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A Macro Update And My Stock Shopping List For 2019

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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 market update.

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 Value Investing Manifesto.

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.

For more info on BXC you can read this dated but still relevant write-up from Adestella Management on the company (link here).

To be continued…

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Have a great week!

 

 

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.

 

A Special Announcement and Market Update

Just wanted to share some exciting news and a quick market update. But first, I’d like to wish everybody a very Merry Christmas and a happy holidays! It means a lot to us here at MO that you’ve chosen to be apart of the MO tribe and for that, I want to extend to you our most sincere thanks and gratitude.

Now onto the exciting news…

Chris Dover is officially joining the MO team. If you’ve been in the Comm Center at all these last few months then you already know Chris. But for those of you who don’t, here’s a quick bio:

Chris is a Quant/Systems trader with over 19 years trading the markets and currently running his family office. A Former Marine, Government Contractor, a serial tech entrepreneur, Angel investor and lifetime student. Chris travels the world with his wife living out of a carry on bag, focusing on health and wellness, quality of life, running his trading systems and helping others achieve their goals of trading for a life.

Chris uses his focus on Quantitative Systems Trading to advise hedge funds, family offices and individual traders on building trading systems that achieve consistency and durability over time.

Chris brings a unique approach to markets, focusing on mindset, health and then finally, consistently profitable trading.

I couldn’t be more stoked to have Chris join the team. Not just because he’s a fellow Jarhead, but also because he’s an incredible trader who shares the Macro Ops passion for relentless learning, growth, and personal evolution.

We’ll be working out the details over the coming weeks on how Chris can best share his knowledge and experience with the group. But, things like a podcast and courses on theory/strategy in building trading systems are definitely in the works.

Our long-term goal at MO is to build a small team of 4-6 traders who are some of the best in their respective niches. This is kind of the old-school macro fund model where a team that includes a classical chartist, a fundamental value investor, a currency specialist, a systems/algo trader and so on…

There are a number of benefits to this approach from a portfolio management standpoint. One is that you get strategy diversification. Various strategies excel in different market regimes and you can tilt-weight your portfolio and focus on the strategies that best align with the current regime.

Another benefit and this is more specific to MO as a group, is that everybody is different and we all need to adopt trading strategies that fit our personality. This is key, because what works for me, likely won’t work exactly for you. That’s why the whole idea of your typical market newsletter which just gives you buy and sell signals is bunk.

Ultimately, everybody’s long-term success in markets comes down to their ability to consistently execute a trading strategy with a definable edge. And if one doesn’t fully understand their system, their edge, or if their approach isn’t aligned with their personality, then there’s zero chance of them executing consistently and they will inevitably fail.

This is why we spend just as much time discussing mental models and theory as we do covering markets and trade setups. We want to give everybody the tools with which you can mix and match and shape to make your own, in a system and framework that works for you.

We plan to do much much more of this. And bringing Chris on the team is going to significantly increase our bandwidth and allow for more of this sharing of ideas and theory.

In the end, we’re focused on rapid personal evolution. Not just in trading but in every area of our lives (health, fitness, meaningful relationships, and helping others), since success and growth in one area tends to overflow and permeate the next. And trading markets may be the best game in the world (I certainly think so) but it’s still just a game, albeit a serious one.

We’ll be looking to further grow our team over the next 12-months. A number of you have reached out in the past, looking to work with us. The timing wasn’t right then but if you’re interested, please shoot us an email and connect. We’re looking for right fits, experienced traders who are maniacally devoted to Learning, Sharing, and Evolving.

Now onto markets!

This is the best explanation I’ve heard as to what’s driving this slow drip selloff in markets. It mirrors what I’ve been hearing from the fund managers I talk with (h/t to @InsiderBuySS). The following is from Kuppy’s blog Adventures In Capitalism (emphasis by me).

Moving to small caps; I’ve been involved in this sector for nearly two decades. I can only think of two other times where I have seen so much pain and frustration amongst my small cap friends. That would be the 2008 to 2009 period and to a lesser extent during the first few months of 2016. I am stunned at how many high-quality businesses trade for mid-single digit cash flow multiples—despite strong balance sheets. I’m even more stunned at how many slightly leveraged businesses trade at low single digit cash flow multiples. It’s outright insane how many companies trade for massive discounts to NAV. Take a look at shipping for instance—you have dozens of companies where you can liquidate the fleet and double your money based on current vessel values. This is despite the fact that charter rates are up and values are increasing. Of course, this still doesn’t quite compare to anything exposed to the energy sector. These things are being given away as dozens of energy funds liquidate and sell everything they own. You could say that some of these businesses are challenged—they aren’t all challenged. Moreover, they shouldn’t all be declining by a few percent a day—with hardly an up day.

What is going on? You are witnessing a massive culling of the hedge fund industry as hundreds of funds are liquidated and thousands more get sizable redemptions. Many of these funds own the same companies—the outcasts from the indexed world, the cheap, the unloved; the same stocks that many other hedge fund managers own. With the hedge fund industry going in reverse, there is suddenly no natural buyer for what must be sold. As a result, you are seeing waves of forced sell orders and few buyers. It is creating rather insane bargains all around.

Like all trends, this one too will end. If your fund is facing a year-end redemption, you need cash in hand by December 31 and you probably finish selling a few days before then. Therefore, at most, there’s 9 ½ days left to make sales. It may get even uglier—it may not. No one knows how to time this. What I suspect, is that the pain will finally abate in two weeks. Or at least the forced selling pain will be done. If you look at Q4, despite only a small drop in the S&P, it has been one of the most painful that my friends or I can remember. There are lots of guys down 20% to 30% this quarter and suddenly forced to de-lever further, to get their risk ratios in order. This sort of pain and indiscriminate selling creates lots of opportunities.

Hedge funds have been getting slaughtered this year. The back and forth chop of the market has essentially taken a sickle to the bloated money management space. This is a good thing for us active traders and was kind of inevitable. There’s just too many money managers all crowding into the same damn trades.

Anyways, this hedge fund killing field, as Loeb put it, is driving end of year redemptions which means forced selling of positions. The Russell small-cap index is now down -27% on the year, with many good individual names I track down 40, 50, 60%+.

Anytime there is forced selling in the market, opportunities are created. This time is no different. I expect this grinding persistent selloff to abate sometime in the next week or two, as it looks like we’re seeing that total sentiment capitulation event that we’ve been waiting on.

Sentiment is nearing outright ridiculous levels…

The equity risk premium (difference in earnings yield versus treasury yields) via Sentiment Trader is now 4 standard deviations below average. This is extreme…

According to SentimentTrader when the ERP Z-score is below -2, the annualized return shot up to 40.1%.

According to the latest BofAML Fund Manager’s Survey, money managers continue to hold large amounts of cash. This is NOT something you see at the top.

And then here’s how every quarter performed following a 10%+ down quarter post-WWII via Bespoke Investments.

