Record Calm Stock Market Gets A Shock

Via Dana Lyons" Tumblr,

After a record run of muted movement, will recent volatility send negative shock waves through stock market?

The recent uptick in stock volatility has some investors on edge (OK, it is mostly just financial news editors on edge). The truth is, while volatility over the past week has seen an increase, it is not all that far away from the historical norm. Last Thursday through Monday, for example, the Dow Jones Industrial Average (DJIA) experienced 3 straight “volatile” days, with daily ranges of between 1% and 1.6% on all 3 days. Looking historically, however, we find that the average daily range in the DJIA over the last 90 years is 1.6%. Even during the current bull market since 2009, the average range is 1.08%. Thus, the recent action should hardly be characterized as volatile.

The reason it perhaps seems so tumultuous is because we are emerging from a long stretch of calm in the market – record calm, at that. Prior to Thursday, the DJIA had gone 72 days without experiencing a daily range as wide as 1%. If that sounds like a long stretch, it’s because it is a record. In fact, the record prior to this recent streak was just 49 days in a run that ended in late February of this year. And prior to 2016, the record going back to 1928, according to our database, was a mere 32-day streak back in 1944 – less than half the recent streak.

Furthermore, historically, there have been just 16 streaks that have lasted as long as 21 days, i.e., 1 month.

Interestingly, this recent streak is the first of any of the 16 that saw 3 straight 1% daily ranges immediately following its culmination. So is mean-reversion starting to rear its volatile head here following the record calm? And is there a nefarious message to the sudden uptick in volatility?

*  *   *

If you’re interested in the “all-access” version of our charts and research, please check out The Lyons Share. Find out what we’re investing in, when we’re getting in – and when we’re getting out. Considering that we may well be entering an investment environment tailor made for our active, risk-managed approach, there has never been a better time to reap the benefits of this service. Thanks for reading!

The Difference Between GAAP And Non-GAAP Q3 EPS For The Dow Jones Was 16%

The last time we looked at the near-record difference between GAAP and non-GAAP Dow Jones earnings, we found that it had crept to a (virtually) unprecedented 25%. To be sure, that was exactly one year ago, when the economy was perceived as being in worse shape than it is now, thanks to the narrative of a "global coordinated recovery" which is really just record central bank liquidity injections, and Chinese credit creation, both of which have recently hit the brakes.

That said, going back to the question of GAAP vs non-GAAP divergence, one would assume that in light of the so-called global recovery of 2017, company earnings would be more real and not the "pro forma, one-time, non-recurring" fabrication that US corporations are so fond of. Alas, one would be wrong.

As Factset"s John Butters writes in a recent blog post, as of today, all of the companies in the Dow Jones Industrial Average (DJIA) have reported actual EPS for Q3 2017, which brings up several questions: what percentage of these companies reported non-GAAP EPS for Q3 2017? What was the average difference and median difference between non-GAAP EPS and GAAP EPS for companies in the DJIA for Q3 2017? How did these differences compare to recent quarters?

Here are the answers:

For Q3 2017, 21 (or 70%) of the 30 companies in the DJIA reported non-GAAP EPS in addition to GAAP EPS for the third quarter. Of these 21 companies, 16 (or 76%) reported non-GAAP EPS that exceeded GAAP EPS. Over the past six quarters (Q1 2016 – Q2 2017) 68% of the companies in the DJIA reported non-GAAP EPS in addition to GAAP EPS and 80% of these companies reported non-GAAP EPS that exceeded GAAP EPS.

Thus, slightly more companies in the DJIA reported non-GAAP EPS in Q3 2017 relative to the average of the past six quarters, while slightly fewer companies in the DJIA reported non-GAAP EPS above GAAP EPS in Q3 2017 relative to the average over the past six quarters.

For Q3 2017, the average difference between non-GAAP EPS and GAAP EPS for all 21 companies was 284.1%, while the median difference between non-GAAP EPS and GAAP EPS for all 21 companies was 10.1%. The average difference between non-GAAP EPS and GAAP EPS for the DJIA was unusually large in the third quarter because of Merck. The company reported non-GAAP EPS of $1.11 and GAAP EPS of -$0.02 for the quarter. Thus, the percentage difference between non-GAAP EPS and GAAP EPS for Merck for Q3 exceeded 5000% (on an absolute basis).

