back its share of world GDP and gets stuck in the middle-income trap.

Moving onto our second unknown: how will the Fed respond to slowing global growth?

And this was the correct move, in my opinion. Powell and team had let the market assume too much of an inflexible stance regarding rate hikes and balance sheet runoff, hence the market volatility in December. Jay and the FOMC have been walking those expectations back and in this, they’ve done a good job.

Fed watcher Tim Duy summarized the FOMC’s stance perfectly, writing:

The Fed made a dovish shift, declaring that they are on the sidelines for the time being. Given that they seem to believe the downside risks are more prevalent, it is reasonable to think the bar to easing in the near term is much lower than the bar to hiking. Importantly, it looks to me that the Fed has shifted gears well ahead of any recession; then did not invert the 10-2 spread and then keep hiking as typically occurs ahead of a recession. A flexible Fed and the lack of inflation was always a saving grace for the economy. The Fed may have just pushed back the next recession. If so, expect everyone who expects an imminent recession to “blame the Fed” when that recession fails to emerge.

Jerome Powell said, “I would want to see a need for further rate increases, and for me, a big part of that would be inflation.” This means that the Fed is on standby with rate hikes until either inflation begins to perk up or — and this is just my take and wasn’t explicitly stated by the Fed — the market begins to run hot again and the Fed wants to cool risk-taking.

The market has responded by driving rate expectations lower (yellow line depicts the latest Fed Funds curve). And if anything, it’s now overpricing the downside risks to rates.

It’s not just the US Fed but central banks globally have pivoted from being in the aggregate hawkish to an easier stance.

The US Fed and central banks, in general, have shown themselves to be very responsive to the economy and the market. Some say that central banks have no mandate and therefore no business to be paying attention to the gyrations of the market. This type of thinking misses a key point regarding the reality of our modern economy and that’s the financial deepening in Western countries, especially here in the US.

You see, secular declining interest rates and inflation coupled with financial ‘innovation’ has led to a boom in consumer and corporate credit versus just 40-years ago. This has resulted in a financial deepening, or the financialization rather, of our economy.

This means that the financial economy is many times the size of the real economy. This financial economy is vulnerable to changing interest rates and widening credit spreads resulting from market volatility, more so than the real one. And because of its large relative size, pain in the financial economy can quickly transmit into pain in the real economy. Thus it’s become an important variable in the Fed’s mandate.

This is why we should expect the Fed to continue to error dovish when either the economic data begins to suggest downside risk is mounting or fear drives the market down to much. In a sense, the Fed put has now become real.

Where does this all leave us?

Let’s summarize what we’ve found so far:

• The Fed has shown itself to be very responsive to the economic data as well as the market. The Fed is no longer a headwind for risk assets and we should expect the Fed to respond in kind to market volatility due to the financialization of our economy.
• China has hit the stimulus button but the actual impact will likely be much less than the perceived size of the credit boost on the surface. We’ll have to keep a close eye on M1 growth but expect data out of China to continue to slowly weaken while the PBoC and CCP manage a gradual slowdown. Look for the real credit stimulus to come sometime in the second half of the year as they gear up for their run into 2021 Party centennial.

I hope this note brings everyone up to speed on the dominant macro narrative of the market.

## A Macro Update And My Stock Shopping List For 2019

Special Announcement — Macro Ops Collective Deadline Extended!

We got a flood of emails on Jan. 1 from many of you saying you missed the deadline this week for the Collective because of vacation and other holiday commitments.

We have decided to extend the Collective enrollment deadline until this Friday, January 4th at 11:59PM EST. So if you missed the first window, now is your last chance. After Friday, the Macro Ops Collective will no longer be available for \$179.50 a month.

Today’s Note and Stock Shopping List

Hope everyone is recovering well from their New Years celebrations and ready to dive back into markets for the year.

Just wanted to share with you some quick thoughts on the market, the dollar, and gold. And then at the end, I’ve got our Stock Shopping List with our favorite names that we’re looking to begin buying over the coming weeks.