The market is setting up for a MAJOR buying opportunity. There’s likely a bit more pain ahead in the short-term but I think a bottom is near. Our puts in NVDA, BABA, TSLA, as well as our DAX short and long bond / long VIX position is hedging us well. We’ll look to take profits on a number of these trades in the week(s) ahead.

I’ll be putting out my stock shopping list this weekend. I haven’t been this excited for deals in a LONG TIME.

That’s all I’ve got for now. Shoot me an email or hit me up in the CC if you’ve got a question.

Enjoy the closed markets tomorrow and we’ll be back in the saddle on Wednesday!

The Bullish Case For US Stocks

Sentiment, positioning, and technicals ALL say that we’re getting close to the bottom of this move. And the market is setting up for a monster rally (at least in US stocks).

Let’s start with sentiment.

We’re still waiting for the capitulation spike in bearish sentiment via the Investors Intelligence report, but we should get that this week.

Other indicators and signs of sentiment suggest that bearish sentiment is finally becoming near consensus.

BofAML’s Bull & Bear Indicator is near “Extreme Bearishness” levels and should give a buy signal in the week(s) ahead.

UBS’s composite positioning amongst fund managers in US stocks show that fund manager holdings of US equities are near extremely oversold levels relative to history.

The mainstream non-financial news is now predicting a market crash in 2019. The above is from the NYT’s Lifestyle section of all places. This is NOT what you see at market tops.

Ron Paul is back to making headlines pitching doom and gloom.

AAII bearishness is at its highest levels since February 2016.

The State Street Investor Confidence Index for North America is at its most bearish level since 2012.

The percent of stocks trading above their 200-day moving averages is now at 19%. This is DEEPLY oversold territory. The last three times the indicator was this low, it marked major bottoms in the market.

The RoC in rates has reversed and is now back in neutral territory and is no longer a headwind for stocks. We should see this come down even further on dovish guidance from the Fed.

Now look at the giant gap between the ISM in the US and YoY change in the SPX. They typically track each other as the ISM is an indicator of economic growth in the US and therefore company earnings. This type of divergence is extremely rare and should be closed by the SPX doing most of the work by moving higher.

I’m looking for the SPX to dump below the trendline in the coming day and perhaps sell off to the 2,500 level before reversing. Odds are that this is setting up to be a major bear trap.

Same thing with small-caps (IWM). They’re getting close to the 200wma and long-term trendline. We should see a dump below followed by a quick reversal to regain the trendline.

I believe US stocks are setting up for an extraordinary buying opportunity in the next 1-3 weeks. I see a LOT of amazing deals in stocks and I’ll be putting out our Macro Ops shopping list later this week.

 

 

China’s Deleveraging Continues

We’ve been writing since the beginning of the year that there are two important macro drivers to markets at the moment. These are:

  1. China is actively trying to restructure its economy and end its incessant leveraging.
  2. A growing issuance of treasury paper, driven by a widening budget deficit and quantitative tightening, is sucking up global liquidity and creating a “crowding out” effect in other markets.

The market seems to be firmly focused on the second driver, the Fed. But, for some reason, still largely ignoring the many blaring warning signs in Chinese economic data — at least for the moment. This data is telling us that Xi and company are moving along with their stated goal of deleveraging.

The market appears to be operating on the old assumption that the CCP will just inject lots of credit into the system the moment things get rough. But, as we’ve been noting the last few months, this isn’t going to be the case.

Our baseline needs to be that China will continue to actively deleverage and attempt to reorganize its economy. This will continue to have increasingly profound effects on global markets. We should expect this story to play out until the end of 2019, at the earliest. That’s when the CCP is likely to reverse course and juice its economy so it can be strong in time for the Party’s centennial anniversary in 2021.

Let’s look at the charts.

The YoY change in the Global Manufacturing PMI has turned negative for the first time since 2015, bringing global equities lower with it.

Fathom Consulting’s Chinese economic momentum indicator (blue line), which has a positive leading correlation to commodities, has turned over and is heading lower. If you were wondering why crude oil prices have collapsed recently, this is one of the reasons…

China’s economy is largely dependent on exports. Well, it’s Export Orders Index recently fell to its lowest readings since 2015.

Earnings momentum in China has turned negative and is now at its lowest levels since 2015.

M1 money supply growth is at its lowest levels since… you guessed it, 2015.

There are increasing signs of deteriorating consumer sentiment and spending.

This slowdown is already being sniffed out by investors in US stocks with high exposure to China. Below is a chart that aggregates the return performance relative to the S&P of the 10 US companies with the highest exposure to China as a percentage of revenues. We can see that these companies have experienced massive underperformance as of late — similar to the years from 14’ to 16’. We should expect this trend to continue.

Bloomberg recently noted that borrowing costs for China’s high-yield issuers (most of whom are real estate developers) have doubled this year, and now sit at their highest levels in over four years. In addition, the property sector faces a record $18 billion in maturities coming due next quarter. And according to Bloomberg, “that number is expected to double if investors demand early repayment on some of these notes.”

One gets the sense that “the most important asset class in the world”, as Jim Chanos (and your author) refers to China’s property market, is about to get interesting.

Again via Bloomberg, “soon-to-be-published research will show roughly 22 percent of China’s urban housing stock is unoccupied, according to Professor Gan Li, who runs the main nationwide study. That adds up to more than 50 million empty homes, he said.”

The chart below shows just how extraordinary this is. Nearly everything in China, household wealth, business income, loan collateral etc… is directly linked to the property market — a market which has been used as the primary source of speculation by the masses for the last 20 years… and one which hasn’t been allowed to suffer material losses, ever.

Chanos estimates that Chinese residential real estate represents somewhere around a quarter of the Chinese economy. That’s roughly $3 trillion dollars or 4% global GDP.

Imagine the knock-on effects of an unwinding Chinese property market. Just think what that would do to commodities alone…

Xi Jinping made it clear what he wants when he said “houses are for living in, not for speculation.” We should probably pay attention.

What does all this mean though from a practical investing standpoint?

Well, over the longer-term (next 12-months) we should expect similar macro dynamics to those of 2015, or worse. The last time the Chinese materially delevered.

That means slowing global growth and rising deflationary pressures.

I recently showed the below chart from Ned Davis which is signalling an 80% probability of a global recession. And since 1970, when this indicator has given a reading above 70, we’ve ended up in a recession 92.11% of the time.

There are two main differences though between now and 2015. One is that this time around the US economy is much stronger. Secondly, positioning and sentiment are already fairly bearish on EM assets compared to 2014 when positioning and sentiment were quite the opposite.

Here’s a chart I made which aggregates all net speculative long US and USD synthetic positioning (orange bars) along with the S&P 500’s performance relative to emerging markets (EEM). You can see that when there’s significant spikes in bullish US asset positioning (orange spikes) it often coincides with a near-term top in relative US outperformance.

