Value Investing Is Dead, Long Live Value Investing

Value investing hasn’t performed so well this cycle. Here’s a chart showing value’s relative performance versus that of growth.

The value-factor strategy pioneered by Fama and French, which consists of buying stocks with the lowest valuations and selling those with the highest has produced a cumulative loss of 15% over the past decade, according to Goldman Sachs.

This is the longest stretch of underperformance for the value-factor strategy since the Great Depression.

And as to be expected, this prolonged drudgery has spawned the hyperbolic “Death of Value Investing” narrative that seems to come around at some point every other cycle.

What I find interesting though is that this “death of value” narrative doesn’t seem to be affecting the value fund managers I talk to. They mustn’t have gotten the memo because they seem to be doing just fine — actually, much better than fine with most of them beating the market by a wide margin this cycle.

Which of course begs the question: why the large performance gap between what’s considered classical value (ie, the Famma-French method of buying statistically cheap stocks) and select discretionary value fund managers who’ve been hitting it out of the park?

The answer is two-fold.

  1. Quantitatively arbitraged: Back in Benjamin Graham’s day getting hold of a company’s most basic accounting information was difficult. Figuring out classical value metrics such as price to book and price/earnings required a great amount of effort (the information simply wasn’t readily available). Today, every Joe Schmoe has access to free quantitative screeners that scan, decipher, and rank every stock in the world according to a long list of metrics. If a stock sells for a low price to book or earnings yield then it almost certainly deserves it. Put simply, the widespread availability of quantitative systems has arbed much of the alpha out of looking at the popular valuation metrics.
  2. Asset-light economy: Famed value investor, Bill Nygren of Oakmark Funds, recently wrote that “as the economy has become more asset-light, intangible assets — such as brand names, customer lists, R&D spending and patents — have become more important.” Nygren goes on to note that “the relative importance of tangible assets compared to intangibles has completely flip-flopped from what it was 40 years ago” and that now, intangibles “account for over 80% of the average company’s market value.” The funny thing is, standard GAAP accounting doesn’t even attempt to measure these assets!

So the headlines above decrying the death of value investing are right… at least sort of. Classical quantitative value investing has become a packed house and the edge has been competed away. But value investing still lives on… just in a new and evolving discretionary framework.

The core-tenets of value investing remain the same. The goal is still to buy companies at below the present value of their future cash flows. But the frameworks used for discerning this value have changed.

Value fund manager Joel Tillinghast puts the aim of value investing as this, “I’m looking for companies that are increasing the amount by which their intrinsic value exceeds their accounting values. This difference is called economic goodwill.”

Discerning “economic goodwill” takes discretionary research and deep thinking. It’s not easy and you won’t find a metric for it on any quantitative website, which is largely why it works.

The value managers that are thriving in this environment are the ones who’ve recognized this changing dynamic and have evolved their process along with it. This group of adaptable managers includes the old Oracle himself, Warren Buffett, who has said, “My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely on economic goodwill.”

As a global macro operator I’ve been fascinated with the changing landscape in value investing. Though we don’t ascribe to a certain narrow and rigid approach to markets, such as being strictly fundamental or trend following practitioners etc…Our approach at Macro Ops is, and always has been, to make high risk-adjusted returns by whatever means necessary. And value investing is one of these means.

Because of this, I’ve spent the last few years studying and dissecting the habits, practices, and frameworks of the very best in this evolving value investing landscape.

And in this month’s Macro Intelligence Report (MIR) I’m going to share all that I’ve learned. We will discuss the foundational principles of value investing and then I will walk you through MO’s framework for seeking out and properly analyzing highly asymmetric value investments. We’ll then apply this framework to three deeply mispriced value stocks that I’ve been digging into the last few months.

All three have multi-bagger potential and won’t pop up on any standard quantitative value screens. They are examples of where the quantitative metrics and GAAP accounting numbers obscure their true potential.

If you want access to my top three value stocks for August 2018, sign up to the MIR at the link below.

Click Here To Learn More About The MIR!

There’s no risk to check it out. We have a 60-day money-back guarantee. If you don’t like what you see, and aren’t able to find good trades from it, then just shoot us an email and we’ll return your money right away.

The S&P looks ready to break out to new highs on the back of strong US economic data. I think these three multi-bagger value stocks can start their run as soon as next week. Don’t miss out, sign up for the August MIR by clicking the link below.

Click Here To Learn More About The MIR!



Has The CCP Turned Off The Tightening?

It looks like China may be folding…

We’ve talked all year about how China is THE largest driver of markets this cycle and their deleveraging was the force behind the widening performance gap between the US and the rest of the world.

The continuation of this trend has been dependent on China’s willingness to stay the course and press on with much needed financial and economic reform. A reversal of policy would be seen as a failure and a direct hit to Xi’s credibility.

Cue recent reports indicating the CCP can’t take the heat and has decided to ease once again. Here’s Bloomberg on China’s policy U-turn (emphasis by me).

China unveiled a package of policies to boost domestic demand as trade tensions threaten to worsen the nation’s economic slowdown, sending stocks higher.

From a tax cut aimed at fostering research spending to special bonds for infrastructure investment, the measures announced late Monday following a meeting of the State Council in Beijing are intended to form a more flexible response to “external uncertainties” than had been implied by budget tightening already in place for this year.