Alright, let’s jump in…

The S&P 500 is trading higher off a short-term bottom. We should see it run up into the 2,600+ range — its 50-day MA acting as an attractor (red line) — but as I note on the chart below, the market is going to bump into significant resistance here. There are a lot of players who bought into this range that are underwater and who will look to close out their positions for break even once price climbs back to these levels. This is called a supply overhang.

With large supply overhangs like this, it typically takes the market a number of attempts before it can break through and move to new highs. The supply needs to be worked off and so I’d expect to see a reversal around the 2,650-75 range followed by a selloff to recent or even new lows — double bottoms are typically the pattern we see after large selloffs like these.

This action will also help to reset that last bit of stubborn sentiment I pointed to in last week’s

Last week, I tweeted this about gold.

Here’s a closer look at the chart. Gold is now at a major make or break inflection point (chart below is a weekly). If it’s turned away and closes lower for the week then that sets it up for a good sell signal.

For those of you who are new to the group, I view gold as a reflection of global relative demand for USD assets (ie, the relative attractiveness of USD assets such as stocks, bonds, and the dollar versus the RoW). This is why gold trades in lockstep with relative equity momentum of EM vs. US equities.

The RoW is currently seeing slowing economic growth while growth in the US remains relatively strong. This higher growth is driving higher real rates in the US. The below chart shows the widening gap between the inverted yield on TIPs (the real yield) and gold. We should see this gap close with gold going lower.

I’ve also commented in the past about how platinum often leads gold. The current gap between the two metals should be concerning for gold bulls (red lines is platinum and black is gold).

One thing to note is that January tends to seasonally be the strongest performing month for gold (chart via Commodity Seasonality). You don’t ever want to trade off seasonality alone but it’s something to keep in mind. I think after the unusually strong December month for the yellow metal that perhaps that performance was pulled forward. In any case, let’s watch gold closely. A weak weekly close will set it up for a high R/R short opportunity.

And then we’ve got the dollar.

Last week I noted (link here) how the divergence between gold and the dollar and how gold often leads the dollar at turning points. The key word there is often, as in not always. That relationship may or may not hold this time around. So stay open minded and flexible.

The EURUSD might be seeing a key reversal day today. We’ll need to see if it holds into the close. The aussie is also making new lows against the dollar. Ultimately, we want to be short both pairs against USD.

The reasons why we want to be long the dollar against the euro and the aussie are pretty much the same for both. When looking at currencies we want to look at: rate differentials, growth differentials, relative equity momentum, and positioning.

Capital flows to where it believes it will earn the highest risk-adjusted return. Both Europe and Australia have large exposure to China — which just printed its first contraction in PMI since May of 17’ — while the US economy is more insulated to slowing Chinese demand.

Looking at the euro (though same holds true for the aussie) we can see that relative financial stock performance between the US and Europe favors a much lower euro. Financials trade off growth and rate expectations which is why this is a key indicator to track for currency pairs as the relative financial stock performance almost always leads.

The most important rate differential to track is the real (inflation-adjusted) 10yr yield. The current difference in rates also suggests we’ll see a much lower euro.

Relative total stock and bond performance favors a much stronger dollar versus the euro.

And the trend in relative economic growth favors a much lower EURUSD pair.

The short-term bear case against the dollar is just that positioning and sentiment remain somewhat crowded to the long side, though much of this has been worked off and is now less of a headwind. And then, the gold divergence which I mentioned above and which is hardly an iron-clad heuristic.

Technically, EURUSD remains in a tight coil resting on significant support in its 200-week moving average. This is around the spot 1.13 level. If we see a weekly close below this level then I think it’ll be high-time to load up on short EURUSD. But, until then, we’ll patiently watch the dollar pairs from the sideline.

Now onto our Stock Shopping List.