We recently saw our largest US long positioning spike since early 2016. That means investors are pretty crowded to one side of the boat. It’s not going to take much positive EM/China news (maybe hints at a potential trade deal or anticipation of renewed easing etc..) to cause a position unwind.

Whether this performance reversion lasts a week, a couple of months — or happens at all —  is anyone’s guess. But it’s something to keep note of. And we’ll just have to follow the tape and play the action as it comes.

We’ll consider playing some Chinese and EM names for a swing trade — IF they set up technically. Names like Tencent (TCEHY) and JD.com (JD) which have been obliterated over the last 6-months and are due for a strong bounce. And we’re currently long an Argentina bank (GGAL) with a tight stop.

Longer-term, the primary trade is to continue to be selectively long US assets, long USD positions, and short gold. It makes sense to move more money into defensive sectors, like XLP and XLU as well.

We should expect increasing market volatility in the year ahead and greater dispersion in stock returns (ie, a widening gap between winners and losers).

That’s all I got for now. The macro landscape continues to evolve at a rapid pace and I’ll update my views accordingly. Keep tabs on our research section of the website for the latest updates.

 

 

China Won’t Bail Out Global Markets This Time Around

I believe there are three important drivers to markets right now. Two long-term and one short-term. These are:

  1. China is actively trying to restructure its economy and end its incessant leveraging.
  2. A growing issuance of treasury paper, driven by a widening budget deficit and quantitative tightening, is sucking up global liquidity and creating a “crowding out” effect in other markets.
  3. Consensus long dollar / long US vs. RoW positioning and sentiment has set the stage for an interim bout of EM outperformance; before another reversal and devastating final sell-off.

We’ve written many times over the last few years about why China is THE most important macro variable this cycle. The reason is in the chart below.

China (orange line) has accounted for the majority of credit creation this cycle. They’ve been the global workhorse by leveraging credit driven demand. As a result, China accounts for over 50% of global GDP growth since the financial crisis.

China is now dead set on ending its super-sized leveraging cycle and transitioning to a more sustainable consumer-driven economy. We know this because President Xi Jingping has told us so as he did here in late 2016.

If we don’t structurally transform the economy and instead just stimulate it to generate short-term growth, then we’re taking our future… If we continue to hesitate and wait, we will not only lose this precious window of opportunity, but we will deplete the resources we’ve built up since the start of the reform era.

Xi finished the above statement by saying the country had until the end of 2020 to make this transition.

Xi’s moves to finally tackle the debt are also clearly showing up in the data. We’ve been writing about it all year, here, here, here, here, here, here, and here.

This is a very big deal that is still largely being ignored by the market. Investors appear to be operating off of the old assumption that Xi and team will stimulate at any moment. But this won’t be the case. It’s very unlikely we’ll see a reversal in policy until the end of 2019, at the earliest. This will give them time to juice the Chinese economy going into the centennial anniversary for the Chinese Communist Party.

Until this happens, we’re going to see a bumpy road ahead for global markets.

Ned Davis’ Global Recession Probability Model is signaling an 80% probability of a global downturn. As noted on the chart, since 1970 we’ve seen a recession 92.11% of the time there’s been a reading above 70 (chart via CMG Wealth & NDR).

Morgan Stanley’s global Financial Conditions Index is rising and now sits at its highest levels since 2015.

And the Global Manufacturing PMI recently turned negative for the first time since the end of 2015.

Meanwhile, we have strong growth in the US — though it’s likely peaked for the cycle — and near record high equity valuations, combined with rising interest rates.

2019 is going to be an interesting year for markets…  

In this month’s MIR, we’ll be covering the opportunities and dangers that we see ahead. We’ll lay out the case for what we think is the most asymmetric macro trade in markets right now; discuss our process for short-selling and pitch some Icarus stocks we’re adding to our books, and then make the pitch for a Greenblatt style hidden value spinoff trade. If you want access to this research click 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 macro situation has become fast moving and turbulent. If the data continues to head south we can see a swift revaluation of all the high flying stocks that have driven this bull market. By reading this month’s MIR, you will have an idea of how to sidestep a potential collapse and even profit from it.

Click Here To Learn More About The MIR!

 

 

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My Notes on the Druckenmiller Real Vision Interview

Alex here.

The Druckenmiller Real Vision interview is well worth the watch if you have a subscription and 90 minutes to spare. And if you don’t, you’re in luck because I’m sharing with you my notes along with some of my thoughts on what the GOAT said.

Let’s begin…

The start of the interview was by far my favorite part and really blew me away.

Stanley Druckenmiller opened the conversation by looking straight into the screen and then spoke some words I’ll never forget. He said, “Alex Barrow, I am your real biological father…” My jaw dropped even though this was something I’ve always kind of suspected. I mean, just look at the photo of me and my dog below. The resemblance is pretty uncanny. It’s nice to finally know the truth for certain.

Now that I’m done showing off my photoshopping skills, let’s get to the real stuff.

13D founder, Kiril Sokoloff, leads the interview and he and Druck discuss a wide range of topics including his views on the current macro environment, the diminishing signal of price action due to the rise of algorithmic trading, central bank policy, and then my favorite which was his thoughts on trade and portfolio management.

Here’s Druck talking about the difficulty he’s been having in this low rate environment, and how he’s made the vast majority of his money in bear markets (with emphasis by me).

Yeah, well, since free money was instituted, I have really struggled. I haven’t had any down years since I started the family office, but thank you for quoting the 30-year record. I don’t even know how I did that when I look back and I look at today. But I probably made about 70% of my money during that time in currencies and bonds, and that’s been pretty much squished and become a very challenging area, both of them, as a profit center.

So while I started in equities, and that was my bread and butter on my first three or four years in the business, I evolved in other areas. And it’s a little bit of back to the future, the last eight or nine years, where I’ve had to refocus on the equity market. And I also have bear-itis, because I made– my highest absolute returns were all in bear markets. I think my average return in bear markets was well over 50%. So I’ve had a bearish bias, and I’ve been way too cautious the last, say, five or six years. And this year is no exception.

It’s no secret the central bank suppressed rate environment has hurt practitioners of old school macro, such as Druck and PTJ. When these guys began their careers they could park their money in 2-year rates and capture high single to double-digit rates.

Not only did this jack up their returns but higher interest rates and inflation caused more volatility and action in markets. And exploiting volatility is the lifeblood of old school macro traders. Like Druck said, he made his highest returns during bear markets.

The last decade of extremely low-interest rates and dovish Fed policy has suppressed volatility, leading to smoother trend paths. This has led to more capital flowing into passive indexing and less to active managers, which in itself helps to extend the trend of less volatile markets; at least to a point.