Fiscal policy should now be “more proactive” and better coordinated with financial policy, according to the statement — a signal that the finance ministry will step up its contribution to supporting growth alongside the central bank. The People’s Bank of China has cut reserve ratios three times this year and unveiled a range of measures for the private sector and small businesses.

“It is now quite clear that Beijing has fully shifted its policy stance from the original deleveraging towards fiscal stimulus that will be underpinned by monetary and credit easing,” said Lu Ting, chief China economist at Nomura Holdings Inc. in Hong Kong.

China’s State Council plans to raise local government spending by roughly 1.35 trillion yuan (roughly US$200b) to be spent primarily on infrastructure this year.

And the tax cuts aimed at boosting consumer spending are equivalent in size to the tax cuts passed last year in the US — not an insignificant amount.

Why has China decided to backpedal on what was one of Xi’s and the Party’s top stated goals last year?  

It seems there’s increasing fear at the top of losing control of the economy and this fear is being exacerbated by the escalating trade war. Chinese State media recently warned that China’s judiciary should prepare itself for a possible spike in corporate bankruptcy cases as a result of the trade dispute with the US.

The South China Morning Post (SCMP) recently shared the following (emphasis mine):

In an opinion piece published on Wednesday by People’s Court Daily, Du Wanhua, deputy director of an advisory committee to the Supreme People’s Court, said that courts needed to be aware of the potential harm the tariff row could cause.

“It’s hard to predict how this trade war will develop and to what extent,” he said. “But one thing is sure: if the US imposes tariffs on Chinese imports following an order of US$60 billion yuan, US$200 billion yuan, or even US$500 billion, many Chinese companies will go bankrupt.”

As Chinese courts have yet to have any involvement in the trade dispute, the fact that the newspaper of the nation’s top court, ran an opinion piece – for a judiciary-only readership – suggests concerns might be rising in Beijing about the possible socioeconomic implications of the row.

There’s also been a number of reports (so far, unverified) over the last few weeks of serious trouble brewing within the party. Geopolitical Futures recently shared this.

Last Friday, online reports indicated that gunfire had been heard for roughly 40 minutes in Beijing near the Second Ring Road. The reports claimed it was a violent spasm by groups that sought to overthrow Chinese President Xi Jinping. The following day, French public radio reported it had heard rumors that former Chinese leaders, including Jiang Zemin and Hu Jintao, had allied with other disgruntled Chinese officials in an attempt to force Xi to step down. A Hong Kong tabloid went so far as to suggest that Wang Yang, chairman of the Chinese People’s Political Consultative Conference, might be the compromise leader next in line.

It’s impossible for us to know if there’s any truth to these rumors (China keeps a tight lid on these types of things) but just the fact that they’re circulating are indication of growing unease with the state of the Chinese economy. And it may be why we’re seeing this policy 180 by the CCP.

We also don’t know if this easing will be enough to reverse the negative trends kicked into gear by the initial deleveraging nor do we know how long and aggressive the CCP will be in this round of easing. All we know for sure is that however they choose to carry out policy will continue to have an outsized impact on markets and the global economy.

For our part, we just have to keep a close eye on the data and change up our positioning to account for the new uncertainty created by this shift back to easing.

Two important data points we’ll want to watch in order to gauge the scale of the current easing response are fixed asset investment (ie, infrastructure spending) and China’s M1 money supply (which has a close leading correlation to changes in industrial metal pricing).




The Principle of Bubble Rotation

In the book Business cycles: history, theory and investment reality, the author Lars Tvede talks briefly about a cycle phenomenon he calls The Principle of Bubble Rotation. He writes:

There is one further common aspect of all these asset classes. We have seen that business cycles from time to time create monetary environments that are conductive to asset bubbles. However, people will recall past crashes for a while, and this means that whatever asset people bought in the last bubble will rarely be chosen for the next. This leads to a systematic bubble rotation. There was a bubble in precious metals/diamonds in 1980, for instance, and then in collectibles (and Japanese land) in 1990, and then in equities in 2000.

Essentially, what Lars is saying boils down to, “what outperformed in the last cycle will not outperform in the next.”

Since trading and investing is a game of comparisons, we evaluate all assets on a relative basis and then choose to buy one thing over another. Using The Principle of Bubble Rotation we can underweight assets/sectors/industries that may look attractive at first glance but are unlikely to outperform for the simple reason that they did so in the prior cycle.

Let’s look at the outperformers from the last cycle and see how they’ve done in the current one.

The top performing assets/sectors/industries in the 02’ to 08’ cycle were:

  • Emerging markets
  • Homebuilders
  • Financials
  • Commodities

So far each of these assets/sectors/industries have adhered to The Principle of Bubble Rotation.

The reasons why this cycle skip exists are three fold:

  1. Psychological: Investors who were burned buying into a bubble in the previous cycle are likely to be hesitant to buy into those same assets in the next. We call these “event echoes” where the psychological scarring from a jarring market event affects investor behavior well into the future. This usually takes two cycles to reset because most investing careers don’t last much longer than that.
  2. Capital Cycle: Asset bubbles are born from overoptimism. This optimism attracts capital and competition which leads to large amounts of capital expenditure into future supply. This leads to over-capacity which takes the subsequent cycle to clear.
  3. Regulatory: There’s a regulatory cycle that is always fighting the last war and which typically goes into motion following the bust process where many investors were hurt or financial instability occurred. Take banks following the GFC or cryptos following the current bust process as an example. These regulations typically take the completion of another cycle before deregulation occurs.