BlueLinx Holdings (BXC)

The best risk/reward opportunities are typically found in stocks that don’t screen well. This is due to the rise of quants along with the free and wide access to a plethora of various screeners and algorithmic stock ranking systems available to any and all. Because of this, any obvious quantifiable mispricing quickly gets repriced in the market. Long gone are the days when buying a stock just because it has a low PE made you money.

Now, the best opportunities are in stocks that are mispriced because their true value is distorted and disguised by the popular GAAP accounting numbers and ratios that people typically look at. If you’re interested in reading more on this then check out our

BXC is one of these stocks.

The company is a wholesale distributor of building products with distribution centers across the Eastern US. Previously, BXC served as the captive distribution arm of Georgia Pacific (GP) which is the country’s largest producer of plywood. In 2004, BXC was spun out of GP by a private equity buyer who did what PE firms do, they saddled the company with lots of debt. This wasn’t great timing of course, with the housing crash just around the corner and all. And in 2017, the PE firm was forced to liquidate its holding in the company at bargain prices.

The stock is underpriced because it doesn’t screen well. The GAAP balance sheet likely understates the value of the company’s real estate to the tune of a couple hundred million dollars while also overstating its leverage.

Here’s the following from Matt Sweeney of Laughing Water Capital on the opportunity in BXC (with emphasis by me).

While buying from a seller that is not concerned with price is a good place to start, by itself this is not
sufficient for investment. We were further attracted to the business because of its misleading GAAP
balance sheet, which we believed under-stated the value of the company’s real estate by almost \$200M.

Importantly, the company had been monetizing their real estate through sale-leaseback transactions,
which allowed the company to paydown debt. While the mechanical screeners that rule the markets were viewing the company as levered ~8x, we believed the company had already reduced its leverage to ~6x, and could be theoretically almost debt free if they simply continued to monetize their real estate.

More important than this theory however, is the reality: they just don’t need all of the land they have.
Because the company started as a part of GP, their footprints were designed to accommodate storage of plywood and other sheet goods. Storing plywood requires a lot of space for a small amount of margin, and is thus not a good business to be in.

Additionally, a look at BXC’s product mix vs. public competitors showed significant room for margin
expansion through moving into more value-added aspects of the building supply distribution business.
Combining the above elements, I felt that BXC was significantly mis-understood by the market, and that
there were multiple ways to win in the years to come.

What I did not consider was that BXC would announce a merger with a competitor that has a highly
complementary business and footprint only months after our purchases. Shares more than doubled on
the news, driving BXC into a top 5 position for us. While it may be tempting to just take the money and
run after a move of this magnitude, reviewing the transaction indicates that the combined company may
be cheaper now in the low \$30s than it was below \$12 just a few months ago. This is a business where scale matters, and the opportunity to take costs out of the combined business and drive revenue through consolidating the footprint to more fully utilize square footage, leveraging purchasing power, leveraging administrative resources, and cross-selling complimentary products is very real. It is not difficult to envision scenarios where the combined company can generate \$8 to \$12 in free cash flow per share looking out a few years, which when combined with a likely de-leveraging of the balance sheet leads to the potential for significant additional upside.

An expanding business that’s moving into higher margined products combined with the benefits of increasing scale make BXC an attractive company. The opportunity is made even richer when you also consider the pace of deleveraging in the balance sheet (lower debt makes the equity worth significantly more) and a business that should be generating \$10+ in free cash flow in the coming years. The stock is currently only trading at \$25…

Insiders think the stock is a steal at current prices and have been loading up on it — typically a good sign. And from a technical perspective, the chart looks great. It’s broken out of a large base and has now retraced to the lower band of its weekly Bollinger Band.

To be continued…

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## Full Capitulation In US Stocks Not Here Yet

Following is just a short note with some things I’m looking at in the market and what I want to see before we start getting more aggressive on the long side.

First, the Russell small-cap index is knocking up against major support this week in its long-term trend line, 50mma (red line), and lower Bollinger Band (chart below is a monthly). We should see more of a bounce here but I’m skeptical it will hold and am looking for a further move lower — I’ll show you some of the reasons why, below.