Eventually, this low rate regime will reverse. We’ll see higher inflation and a secular rise in interest rates. In fact, this is one my highest conviction ideas for the next secular cycle. The massive debt and unfunded obligations in developed markets, along with the secular rise in populism, nearly ensures that we’ll see profligate government spending and competitive devaluations in the decade ahead.

So we’ll see the rise of volatility and an environment conducive to old school macro once again!

Here’s Druck discussing the major macro thematics he’s been tracking this year.

I came into the year with a very, very challenging puzzle, which is rates are too low worldwide.

You have negative real rates. And yet you have balance sheets being expanded by central banks, at the time, of a trillion dollars a year, which I knew by the end of this year was going to go to zero because the US was obviously going to go from printing money and QE to letting $50 billion a month, starting actually this month, runoff on the balance sheet. I figured Europe, which is doing $30 billion euros a month, would go to zero.

So the question to me was, if you go from $1 trillion in central bank buying a year to zero, and you get that rate of change all happening within a 12-month period, does that not matter if global rates are still what I would call inappropriate for the circumstances? And those circumstances you have outlined perfectly. You pretty much have had robust global growth, with massive fiscal stimulus in the United States, where the unemployment rate is below 4. If you came down from Mars, you would probably guess the Fed funds rate would be 4 or 5/ and you have a president screaming because it’s at 175.

I, maybe because I have a bearish bias, kind of had this scenario that the first half would be fine, but then by July, August, you’d start to discount the shrinking of the balance sheet. I just didn’t see how that rate of change would not be a challenge for equities, other than PEs, and that’s because margins are at an all-time record. We’re at the top of the valuation on any measures you look, except against interest rates. And at least for two or three months, I’ve been dead wrong.

So that was sort of the overwhelming macro view. Interestingly, some of the things that tend to happen early in a monetary tightening are responding to the QE shrinkage. And that’s obviously, as you’ve cited, emerging markets.

We talked about this obvious market mispricing in our latest MIR, The Kuhn Cycle (Revisited). The old narrative of low rates for longer had become extremely entrenched. And this narrative consensus has created a certain amount of data blindness, as is typical with popular and enduring narratives. This data blindness has led to a large mispricing of interest rates, particularly in developed markets.

Where things get interesting is all the corollaries that stem from a low rate narrative like this. Think of the billions of dollars that have poured into private equity over the last decade. The current PE model is predicated on the assumption of interest rates staying low, which is needed for their businesses’ long-term funding needs and justification for their sky-high valuations etc…

A really interesting section of the interview is when Druck talks about the diminishing signaling value in price action. He says:

The other thing that happened two or three months ago, mysteriously, my retail and staple shorts, that have just been fantastic relative to my tech longs, just have had this miraculous recovery. And I’ve also struggled mightily– and this is really concerning to me. It’s about the most trouble I’ve been about my future as a money manager maybe ever is what you mentioned– the canceling of price signals.

But it’s not just the central banks. If it was just the central banks, I could deal with that. But one of my strengths over the years was having deep respect for the markets and using the markets to predict the economy, and particularly using internal groups within the market to make predictions. And I think I was always open-minded enough and had enough humility that if those signals challenged my opinion, I went back to the drawing board and made sure things weren’t changing.

There are some great nuggets in here. I’ve long thought that one of the most important skill sets of a great trader — and something Druck has in spades — is to be extremely flexible mentally; never marrying oneself to a viewpoint or thesis and continuously testing hypotheses against the price action of the market.

Market Wizard Bruce Kovner said he owed much of his success to this, saying:

One of the jobs of a good trader is to imagine alternative scenarios. I try to form many different mental pictures of what the world should be like and wait for one of them to be confirmed. You keep trying them on one at a time. Inevitably, most of these pictures will turn out to be wrong — that is, only a few elements of the picture may prove correct. But then, all of a sudden, you will find that in one picture, nine out of ten elements click. That scenario then becomes your image of the world reality.

And Livermore noted the importance of flexibility when he wrote, “As I said before, a man does not have to marry one side of the market till death do them part.”

Now compare this to the “Fintwit experts” who have peddled a doom and gloom outlook for the last 7 years without ever taking a step back to maybe rejigger the models they use to view the world, which have been so consistently wrong.

Anyways, Druck then goes on to lay out the cause behind the diminishing power of price signals.

These algos have taken all the rhythm out of the market and have become extremely confusing to me. And when you take away price action versus news from someone who’s used price action news as their major disciplinary tool for 35 years, it’s tough, and it’s become very tough. I don’t know where this is all going. If it continues, I’m not going to return to 30% a year any time soon, not that I think I might not anyway, but one can always dream when the free money ends, we’ll go back to a normal macro trading environment.

The challenge for me is these groups that used to send me signals, it doesn’t mean anything anymore. I gave one example this year. So the pharmaceuticals, which you would think are the most predictable earning streams out there– so there shouldn’t be a lot of movement one way or the other– from January to May, they were massive underperformers. In the old days, I’d look at that relative strength and I’ll go, this group is a disaster. OK. Trump’s making some noises about drug price in the background.

But they clearly had chart patterns and relative patterns that suggest this group’s a real problem. They were the worst group of any I follow from January to May, and with no change in news and with no change in Trump’s narrative, and, if anything, an acceleration in the US economy, which should put them more toward the back of the bus than the front of the bus because they don’t need a strong economy.

They have now been about the best group from May until now. And I could give you 15 other examples. And that’s the kind of stuff that didn’t used to happen. And that’s the major challenge of the algos for me, not what you’re talking about.

Well, I’ll just, again, tell you why it’s so challenging for me. A lot of my style is you build a thesis, hopefully one that no one else has built; you sort of put some positions on; and then when the thesis starts to evolve, and people get on and you see the momentum start to change in your favor, then you really go for it. You pile into the trade. It’s what my former partner George Soros was so good at. We call it– if you follow baseball, it’s a slugging percentage, as opposed to batting average.

Well, a lot of these algos apparently are based on standard deviation models. So just when you would think you’re supposed to pile on and lift off, their models must tell them, because you’re three standard deviations from where you’re supposed to be, they come in with these massive programs that go against the beginning of the trend. And if you really believe in yourself, it’s an opportunity. But if you’re a guy that uses price signals and price action versus news, it makes you question your scenario.

So they all have many, many different schemes they use, and different factors that go in. And if there’s one thing I’ve learned, currencies probably being the most obvious, every 15 or 20 years, there is regime change. So currency is traded on current account until Reagan came in and then they traded on interest differentials. And about five years, 10 years ago, they started trading on risk-on, risk-off. And a lot of these algos are built on historical models. And I think a lot of their factors are inappropriate because they’re missing– they’re in an old regime as opposed to a new regime, and the world keeps changing. But they’re very disruptive if price action versus news is a big part of your process, like it is for me.

If you’ve been trading for any significant amount of time then you’ve certainly noticed the change in market action and tone due to the rise of algorithmic trading over the last decade. There’s often little rhyme or reason behind large inter-market moves anymore. Moves can simply happen because, as Druck said, algos that run on standard deviation models determine one sector has advanced too much relative to another, so the computers start buying one and sell another.