The Principle of Bubble Rotation isn’t a hard and fast rule. There’s examples where it didn’t hold true and certain industries are susceptible to their own unique capital cycles which affect the length of their boom/bust process.

Still, it’s a useful heuristic to use for filtering down your universe of potential trades. It would have kept you from buying financials this cycle, which has been a popular but dead money trade. Also, it would have alerted you to areas of the market that were more likely to outperform since they underperformed in the previous cycle; the technology sector being a perfect example.



Trading Is Simple, Not Easy… and a 320%+ oil trade

Good trading is simple, just not easy.

Literally, successful trading can be boiled down to these few words from the original OG, Amos Hostetter.

Cut your losers short, and let your winners run…

This old trading axiom has been repeated throughout time by all the greats. It’s also continuously ignored by nearly everybody.

It’s not that people don’t get it or they don’t think it’s a good principle. Traders talk about how important it is all the time… yet, very few consistently apply it.

The reason why is because it’s incredibly hard to do. It goes against hundreds of thousands of years of our evolutionary neurological wiring.

Evolution wired us to be so risk averse that our instinct is to avoid losses at all costs… even small ones. It’s easier for us to renege on our risk points and let the dice roll in the hopes that price comes back our way; at least until the loss becomes painfully unbearable, our uncle point is hit, and we tap out in despair…  

On the flip side, we’re wired to want to take profits quickly because we count those paper gains as already ours and the psychological pain of losing them instinctively outweighs the perceived value of sitting on the position in hopes of further gain.

This is all part of Prospect theory that was first put forth by Kahneman and Tversky. Wikipedia describes the concept as, “a behavioral economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics.”

We’re wired to cut winners short, and let losers run.

We evolved to be bad traders. Trading is simple, just not easy.

You may say, “well, yeah… cutting losers short and letting winners run is important but it’s hardly the whole kit and kaboodle…”

And technically you’re right. Cutting your losers short and letting your winners run isn’t everything… It’s just pretty close to being everything.

You also need to be an independent thinker; be able to develop contrarian ideas; possess mental flexibility, be able to hold multiple opinions and weight them effectively — the whole strong opinions weakly held idea.

But, really, all these mean nothing if you can’t do the basics of cutting your losers short and letting your winners run. And most can’t.

This trading maxim is so important because of the bunchy nature of market returns. Portfolio returns follow a natural power law. This power law exists in all of nature. It’s Pareto’s 80/20 rule… and in markets, it’s more like 90/10.

This means that over time, 90% of your profits will come from 10% or fewer of your trades. For example, if you’re a good trader and you place 100 trades a year, 90 them will be small losers and small winners that will effectively cancel each other out. And just 10 will account for the vast majority (90%) of your nut for the year.

This is an ironclad law. It’s true for everybody. If you study the returns of any of the greats (Buffet, Druck, Soros, Tepper, Livermore etc…) you’ll see the same 90/10 distribution of returns.

Cutting losers short, and letting winners run works because it’s in harmony with this natural power law that’s inherent to markets.

Cutting losers short cuts off the left-tail distribution of losses — yes, losers will follow the same power law if they aren’t cut short. And letting winners run let’s you fully exploit the right tail events; those 10%’ers, the fat pitches, the ungodly asymmetric trades… that only come down the pipe every so often.

But back to this not being easy to do.

It’s not only not easy because we’re psychologically wired to want to instinctively do the wrong thing. But it’s also just really hard to sit and hold through a monster trend.

Take W&T Offshore (WTI). This was a trade that we recently took full profits on. It ended up being one of our 10%’ers for the year — though far from being our biggest winner.

We first pitched our high conviction bullish oil call in August of 2017. It was clear to us that the market and popular bearish oil narrative we’re completely detached from the developing fundamentals.

We bought into WTI in August for around $2.18.

Over the following 8 months, WTI’s stock price increased over 320%, to just under $9…

We 30x’d our risk on the trade. (Our stop was at $2.00.)

This is what we consider a good trade. But sitting for the full gain was not easy. During the 8-month 320%+ rise, we had to sit through two 30%+ drawdowns and countless 5-10% drawdowns along the way.

Meanwhile, we had to endure these large pullbacks all while the majority of the market was telling us a host of very good and smart sounding reasons for why we were wrong; why the correct position was to be bearish on oil — being a contrarian is NEVER easy.

It was tough to follow the foundational trading principle of cutting your losers short, and letting your winners run… specifically, the latter.

But that’s necessary to being a good trader. You have to have the discipline to sit on your winners, ride through the inevitable pullbacks, and weather the storm as long as your reasons (for us it’s always a confluence of macro, technical, and fundamentals) for being in the trade are still valid.

This is the only way you can harness the power law of the markets and exploit it to your benefit.

Chess Grandmaster Josh Waitzkin wrote in his book The Art of Learning that:

It’s rarely a mysterious technique that drives us to the top, but rather a profound mastery of what may well be a basic skill set.

This couldn’t be any truer for trading. The best are the best because they are really good at harnessing the 90/10 power law of markets and utilizing it to their advantage. They do this by cutting their losers short, and letting their winners run.

We were fortunate enough to outperform the market during the first half of 2018. And we did so because we stuck to the basic principles of profitable trading and letting the 90/10 power law play out.