One of the big ones is the stubbornness in the II Bull/Bear sentiment data to budge. We’ve talked about this chart quite a bit over the last few months, so I won’t continue to beat a dead horse. But II sentiment provides the highest signal to noise out of all the sentiment data, imo. And the failure to see capitulation on this size of a selloff in the market, tells me this move lower most likely isn’t over.

Now we don’t NEED to have a full capitulation sentiment reset for a bottom to be in. But it’d give me a lot more confidence to be aggressive on the long side if we did.

Besides sentiment, here are a few other things that I want to see to confirm that a new uptrend is starting.

Druckenmiller often talks about how “the market is smarter than he is and so he listens to the signals of the market” to figure which side of the trade to be on. One of the things he pays close attention to — and we at MO do as well — is the trend in cyclical versus defensive stocks.

Check out the chart below which shows cyclical versus defensive stocks (orange line) and the S&P in blue. When the orange line is trending up, it means that cyclical stocks are outperforming defensive sectors. This means that investors are moving to more risk-on positioning as their perceptions of future economic growth become more optimistic. And when the orange line trends lower it means that investors are becoming more defensive in their positioning and more pessimistic on the market outlook.

Now we want to see the trend in cyclical vs. defensive confirm that of the broader market. When it doesn’t, it often means that the market’s internals are shifting and there’s likely a major change in trend coming, as we can see in this chart.

We want to see this orange line (cyclical vs defensive) put in a higher low in order to signal a shift in market internals and confirm that a bottom is in.

In the hierarchy of traders, bond traders tend to be the most well informed. This is why moves in credit almost always precede large trend changes in the equity market. Similar to the market bottom in early 2016 we want to see the orange line (investment grade bonds relative to USTs) confirm a bottom is in by moving higher. Without this, it’s unlikely any stock rally will have legs…

The below chart is my take on the late Marty Zweig’s Breadth Thrust indicator. It’s simply the 10-week moving average of all NYSE advancing issues divided by advancing plus declining issues: ADVN/(ADVN+DECN).

For a true confirmation of a breadth thrust and thus an indication that the market move higher is likely to have legs, we want to see the indicator (red line) dip below 0.4 (lower horizontal black line) and then quickly thrust above the 0.60 level (upper horizontal black line). The vertical red lines show past instances when this indicator has been tripped. Each marks the end of a major down move and the beginning of a major advance.

An important question is which markets will lead the next advance: the core (US) or periphery (EM)? I shared this chart in one of our more recent MIRs which shows the aggregate total long USD synthetic positioning in the futures market. Large orange spikes indicate that traders are crowded long USD assets. We can see that when this spike crosses above the red horizontal line, emerging market stocks typically enter a period of outperformance against the US.

We saw one of our largest long USD positioning spikes this last October. And ever since EM stocks have been outperforming, but the positioning has dropped and though still a bit elevated is getting close to a neutral level.

This brings us to our next chart which shows gold (gold line) overlaid on a AUDUSD chart (black line). I’ve written about in the past (link here) about how gold often leads the dollar at turning points. Similar to using market internals like cyclical vs. defensive sectors for confirming/disconfirming signals, we need to pay attention to the trend in gold when it diverges from the inverse trend in the dollar.

The recent divergence between gold and the dollar (AUDUSD) is worth noting. What this tells me is that it’s odds on that we see a sizable dollar selloff in the coming weeks. This view is also in line with the long synthetic dollar positioning that still needs to be worked off.

I’m ultimately bearish on gold and bullish on the dollar and would view this move as a tactical short-term one. But due to the tight coiling action in the EURUSD (which makes up more than half the trade-weighted USD basket) it seems as though a sharp move is possible.

I’m not sure what the catalyst is going to be; maybe more noise about a US/China trade deal or a dovish turn from the Fed when the FOMC next meets at the end of January. But it looks to me like we may first see more continued EM outperformance, coupled with a dollar selloff, and precious metals staying bid before the dollar finds a bottom and the US stock market really starts taking off.