What we can do as traders now is to evolve and adapt. Work to understand what the popular models are that drive these algos so we can understand when they’re likely to buy and sell.

Also, I love his line about how he works to build a thesis and a position when he says:

A lot of my style is you build a thesis. Hopefully, one that no one else has built; you sort of put some positions on; and then when the thesis starts to evolve, and people get on and you see the momentum start to change in your favor, then you really go for it. You pile into the trade.

This a great lesson in trade management and how to build into a position using the market as a signal.

Druck also talked about Google (one of our largest positions) and reveals how he looks at some of the tech stocks that are popularly thought of as “overvalued” by the market.

I guess, let’s just take Google, OK, which is the new bad boy, and they’re really a bad boy because they didn’t show up at the hearing. They had an empty chair because they only wanted to send their lawyer.

But it’s 20 times earnings. It’s probably 15 times earnings after cash, but let’s just say it’s 20 times. Let’s forget all that other stuff. And they’re under earning in all these areas, and losing money they could turn it off. And then I look at Campbell’s Soup and this stuff selling at 20 times earnings.

And they’re the leaders in AI– unquestioned leaders in AI. There’s no one close. They look like they’re the leaders in driverless car. And then they just have this unbelievable search machine. And one gets emotional when they own stocks, when they keep hearing about how horrible they are for consumers.

I wish everyone that says that would have to use a Yahoo search engine. I’m 65, and I’m not too clever, and every once in a while, I hit the wrong button and my PC moves me into Yahoo. And Jerry Yang’s a close friend so I hate to say this, but these things are so bad.

And to hear the woman from Denmark say that the proof that Google is a monopoly and that iPhones don’t compete with Android is that everyone uses the Google search engine is just nonsense. You’re one click away from any other search engine.

I just I wish that woman would have to use a non-Google search engine for a year– just, OK, fine, you hate Google? Don’t use their product, because it’s a wonderful product. But clearly, they are monopolies. Clearly, there should be some regulation. But at 20 times earnings and a lot of bright prospects, I can’t make myself sell them yet.

Kiril then asks Druck about portfolio construction and how he builds positions, which was one of my favorite parts of the interview.

Kiril: When you worked with Soros for 12 years, one of the things that you said you learned was to focus on capital preservation and taking a really big bet, and that many money managers make all their money on two or three ideas and they have 40 stocks or 40 assets in their portfolio.

And it’s that concentration that has worked. Maybe you could go into that a bit more, how that works, how many of those concentrated bets did work, when you decided to get out if it didn’t work, do you add when the momentum goes up assuming the algos don’t interfere with it?

Druck: As the disclaimer, if you’re going to make a bet like that, it has to be in a very liquid market, even better if it’s a liquid market that trades 24 hours a day. So most of those bets, for me, invariably would end up being in the bond and currency markets because I could change my mind. But I’ve seen guys like Buffett and Carl Icahn do it in the equity markets. I’ve just never had the trust in my own analytical ability to go in an illiquid instrument, which in equity is if you’re going to bet that kind of size on– you just have to be right.

But to answer your question, I’ll get a thesis. And I don’t really– I like to buy not in the zero inning and maybe not in the first inning, but no later than the second inning. And I don’t really want to pile on in the third or fourth or fifth inning.

But even against the dollar, it’s not all-in right away. Normally, I’ll wait for– I’ll go in with, say, a third of a position and then wait for price confirmation. And when I get that, when I get a technical signal, I go.

I had another very close experience with the success of the Deutschmark, which was the euro. I can’t remember– I think it was 2014 when the thing was at 140, and they went to negative interest rates. It was very clear they were going to trash that currency, and the whole world was long the euro. And it would go on for years. I’d like to say I did it all at 139, and I did a whole lot, but I got a lot more brave when it went through to 135. And that’s a more normal pattern for me.

We write a lot about the importance of concentrating your bets due to the natural power law distribution of returns (here’s a link).

This part of the interview was great because it shows how Druck uses a confluence of factors to leg into a trade. He says he develops a theory then waits for the market to begin to validate that theory and he puts a small (usually ⅓ position on). He then waits for further market confirmation that he’s correct (he calls this point the second inning) at which time he piles in and goes for the jugular.

The chart below illustrates perfectly his short EURUSD trade.

Here’s Druck talking about the 2000 tech bubble and what made him turn bearish.

Then there would be this strange case of 2000, which is kind of my favorite, and involves some kind of luck. I had quit Quantum, and Duquesne was down 15%. And I had given up on the year and I went away for four months, and I didn’t see a financial newspaper. I didn’t see anything.

So I come back, and to my astonishment, the NASDAQ has rallied back almost to the high, but some other things have happened– the price of oil is going up, the dollar is going way up, and interest rates were going up— since I was on my sabbatical. And I knew that, normally, this particular cocktail had always been negative for earnings in the US economy. So I then went about calling 50 of my clients– they stayed with me during my sabbatical– who are all small businessmen. I didn’t really have institutional clients. I had all these little businessmen. And every one of them said their business was terrible.

So I’m thinking, this is interesting. And the two-year is yielding 6.04, not that I would remember, and Fed funds were 6 and 1/2. So I start buying very large positions in two and five-year US treasuries. Then, I explained my thesis to Ed Hyman, and I thought that was the end of it. And three days later, he’s run regression analysis– with the dollar interest rates and oil, what happens to S&P earnings? And it spit out, a year later, S&P earnings should be down 25%, and the street had them up 18.

So I keep buying these treasuries, and Greenspan keeps giving these hawkish speeches, and they have a bias to tighten. And I’m almost getting angry. And every time, he gives a speech, I keep buying more and more and more. And that turned out to be one of the best bets I ever made. And again, there was no price movement, I just had such a fundamental belief. So sometimes it’s price, sometimes it’s just such a belief in the fundamentals.

Higher oil, higher dollar, and higher interest rates is likely to eventually lead to a negative earnings surprise for us as well; though that’s probably at least a few quarters if not further away.

Kiril then asks Druck about how he manages a drawdown. What he does emotionally and practically to stage a comeback.

Kiril: One of the great things I understand you do is when you’ve had a down year, normally a fund manager would want to get aggressive to win it back. And what you’ve told me you do, you take a lot of little bets that won’t hurt you until you get back to breakeven. It makes a tremendous amount of sense. Maybe you could just explore that a little bit with me.

Druck: Yeah, one of the lucky things was the way my industry prices is you price– at the end of the year, you take a percentage of whatever profit you made for that year. So at the end of the year, psychologically and financially, you reset to zero. Last year’s profits are yesterday’s news.