Tomorrow night, we’re throwing a live special event: How We Beat The Market In The First Half of 2018. Tyler, my partner here at Macro Ops, will be showing you guys exactly how we navigated through a tough and volatile year to produce multiples of what the S&P 500 has delivered to passive buy and holders. It’s going live at 9PM EST on June 28th.

Click here to register for this event!

On top of a full breakdown of our 2018 trading, he’ll also be updating you guys on our DOTM option strategy as well as our best practices for drawdown management. Until we hit that big trade in WTI, we had a lengthy multi-month drawdown which would’ve been impossible to endure without our drawdown management techniques.

Finally, you’ll hear how we’re positioning into year-end, and where we expect to find our next 10%’er. You don’t want to miss this!

Click here to register for the live event!



The Data Says This Bull Market Still Has Legs

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

Over the next 12-18 months we expect the US market to outperform the rest of the world as we head into the final stages of this economic expansion.

Once a quarter we like to review our US macro indicators to see if they confirm or reject our primary macro thesis. Here are the latest readings.

US liquidity is near its cycle highs (meaning, it’s extremely loose). This is very bullish US risk assets and should prevent emerging markets from going into full-blown crisis mode. This indicator will turn over well before this bull market ends.

LEI (Leading Economic Index):
The Conference Board LEI, which tracks a basket of US economic indicators, is still in a strong uptrend on both an absolute and YoY basis. This indicator will roll over well before we enter a recession.

CLI (Composite Leading Indicator):
Our US composite leading indicator shows the US economy is in an accelerating expansion which should continue into the end of the year.

Inflation ROC:
The 3-month annualized core inflation rate has come down from its Jan/Feb highs, which sent interest rates shooting up. A slower change in inflation eases up pressure on yields and is bullish for stocks.

Advisor Sentiment:
Advisor sentiment has reset from its excessively bullish Jan/Feb highs and is now giving a neutral reading. This is supportive of stocks moving higher.

BAA Yield ROC:
The rate of change in yields has come down from its highs at the start of the year but it still remains elevated. This indicator is in neutral/headwind territory for stocks.

AAII Sentiment Survey:
Bullish sentiment has completely reset since the beginning of the year and is now supportive of stocks moving higher.

S&P 50-day MA Spread:
The percentage of SPX stocks above their 50-day moving averages is in overbought territory. It can and probably will move higher from here but we should be on the lookout for a pullback in the next few weeks as the short-term trend is becoming extended (chart via Bespoke).

The US economy is strong and growth is accelerating. All our leading economic indicators are giving positive readings making the odds of a recession in the next 12-months extremely low. Liquidity is still flush which is supportive of the broader trend higher in stocks. Market sentiment has reset from its highs reached at the start of the year. All this means that the primary bullish trend in US stocks is supported by the data and the primary path of least resistance remains up.

However, over the short-term, the trend is overbought and the ROC in yields is elevated. This makes the market more susceptible to a selloff over the next few weeks. A selloff would reset both of these and give us a good opportunity to add risk. There are numerous catalysts that could spark a selloff this week ahead. We have CPI and DPRK Summit on the 12th, the FOMC meeting on the 13th, and June OpX on the 15th.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.



Why You Should Be Focused On India & Commodities

In this video we talk about why India (INDA) and commodities in general are the next huge investment trend. To understand why, we need to understand the S-curve. Macro Ops has a detailed article on this topic that I’ll link to in the comments. Be sure to check it out!

As people’s wealth increases, they buy more nonessential goods. As they do so, they consume a lot more commodities, including oil, gas, wheat, copper, and livestock. The growth in commodity consumption is exponential at this point.

We can actually predict when this will happen by tracking the GDP per capita of a country. Once the country hits a certain level, which is around $2,300 to $3,300 GDP per capita, their commodity consumption takes off. This happens in energy, but also in agriculture, where populations begin to increase their meat consumption. Raising livestock is over seven times more grain-intensive than producing for a simple plant based diet. That’s why we also see agriculture explode as well.

We’ve already seen this S-curve phenomenon happen in China (FXI). The last secular bull market in commodities which started in the early 2000’s and ended in 2011, occurred as China hit the S-curve take off point. If you bought the commodity index in 2000, right as the tech bubble was bursting, you would have compounded your money at over 20% annually over the following decade.

India is about to hit that point. Their GDP is exactly where China’s was in 2001, right before the last commodity bull market began. The country also has a population of over 1.3 billion people, just 60 million shy of China’s. Because of this, we think we’re about to enter the largest period of commodity demand growth the global economy has ever experienced.

Watch the video above for more!

And as always, stay Fallible out there investors!



Misconceptions, Mispricings, and Models: A look at today’s market

I like to look for things (beliefs and narratives) that the market believes but that just aren’t so…

These false narratives drive price action, spurring greater narrative adoption, which then drives prices further away from the underlying fundamentals (aka, reality).

A trend not based on supporting fundamentals is not sustainable. It’s a mispricing; which is another word for opportunity.

But how do we discern true narratives based on supportive fundamentals from false ones based on faulty beliefs and misconceptions?

It’s not easy. We’re always working with incomplete information, so we have to to operate from a position of humility. And use all the tools at our disposal.

For the macro trader, these tools come in the form of models (both qualitative and quantitative). Think Munger’s idea of having a latticework of mental models from which to operate from.