So I would always be a crazy person when I was down end of the year, but I know, because I like to gamble, that in Las Vegas, 90% of the people that go there lose. And the odds are only 33 to 32 against you in most of the big games, so how can 90% lose? It’s because they want to go home and brag that they won money. So when they’re winning and they’re hot, they’re very, very cautious. And when they’re cold and losing money, they’re betting big because they want to go home and tell their wife or their friends they made money, which is completely irrational.

And this is important, because I don’t think anyone has ever said it before. One of my most important jobs as a money manager was to understand whether I was hot or cold. Life goes in streaks. And like a hitter in baseball, sometimes a money manager is seeing the ball, and sometimes they’re not. And if you’re managing money, you must know whether you’re cold or hot. And in my opinion, when you’re cold, you should be trying for bunts. You shouldn’t be swinging for the fences. You’ve got to get back into a rhythm.

So that’s pretty much how I operated. If I was down, I had not earned the right to play big. And the little bets you’re talking about were simply on to tell me, had I re-established the rhythm and was I starting to make hits again? The example I gave you of the Treasury bet in 2000 is a total violation of that, which shows you how much conviction I had. So this dominates my thinking, but if a once-in-a-lifetime opportunity comes along, you can’t sit there and go, oh well, I have not earned the right.

Now, I will also say that was after a four-month break. My mind was fresh. My mind was clean. And I will go to my grave believing if I hadn’t taken that sabbatical, I would have never seen that in September, and I would have never made that bet. It’s because I had been freed up and I didn’t need to be hitting singles because I came back, and it was clear, and I was fresh, and so it was like the beginning of the season. So I wasn’t hitting bad yet. I had flushed that all out. But it is really, really important if you’re a money manager to know when you’re seeing the ball. It’s a huge function of success or failure. Huge.

This is perhaps the most important section of the interview. So much of being a great trader is learning to arbitrage time and I mean that in a number of different ways.

First, it means to analyze things on a longer timescale, to be able to pull back and look at the bigger picture, the broader trends, and not get hung up on a missed earnings or the latest news cycle. And secondly, it’s to have enough experience to be able to trust your process to the point that you know returns will eventually come to you if you just stick to your game. This form of time arbitrage means that you’re focusing on having a good return record over a 3, 5, and 10 year time period and you won’t go full-tilt if you’re down for a quarter.

Capital preservation always comes first and a strict adherence to a solid process produces good outcomes over the long pull.

That’s it for my notes. I tried to include all the sections that I thought were worth sharing though I’m sure I missed some stuff. Watch the interview yourself if you can. Here’s a snapshot of Quantum Funds returns; Druck took over in 88’.

 

 

Real Vision’s The One Thing With AK Fallible

Welcome to AK Fallible’s brand new show with Real Vision — The One Thing. Our first episode is called “The Crypto Conundrum”. Make sure to subscribe to our YouTube channel for more! https://www.youtube.com/c/Fallible?sub_confirmation=1

Be sure to check out our China’s Downfall series here: https://bit.ly/2Ig0JZz

Everyone seems to have an opinion on how much Bitcoin and all these cryptos should be worth…. It seems like everyone is in 1 of 2 camps as usual, yet another binary argument…..Either they think it should be the only thing with value in the world or it’s a zero…… Reality as usual is somewhere in the middle.

But how should we know what’s worth when we haven’t really defined what it is! First let’s talk about what it isn’t….

Well as of right now in 2018 it’s not a currency! The name Cryptocurrency is totally misleading! I can’t directly pay my mortgage with bitcoins, the IRS won’t accept Tax payments in bitcoin…

It’s not Gold either! How can you be called a store of value when you’re value gets destroyed at an almost unprecedented rate! Ethereum the world’s second largest Crypto is down over 80% from its January highs! Stability is key component of value storage!!!

It will also be key to see how cryptos do when the stock market hits the skids….. Gold typically acts as a safe haven in times of uncertainty, and catches a bid, will crypto?

Well then what is it were buying! We’re buying a speculative asset with a valuable technology.

The technology behind blockchain, can be a powerful tool for financial transactions in particular but were not there yet. And we don’t know what shape or form blockchain will look like when it’s widely utilized

To learn more, make sure you watch the video above!

And as always, stay Fallible out there investors!

Follow AK on Twitter: https://twitter.com/akfallible

And Instagram: https://www.instagram.com/fallible_money/

***All content, opinions, and commentary by Fallible is intended for general information and educational purposes only, NOT INVESTMENT ADVICE.

 

 

The Knock-On Effects Of A Deleveraging China

Over the last two decades China has been following the Gerschenkron Growth Model to deliver high levels of extended economic growth.

The Gerschenkron model of growth goes like this:

  • Undeveloped countries are plagued by poor infrastructure and have low savings and investment rates.
  • To increase investment and boost development, they lower the household’s share of GDP thus increasing governments and producers share of GDP. This in effect raises the nation’s savings rate, providing more money to invest.
  • This investment is then directed by government into big infrastructure projects and export focused industries.
  • The country then grows by increasing its market share of global exports and investing in high return projects.
  • Eventually the country maxes out the amount of productive investment it can absorb. This results in each new unit of debt having less and less of a positive economic effect.
  • The vested interests who became rich and powerful on the back of the investment led economy aren’t incentivized to rebalance. So they keep adding unproductive debt until, eventually, debt servicing costs exceed the economy’s capacity to service it and the economy inevitably goes through a painful forced or managed rebalancing.

China is now at this last step.

China has to rebalance its economy. It needs to transition from an investment and export led economy to a consumption based one; retransfer wealth from the vested interests in local government and private businesses back to households. In addition, it needs to deleverage by paying down, writing off, or inflating away its debt stock.

The quickest way to resolve a debt problem like this and rebalance an economy is to go through a financial crisis where assets are sold and debt written down. This is what the US did in the 1930s. But China can’t go this route because this path involves high levels of unemployment that bear socio-political risks, which the CCP can’t afford.

A much more likely scenario (which I believe we’re beginning to see now) is one where the CCP takes a gradual and pragmatic approach.

They assign the debt servicing costs to local governments, who are then forced to sell assets in an orderly manner to pay down debt. And then the CCP goes after debt in the most vulnerable areas of the economy, primarily the off-balance sheet / shadow banking sector and P2P lending, while balancing this with leveraging in the visible areas parts of the economy (ie, local government issuing bonds to boost specific investment).

This approach means that we shouldn’t expect a hard landing or financial crisis. It’s likely to look much more like Japan’s lost decade, though China has made it very clear in recent months that they won’t make the same mistake the Japanese did and let their currency strengthen too much. So we should expect the yuan to continue slowly devalue against the dollar.

When I share this China bear thesis with people I almost invariably get the question “Why now? What’s keeping them from kicking the can down the road, again?”

That’s a fair question. Chinese leaders have publicly stated as long ago as 2006 that the country had a serious debt problem and that they’d work to deleverage. Only to obviously do the opposite.

But there’s been a very important change over the last year that makes this time different. And that’s the centralization of power.

Only two types of government have been able to handle and survive a difficult economic and debt rebalancing like this (1) robust democracies with strong institutions (like the US in the 30s) or (2) strong centralized authoritarian regimes (like China in the 80s).

This is what the whole anti-corruption campaign and last year’s 19th Party Congress where Xi became de facto emperor, are all about: Xi consolidating power.

Many people have the misconception that the Chinese government is a well oiled machine, where word is past from on top and carried out at the bottom. But in practice this isn’t the case at all.

The real power and control over debt fueled spending has rested with the vested interests at the local government level; from the provincial on down.

There are two Chinese idioms that relate how things actually work, one is ‘heaven is high and the emperor is far away’ and ‘from above there is policy, but from below there are countermeasures’. Meaning, local government officials are free to do as they please, even if it goes against Beijing’s wishes.

This is why over the last decade we’ve seen leaders in Beijing come out talking about the dire need to rein in the country’s debt but local leaders continuing to borrow, spend, and build.

The vested interests who have become rich and powerful are reluctant to stop the activities that made them so.

The anti-corruption campaign that has punished or jailed over 1.5 million party members since 2012 has been effective in clamping down on dissidence. Xi now has the control and authority to carry out Beijing’s wishes.

The SCMP reported last week that updated party rules “state that failing to implement policies from the top is now officially a breach of discipline that can see cadres lose their jobs or even be expelled from the party. Those who refuse to implement policy directives from the party’s Central Committee, who run their own agenda, or ‘are not resolute enough, cut corners or make accommodations’ in applying them, will be subject to punishment under the new rules, which took effect on August 18.”

That’s why this time IS different

President Xi clearly stated his intentions in 2016, saying “If we don’t structurally transform the economy and instead just stimulate it to generate short-term growth, then we’re taking our future… If we continue to hesitate and wait, we will not only lose this precious window of opportunity, but we will deplete the resources we’ve built up since the start of the reform era.” He finished by stating that the country had until the end of 2020 to make this transition.

Another common objection I hear is, “they’re not deleveraging, they’re easing!” But this isn’t so. This misunderstanding is partly due to a failure to view the data holistically as well as intentional misdirection by the Chinese in order to manage the market’s response.

A recent paper by the Paulson Institute (the Macro Polo blog) helps clarify the recent words and actions out of Beijing. Here’s some highlights from the report with emphasis by me.

Upon a cursory look, the message from the Politburo meeting seems contradictory, emphasizing both deleveraging and growth. But this can be reconciled by clarifying just exactly what Beijing means by “deleveraging” in the current context.

Top policymakers are well aware that they’ve gotten a lot of flak from businesses and investors, as well as local governments, for tightening policies that have dried up credit. The complaints have grown since the beginning of 2018, so the Politburo meeting’s emphasis on deleveraging is meant to signal that amid grumbling among the masses, the central government is holding the line. In other words, Beijing isn’t going to do what’s popular—opening up the credit spigot again—but rather doing what it deems necessary for China’s economic stability. Indeed, the July Politburo meeting readout notably included Beijing’s renewed vow to uphold deleveraging, which was not included in both the April Politburo meeting readout and the December 2017 Central Economic Work Conference.

Even though the emphasis on deleveraging remains fixed, the central government appears ready to tweak its approach around the edges. Based on the readout of the latest State Council Financial Stability Commission meeting, deleveraging in 2H2018 and beyond will be targeted rather than across the board. At least for the time being, deleveraging has been tweaked to mean “structural deleveraging.”

What this means in the second half is that deleveraging will mostly rely on administrative measures targeted at state-owned enterprises (SOEs) and local governments. Meanwhile, the existing financial measures will remain but will not be further tightened, and monetary policy will become more accommodative and be more in line with inflation trends. In other words, Beijing is simply moving from its triple threat on tightening to just a “double” threat.

A more accommodative monetary policy does not necessarily mean that credit growth will increase. In fact, credit growth will likely remain subdued because of the continued clampdown on shadow banking. Even in the absence of additional regulations, the shadow banking sector will continue to shrink in size under the existing policy environment. If Chinese banks remain reluctant to lend to high-risk borrowers, then the disappearance of shadow banking won’t be offset by increased lending through formal channels.

You can find the report here, it’s worth reading in its entirety.

China is deleveraging and we should expect this deleveraging campaign to gain momentum over the next two years. The current trade war with the US gives the CCP even greater political cover in carrying out painful reforms as it gives them an easy scapegoat to assign blame.

Why this matters

The knock-on effects of a deleveraging China will be numerous and far reaching. The increased market volatility, the bear market in EM, the collapse in gold, and the rise of the dollar are all just the start of things to come. There’s no doubt that it’s long and slow deleveraging will be felt everywhere.

And one thing I find interesting is that this is all starting just as the market’s become blind to the China slowdown threat after fretting about it for years. The chart below via BofAML shows that the China tail risk is hasn’t been front and center on investor’s minds in nearly 4 years.

Practically speaking, we should expect EM to continue a slow and grinding descent lower — again, we shouldn’t expect any quick crashes, as global liquidity remains relatively robust. It’s likely that the EEM breakout of last year was just a massive bull trap. Price should continue lower back into its consolidation zone from here.

China’s largest trading partners (shown on the chart below via Atradius) are some of the most exposed to a Chinese deleveraging.

 

 

Why Emerging Markets Are A Dead Money Trade

In our most recent MIR we talked briefly about the growth struggles of EM in the context of the Gerschenkron Growth model, using China as our example.

Our conclusion was that China, and EM in general, is set to be a dead money trade and massive value trap for the remainder of this cycle.

So let’s flesh out a little more why this is likely to be the case.

To start, what exactly separates an emerging market from a developed one? Here’s a good explanation from Eric Lonergan writing on his blog Philosophy of Money (emphasis by me).

Emerging markets are not poor countries, nor are they countries which are making economic progress. They are defined by a very specific set of macroeconomic properties, which financial markets are conscious of, but are rarely clearly articulated.

The overriding characteristic of an emerging market is that a currency devaluation is a tightening of policy. In the developed world, a devaluation is typically an economic stimulus, indeed it often coincides with an easing of monetary policy through lower interest rates or an increase in QE. The post-Brexit policy response of the Bank of England is a case in point – sterling fell sharply and the Bank cut interest rates and initiated more QE.

In emerging markets the opposite occurs. These economies usually have public and private sector liabilities denominated in a currency which they do not issue. So when the Turkish Lira falls against the dollar the burden of finance on many Turkish corporates increases. Due to their US dollar liabilities, the interest payments and capital repayments in Turkish Lira rise. That is the first way in which a devaluation is a tightening of monetary conditions.

The second mechanism is more instructive and carries important lessons for monetary reform in the developed world, and in particular how we should think about the challenges posed by the zero-bound.