Since the market is a dynamic non-linear beast — meaning, it’s complex and unpredictable — we need to have a wide range of models that we can try on for size and see if it fits the current regime; using price as the final arbiter of truth.

Adhering to Occam’s Razor, we then use these models to form assumptions, or hypotheses about the market, from which to act upon and place trades; applying bayesian analysis to continuously update our opinions as new information comes in.

Notice how this is a fluid and continuous process. We never latch onto to a single model or hypothesis about the market. Instead, we constantly try on new ideas/models and test them against the environment (price action) and discard them when they lose their efficacy.

This keeps us from wedding ourselves to a belief (being a perma bear or bull for whatever reasons) which is how powerful distorting biases are created. And these biases, are what eventually lead to one getting steamrolled. There are endless examples on fintwit of people stuck in this mode of operating.

Now that I’ve explained the process, let’s apply this framework to understanding today’s market. Here’s a short summary of some of the mental models I’ve found helpful in the current regime:

  • Core/Periphery: The US is the core and emerging economies are the periphery with other developed markets sitting in the middle. Long-term capital flows tend to cycle back and forth between concentration in the core, to strong flows to the periphery. The primary fundamentals of this model are relative growth numbers between the regions and the market’s overall perception of risk.
  • Perception Lags Reality: Market participants mostly form their opinions about the future by taking current trends and extrapolating ad infinitum. It’s a natural herding response which leads to consensus thinking and positioning. And because markets are reflexive (our thinking affects prices which affects our thinking) it’s inevitable that this process leads to large mispricings.

  • Event Echos: Powerful psychological events (think crypto boom/bust or the GFC) echo through time and affect the thinking and actions of the market for years and 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 the policy makers who pull the levers on the economy (ie, central bankers). Everybody always fights the last war…
  • Capital Cycle: Capital investment flows in and out of sectors and economies like the tide. It’s attracted by high returns, which leads to large inflows of investment, which then leads to greater capacity, and since greater capacity means greater supply, it eventually leads to falling prices and lower returns. The boom leads to bust. And then the cycle starts anew.
  • FX Momentum Chasing: The currency market is dominated by speculative flows. These speculative flows go to where investors think they’ll receive the highest total return (currency + capital appreciation). This means FX is largely a momentum chaser and the process is filled with self-fulfilling feedback loops. Because of this, the relative equity momentum between countries is one of the most important inputs to look at when analyzing currencies.
  • ROC inflation/yields: Stocks and bonds compete for capital. The risk premiums and expected returns for both, are what drive positioning decisions between the two. All else being equal, rising bond yields are bearish for stocks. And it’s the rate of change in yields (the speed at which they rise and fall), not so much the absolute levels, which greatly affect short-term action in the stock market. And since inflation is a key input into bond prices, the rate of change of inflation is also very important to understanding the bond/stock relationship.
  • Playing the Player: The market is the aggregate of the beliefs and moods of those that play in it. Because of reflexivity and the herding tendencies of people, the market is constantly crowding from one side of the boat to the other. Leading to mispricings. This is why we need to track sentiment, dominant narratives, and positioning to see when the market becomes too one-sided.

Now let’s apply these models and use them to form some assumptions about the market.

Starting with core/periphery. There’s many ways to gauge where capital is going and where it will flow to. We can look at relative growth versus expectations or track the underling flows directly. But a simple way is to just see what relative prices are doing, since these flows show up directly in asset prices.

Here’s a chart of SPY (core) versus EEM (periphery). I’ve cleared the price so we just see the 50 and 100-day moving averages which allows us to see the clear trend in capital flows between the two.

We can see that the core has dominated this cycle up until mid-2016, when the periphery began to outperform the core and thus attracted more flows.

But recently, the 50 and 100-day moving averages have begun to turn back up. Suggesting that capital is beginning to flow back into the core.

We can see similar action in the trade weighted dollar (DXY) which is a reflection of our core/periphery and FX momentum chasing models. The 50 and 100-day moving averages have turned up as well.

I’m working on the assumption that this recent upturn in a stronger dollar and flows back to the core will be sustained. This is because of a number of things, including a slowing China which should feed through to softening EM and a general repricing of global risk. Both dollar and core bullish.

The market, viewed through the lens of our perception lags reality model, is still operating off assumptions formed in 2017, when the world saw global synchronized growth and near zero volatility.

This perception is no longer true and much of the market is offsides. This mispositioning is what led to the large move in the dollar and core outperformance. The more this trend continues the more people working off the old assumption will be forced to reverse positioning, thus exacerbate the trend their positioned against.

Despite the benign assumptions adopted by much of the market last year there persists an underlying bearishness and knee-jerk fear response to every selloff. A clear event echo leftover from the GFC. This is why cash balances still remain extremely high (chart below via BofAML’s latest fund manager survey).

We can also see this risk averseness in the year-over-year change of NYSE margin debt. Pundits keep opining about how “late cycle” we are, but we’ve yet to see the euphoria driven leveraging — the investors getting out over their skis —  that typifies the end of bull markets.

I don’t doubt this is coming but we just haven’t seen it yet, which is why this bull market is likely to continue longer than everybody thinks.

Using our capital cycle framework we’ve been bullish on oil and oil stocks since last summer, which we reported on in our monthly Macro Intelligence Report (MIR) titled “The Capital Cycle”.

We can see here that capex in the energy space (ie, investment into future production) fell off a cliff in 14’. This is the most intense decline in energy capex over the period for which we have data.

Low capex = low future supply = higher future prices, which we’re seeing now. This is also why we’ve held the unusual position of being bullish both the dollar and oil over the last few months, since both have a strong tendency to move inversely to one another.

Using our ROC inflation/yields model we can see how the quick increase in inflation at the start of the year drove yields higher which pinched stock valuations and caused a selloff.

Both have since come down and are now at neutral/tailwind levels for the stock market.

Using our Play the Player model we can look at shorter-term indicators to see that general market sentiment has reset from its January bullish levels. In addition, we can see that speculators hold the largest net short position against the Nasdaq since 2010 — which happened to mark the beginning of a large bullish run in tech.

This completes our quick run through of some of our models and now we have our working assumptions (hypotheses). These are:

  • Global risk is starting to be repriced higher from very low levels. This is leading to capital flowing back to the core from the periphery.
  • Capital flowing back to the core is leading to a stronger dollar and greater outperformance by the core vs. periphery which is about to kickstart a feedback loop of: flows to the core = strong dollar = tighter global liquidity = higher volatility = greater US vs ROW outperformance = greater flows to the core and a stronger dollar…
  • Longer term sentiment is still overly bearish due to the event echo of the GFC. Because of this, we have yet to see the euphoric/leveraging phase of the cycle and therefore this bullish trend is likely to last longer than the market expects.
  • The rate of change in inflation and yields has reversed from their pop higher at the beginning of the year. They are now at levels that are neutral to bullish for stocks.
  • Short-term sentiment has reset from its overly bullish levels hit at the beginning of the year and is now at neutral to positive levels for stocks. And the market is overly bearish US tech stocks.

I’ll continue to operate from these working assumptions until new information comes in that makes me change my mind. And when it does, I’ll do so willingly.

We can take this framework and apply it at a micro level to identify particular sectors/companies that are drastically mispriced due to faulty beliefs and misconceptions. I’ll be doing exactly that in the June issue of our Macro Intelligence Report (MIR).

Click Here To Learn More About The MIR!

There’s no risk to check it out. We have a 60-day money-back guarantee. If you don’t like what you see, and aren’t able to find good trades from it, then just shoot us an email and we’ll return your money right away.

Our dollar and big tech plays from last issue crushed it and I expect this month’s ideas to do the same. Make sure to pick up a copy so you have access to our best summer trading ideas. The market is ready to make another leg higher and you don’t want to be left behind…

Click Here To Learn More About The MIR!



Rising Interest Rates & Discovery Inc. (DISCA)

Interest Rates Rising!? Discovery Channel Stock Pick Analysis

Today we’re going to review the broader market (SPY), see what rising rates (TLT) mean, and then we’ll also go over our long Discovery (DISCA) thesis.

The broader market is looking strong. Small-caps just hit new highs and overall breadth is solid. Sentiment reset itself and now it’s acting as a neutral to bullish tailwind for the market.

The main hurdle markets have to face going forward is rising rates. The yield on the 10-year is hovering just below 3.1% and the rate of change in yields is at levels that usually precede stock market volatility. There’s a circular relationship between yields and equities. When yields rise fast, we see stock market volatility, which in turn causes people to flood into bonds which lowers bond yields again. So it’s a self correcting process. We’ll probably see this cycle play out again soon with another small sell off in stocks. But that will hopefully put an intermediate ceiling on yields and clear the way for a more sustained stock rally.

A stock our team is digging into to play this trend is Discovery (DISCA). You guys are probably familiar with the Discovery channel with programs like Shark Week and MythBusters. Discovery Inc is a global media company that owns Discovery channel and more including TLC, Animal Planet, HGTV, Food Network, and the Oprah Winfrey Network. They have 400 distribution feeds in 40 different languages around the world.

The stock has been beaten down the last few years because of the “old media” narrative and the rise of cord cutting. These are legit reasons, but now the stock is trading 50% below its price from a few years ago and it’s looking like the market has overdone it. We are now looking at going long.

If you’d like to learn more, make sure to watch the video above.

And as always, stay Fallible out there investors!



Is Volatility Signalling Higher Prices?

Let’s quickly review the overall stock market and see what’s going on. We’ve had some real nice bullish action over the last week, but is it going to last?

Well the S&P 500 (SPY) has officially broken out of its consolidation from the beginning of the year. Price cleared its downtrend line and the prior high of the consolidation. This raises the probability of a new bull trend starting and lowers the probability of continued consolidation and chop. And yea, price is coming back to kiss the breakout, line but that’s just normal action. The breakout should hold.

We’re also seeing confirmation in the volatility markets with VIX (VIX) closing below its prior low put in on March 9th. You almost never see the S&P downtrending with VIX in the teens.

Oddstats tweeted a pretty cool chart of this correlation between the S&P and VIX the other day. The green and blue shading on the equity curve shows what SPX price action looks like with VIX levels of 18 or less. This makes it easy to see that low volatility = bull trends. A low VIX, means stable SPX pricing, which gives large investors the confidence they need to put money to work.

The volatility term structure has also relaxed which means stress is leaving the system. This ratio trades above 1 during times of stress and below 1 when liquidity conditions are favorable. It’s been holding levels below 1 for the last few weeks which gives us more evidence that this bull has legs. The current value is 0.92.