Emerging markets suffer from widespread price indexation and significant inflation expectations. In other words, when the currency falls, inflation rises, and when inflation rises the economic system attempts to respond by raising wages, and then raising prices. The 1970s concept of a wage-price spiral has meaning.

Because emerging markets have widespread wage and price indexation and alert inflation expectations central banks cannot exploit ‘temporary’ increases in the inflation rate by reducing real interest rates and stimulating demand, as they do in the developed world. Central banks, as we have seen in Brazil, Turkey and South Africa, have to respond to devaluations by tightening policy in order to prevent an increase in the underlying inflation rate.

EMs have what are called soft currencies, which is one of the three subsets of currencies in the global core-periphery paradigm that we talked about in our Jan 17’ MIR Vicious or Benign? To recap, these are:

  1. The reserve currency which is currently the US dollar.
  2. Hard currencies, that come from countries that can lend to themselves at competitive rates. These tend to be net-importers of commodities. Hard currencies generally act as safe-havens during periods of risk-off.
  3. And soft currencies. Soft currencies tend to be commodity producers. They are countries that have to borrow in other currencies at higher rates. These currencies depreciate during periods of risk aversion.

So… EMs are countries with soft currencies whom have to borrow in foreign hard money (typically dollar or euros) and therefore run into debt repayment problems when their currencies fall AND… due to widespread price and wage indexation, suffer from higher inflation when their exchange rate drops forcing their central banks to carry out procyclical tightening (ie, raising interest rates into a crisis) which causes a spiraling negative economic shock.

These conditions are what lead to the standard balance of payment (BoP) crises that EMs go through seemingly every few years.

A typical BoP crisis looks like this:

  • Rapid economic growth attracts large capital inflows from foreign investors chasing higher returns.
  • This capital flows into equities and hard currency denominated debt.
  • The strong domestic growth leads to a rise in imports which creates a current account deficit (more imports than exports) which then needs to be financed by more foreign capital flows.
  • Eventually, growth slows and debt reaches levels that cause foreign investors to become concerned about the country’s ability to service it and pay it back.
  • This causes the hot money flows to reverse, which drive the currency down, making the hard currency debt more expensive to repay, which causes more hot money outflows, in a crushing positive feedback loop.
  • This goes on until the central bank raises interest rates enough to steady the currency and domestic demand collapses which brings imports back below exports, thus balancing the current account.

This is what we’re seeing variations of occuring in EM now, specifically in Turkey and Argentina.

But here’s why this time is going to be different.

You see, in the past, an EM BoP crisis led to a painful but typically very short, economic contraction where the economies and markets experienced v-shaped recoveries. The 97’ Asian crisis being a perfect example.

They were able to do this because they were rapidly expanding their share of global exports from a low base. A devalued currency meant more attractive exports which meant rising profits and a quickly balanced current account (exports greater than imports). This enabled EMs to deleverage and grow their way out of trouble.

Sri thiruvadanthai of the Jerome Levy Institute wrote about this in one of his recent papers (emphasis by me).

Given this background, it is clear why globalization, especially the period 2000-08, was so beneficial for EMs. Globalization allowed EM exports to DMs to grow exponentially, relaxing the BOP constraint. Moreover, increased capital flows allowed EMs to build their foreign currency reserves, further weakening the BOP constraint. The process of building reserves also fueled demand for safe assets, depressing yields in DMs and extending the unsustainable process of debt-fueled growth in the DMs. However, the EM boom of the 2000s was in part supported by an unsustainable debt driven growth in the DMs. Thus, when the financial crisis of 2008-09 forced DMs to deleverage, it undermined a key pillar of EM growth. The weakness of DM growth post 2008 and the plateauing of offshoring and outsourcing meant that EM export growth hit a wall. Initially, EMs were able to counteract these headwinds by running large fiscal deficits and by turning to domestic profit sources. As we have seen in a previous section, domestic profit source growth requires domestic credit creation. Unsurprisingly, EM credit growth exploded post-2008, and not just in China. The limits of EM domestic demand-driven strategy were reached sometime in 2012-14, and since then EM economies have been struggling.

EM’s structural growth limitations can be boiled down to the following:

  • EMs are BoP constrained. Since they have soft currencies — meaning, they can’t finance current account deficits in their own money — they can’t grow faster than their exports for an extended period of time. Because, a current account deficit leads to a build up of hard currency debt, hot money outflows, and a BoP crisis.
  • EMs have maxed out their market share of global exports. EMs now comprise over 50% of global non-commodity exports (see chart below) and further export share growth will likely be from one EM cannibalizing another. Globalization has peaked and with increasing trade tensions, we should even see a reversal of some of the outsourcing and offshoring that’s occurred over the past two decades.
  • EMs are facing a significant debt burden amid tightening global liquidity. EMs are weighed down by a large amount of debt which they’ve accumulated in financing their current account deficits over the last decade, and much of this debt is dollar denominated. Rising US interest rates and a strengthening dollar will continue to put pressure on EMs going forward.

(Image via Bridgewater)

Then of course there’s a deleveraging China, which has been a big source of demand growth for EMs over the last decade but won’t be any longer.

So EMs are in a tough spot going forward. They need to rebalance their economies and boost domestic demand since they can no longer rely on exports as a serious source of growth. But, until they can get other countries to accept their currencies as payment, they will remain BoP constrained by their soft currency which won’t allow them to grow faster than their export growth. Which, as we’ve discussed, is going to be low.

I see a lot of investors and financial journos talking about how now is a good time to buy EMs. They’re all playing off the old EM playbook and are expecting a v-shaped recovery which is not going to materialize. What will, is a slow moving economic contraction with occasional country specific crisis that will frustrate investors trying to bottom pick.

Select EMs will make for incredible asymmetric investments once the next cycle begins in a few years time. By then, I expect the narrative to have completely flipped from where it is today and EM in general will be a hated and completely discarded asset class. That’s when it’ll be a good time to buy.

Lastly, here’s some good charts that show some of the headwinds EM is up against in the coming years.

A large amount of EM corporate high yield USD debt is maturing in the coming years. As the dollar continues to strengthen, the global dollar shortage will become more apparent and EMs will suffer for it.

(Image via Bloomberg)

Global investors put money in EM stocks and bonds (which are generally seen as riskier) because they are chasing higher relative growth and thus, higher returns. When their growth is declining relative to that of DMs then there’s little reason for investors to invest in EM. This is part of the core-periphery paradigm (charts via MS).

Over the last few years, there’s been a huge amount of hot money flowing into EM equity and debt. There’s still plenty of capital that needs to be unwound.

There’s going to be a reflexive global growth feedback loop in all this. EMs today make up a much larger share of global growth than they did 20-years ago. A slowdown in EM will drive a slowdown in developed markets which will reduce EM export growth, further constraining their ability to grow and so on.

(Image via Bridgewater)

(Image via Bridgewater)