In just 3 months we’ve gone from hyper volatility back to 2017 style vol. This supports the theory that that the selloff we had was machine driven. It had nothing to do with the fundamentals. It was all because the auto selling from margin calls and crowded positioning that needed to be unwound. The fundies never deteriorated with the price action.

In the video above we cover market fundamentals as well. So make sure you watch it!

And as always, stay Fallible out there investors!

Will China’s Slowdown Wreak Havoc On Markets?

The following is an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.

Last July, we laid out the case for why China is the most important macro factor this cycle. We talked about why it’s a debt riddled neutrino bomb waiting to go boom… But we also noted how the Chinese Communist Party (CCP) had been injecting liquidity into its economy in order to steady the boat during its all-important National Congress last year.

Our pitch was that we were tactically bullish but strategically bearish (which so far looks to have been the right call).

Well, now that the big gathering of Marx lovers is over and Xi Jinping has been anointed the Grand Emperor for life. The CCP has the all-clear to move forward with managing the country’s deleveraging and transitioning from an export economy to a consumption based one

Why does this matter? Why is China so important to global markets?

Well, it’s mainly because they are the world’s marginal buyer of commodities… by a wide mile. So when China wheezes the rest of the world (and especially emerging markets) catches cholera.

Here’s a short summary of just how important the red dragon has become.  

It’s been said that China builds a new skyscraper roughly every five days.

In the last year alone, the country has built half of the worlds new super skyscrapers (buildings with a minimum height of 656 feet). To put that into perspective, there’s only 113 buildings in New York city, total, that are over 600 feet.

That takes a LOT of steel, copper, cement and other such resources. Another fun fact that I often like to share is this mind bender: China consumed more cement from 2011 to 2013 than the US did in the entire 20th century.

China dominates global commodity consumption. They consume more than half the world’s cement, nickel, coal, copper, and steel every year (image via Visual Capitalist).

Paul Podolsky, a PM at the macro hedge fund Bridgewater, estimates that over “70 percent of the swings in the global economy are driven by swings in the Chinese economy.”

Famed short-seller and fund manager, Jim Chanos, recounted the following regarding China a while back in an interview with the FT :

This story is internally now one of our great stories.

A real estate analyst was addressing the partners and he said: ‘Currently there’s 5.6 billion square meters of high rises in China under construction. Half residential, half office space.’ And I thought for a second and I said: ‘No, you’ve gotten the American, rest of the world metrics wrong. You must mean 5.6 billion square feet. Because 5.6 billion square meters is roughly 60 billion square feet.’

And my analyst looked at me sort of terrified. He was a young analyst at the time. He said: ‘I know. I double checked. It’s 5.6 billion square meters.’ And I thought for a second and I said: ‘Well if half of that’s office space, that’s roughly 30 billion square feet of office space. And that’s a five foot by five foot office cubicle for every man, woman and child in China!’

And that’s when we all looked at each other and our jaws dropped. We realized, wow, this is a once in a lifetime kind of thing, where this whole country is in effect building itself out in a very short period of time.

So then we looked at the capital spending of their miners, and we went back and looked at a time series of those that were around from 1990 on, and once again it was just one of these hit your head kind of moments.

And with the government’s explicit backing to do whatever it takes to keep China growing faster than the rest of the world’s major economies. Right now markets believe in two things: central banks have the market’s back and China has the global economy’s back.

Those are two very, very big pillars and they’d better hold up… because everybody believes them.

This is important —> Right now markets believe in two things: central banks have the market’s back and China has the global economy’s back… One of these beliefs is going to be tested in the coming year.

Before I explain why, let me first layout what exactly makes the CCP and its leader, Xi Jinping, tick. Since they ultimately pull the levers in the country which affect the rest of the world so much.

It can be boiled down to the following: power and control.

Xi Jinping, as the leader of the CCP, cares solely about keeping his grip on power. All leaders, especially authoritarian ones, sit under a heavy sword of damocles. Xi is no different. Maintaining power and control are necessary to his survival.

The same goes for the broader party and its members. The CCP fears social unrest more than anything else; lest the people take to the streets and begin to demand a voice in government. Both know that the best way to keep the peace is by keeping the engine of economic progress turning and never letting things regress, too much.

This is one of the many reasons why undemocratic systems are inherently fragile. They don’t have the shock absorbers that are organic to democracies — we can vote our frustration out.  

Question. Do you know why communism is superior to capitalism?

Answer: Because it heroically overcomes problems that do not exist in any other system.

Anyways, so Xi and fam know that they must maintain stability, both economically and politically to ensure their survival. And since their government is filled with very bright technocrats, they know that they have to deal with their debt problem. They can’t afford to keep kicking that can down the road, anymore.

In addition, communism is all about outward appearance. Dog and pony shows are extremely important in reminding the people that the communist system is really the best. Which is why the CCP’s coming centenary anniversary in 2021 is such a big deal. They need to celebrate 100 years of economic progress.

It’s very important that the Chinese economy is strong like dragon for the centenary in just three years time. The technocrats know this. And they know that if they want a strong economy in 2021 then they need to slow it down, now. This was the theory first put forth by macro hedge fund manager Felix Zulauf, which I wrote about here.

Here’s Felix’s updated thinking on this hypothesis from a recent interview he did with Real Vision (emphasis mine).

2021 is the 100th anniversary of the Communist Party… So I assume that the current president, who is now president for a lifetime, wants to have a good economy in 2021. If he wants to have a good economy then, he’s no dummy, and his experts aren’t either because I think, actually, the Chinese government has the best experts of all the governments in the world. So they have to slow down the pace of the economy in ’18-’19, and reduce some of the risks they have built up. And I think you are seeing that already.

And I think the Chinese think that the fiscal stimulus in the US could take up some of the slack. And I think it is timed that way that when the US pushes their economy a little bit further through the fiscal stimulus, that they could retreat some and it would be balanced. Of course, it will not be balanced because China’s effect and impact on the world economy today is much bigger than the US economy.

So I think the Chinese will most likely overdeliver in their restructuring efforts over the next two years, compared to what the world expects. If that is true, then we will have a stronger dollar for longer, and will have weaker commodities for longer. But once the world then gets disappointed in ’19 or whenever they figure that out– the Chinese are beginning to kick start their economy from 2020 onwards. So I think there are many cycles within these long cycle that we are in. And the mini cycle, I think, is topping.

The theory sounds solid doesn’t it?

I mean, we know the Chinese government is worried about its excessive leverage. And we know that political anniversaries and pageantry are important in their culture. And… it would be wise — and China’s technocrats are wise, if not sometimes hamstrung — for China to move aggressively in deleveraging while the US (its counterpart engine for global growth) is firing on all cylinders, with unemployment sittings at 17-year lows and capital expenditures trending towards generational highs…

But a theory is just an opinion if we can’t back it up with numbers. And as macro operators, we need to be like the late W. Edwards Deming where, “In God we trust; but all others must bring data.”

So let’s peruse the data. And since China likes to fudge the more popular datasets, we’ll look at a dashboard of more esoteric stuff that tends to fly under the radar, unmolested.

Here’s one of my favorites.

It’s the YoY change of railway freight. Remember, in our recent article, we talked about why it’s best to view data at the second derivative level. Because the rate-of-change reveals important trend changes in velocity. Well, we can see that in the chart below.

Growth in railway freight slowed, then turned negative, from 2010-14’ when China was doing its stealth tightening.

Looking at this chart alone would have tipped you off to something being amiss. You could have triangulated this with price action in commodity and emerging markets to either help you to side-step or go outright short into what became a nasty bear market.

And then in early 16’, this chart reflected the massive credit injection by the PBoC (China’s central bank) by hockey sticking upwards, which subsequently marked the nadir of the commodity/EM bear market.

Now, while growth in freight traffic is still positive. It’s slowed dramatically since its 17’ peak and looks to be decelerating further. Something we’ll have to keep a close eye on.

Now onto the second derivative of another favorite of mine… year over year Industrial Production Electricity Usage… Fun!

This one is sketching out the same pattern as railfreight traffic. Growth is clearly decelerating from its high-water mark hit last year.

Real estate, both commercial and residential, are telling a similar story.

Home prices in China’s two hottest cities, Beijing and Shanghai, are falling. And the growth in the amount of commercial floor space sold is about to turn negative for the first time in over 3-years.

Real estate plays an important role in the Chinese consumer psyche. If this trend continues it’ll make the economy’s transition to a consumption based one, that much more difficult.

Since China is such a dominant source of global commodity demand, I’ve found that tracking their imports from commodity producing countries to be a fantastic bellwether for what’s really going on in the country.

Below is a chart showing the year-over-year changes in exports to China from the countries largest commodity trading partners.

This chart, like the others, paints a picture of decelerating growth.

Our theory now looks less and less like an “opinion” and more like the word of God, doesn’t it?

But, we can go even further. Let’s look at the source of this deceleration. The supply of money (liquidity), itself.

China’s M1 money supply (narrow money) growth turned negative following its large upswing in 16’-17’. Here it is, charted along with the year-over-year change in industrial metal spot price index. Notice any correlations? Perhaps any leading correlations?

Hopefully, the puzzle pieces are beginning to come together for you.

China is the dominant source of global commodity demand. And liquidity (ie, money supply) drives demand. So ceteris paribus, collapsing Chinese liquidity leads to falling commodity prices.  

So this chart and the next one should have us somewhat concerned; because they clearly show that liquidity in China is rolling over.

People have been wondering why emerging market debt and currencies have dived into a hole, recently. Well, the above is why. China is deleveraging and the rest of the world is just starting to feel the affects.

Does all this mean that we should sell all our positions, convert to cash, and join a friendly prepping community?

No, not exactly…

I’m no curmudgeon or China doomsdayer. I think China will manage things just fine. But growth there is clearly decelerating. And the CCP’s actions give weight to our “slowdown into 2021” theory. So, as long as the data continues to confirm our theory, that’s the one we’ll base our assumptions off of.

I’m guessing the CCP learned its lessons from the painful economic slowdown in 14’-16’ and will proceed with more caution this time around. Taking one step back for every two forward in their move to deleverage — or crossing the debt river by feeling the stones, as Deng Xiaoping would say.

Lucky for them, the US economy is booming and will help soften the blow to the global economy. Which is why we’re not predicting fire and brimstone, just yet.

The above was an excerpt from our Macro Intelligence Report (MIR). If you’d like to learn more about the MIR, click here.