So let"s normalize: excluding Merck, the average difference between non-GAAP EPS and GAAP EPS for the remaining 20 DJIA companies was 15.8%. How does that number look in context: Over the past six quarters, the average difference between non-GAAP EPS and GAAP EPS for companies in the DJIA was 72.8%, while the median difference between non-GAAP EPS and GAAP EPS was 13.4%.

Finally, if one takes the average of the median DJIA median differences for the past 4 quarters (LTM), one gets just over 14% (and 15.8% if "normalizing" the latest quarter"s data).

This means that while the forward non-GAAP P/E multiple may be 18x based on a 33.4 (non-GAAP) S&P EPS, if one assumes that roughly 14% of the latest earnings, and those projected for the next 5 quarters, are "fluff" then applying a 14% haircut to the forward consensus EPS of 143... 

... which amounts to 123 in EPS for the S&P500 - then the market"s forward GAAP PE multiple is 21x. With the exception of the pre-dot com burst, the market"s forward P/E multiple has never been that high.

Matt King: "We Are More Reliant On Central Banks Holding Markets Together Than Ever Before"

Two weeks ago we summarized the stunning impact that ECB Predit Mario Draghi"s "whatever it takes" efforts have had on European capital markets in one simple chart...

... which as Wolf Richter showed on Friday meant that European junk bond yields are now on top, if not lower than 10Y US Treasurys, indicative of a market that has "gone nuts" largely thanks to the ECB"s daily intervention, which as reported moments ago, now holds €103.39BN in Europe"s corporate bonds, or nearly 13% of the total outstanding.

Today, perhaps troubled by the ongoing distortions in the European bond market, Citi"s global credit strategist Matt King also looks at the European bond market and in a note titled "Partying like it"s 2007", he looks at recent development in the Investment Grade bond market and writes that "after the rally in recent weeks, the 53bp z spread on € iBoxx Corp is 20bp wide to the 33bp it reached in June 2007. However, he noted that a straight comparison of the index spread level now with then is misleading."

King points out that a huge decline in index rating quality means that, on a like-for-like basis, spreads would only be 41bp: just 8bp shy of the tightest € IG spreads ever.

This means that the upside is very limited: "Even if we do rally back to the all-time tights, that would equate to less than 0.5% of excess returns from here."

We won"t go into the details of the breakdown of the adjusted credit spread, but we will highlight a key thing in King"s observations, namely what is the true level of European leverage, and what is prompting this market distortion (spoiler alert: central banks).

Sceptics may argue that the system is much less levered now than in 2007, and (insofar as it goes) this is true. Back then, the response to tight spreads on what was believed to be low-risk assets was to lever up – by taking exposure through a hedge fund buying on margin and benefiting from European banks’ lack of constraint on leverage ratios, or by buying a structured product which leveraged the underlying assets.

Still, even if the growing back then leverage may have been a source of risk, King is not so sure that it all led in the direction of spread tightening, and as he adds "we are doubtful that today’s one-way reach-for-yield, in which many investors have almost despaired of relative value as a concept, is as much safer as regulators like to think."

To the extent that higher gross CDS notionals (Figure 14) are a crude reflection of this increased leverage, much of the trading being done involved relative value relationships – shorts as well as longs – in a way that simply doesn’t happen today. Indeed, it feels to us as though markets were much more two-way back then than they are now. In some sense the additional leverage clearly did add to systemic risk – it is impossible to look at the 2008 liquidity squeeze and argue otherwise – but we are doubtful that today’s one-way reach-for-yield, in which many investors have almost despaired of relative value as a concept, is as much safer as regulators like to think.

Another difference between 2017 and 2007 is CDO issuance, a product which remains largelly dormant in the current market:

Probably the biggest source of “artificial tightening through leverage” back in 2007 was the volume of synthetic CDO issuance. Synthetic CDOs (CSOs) effectively created negative net supply, as net protection selling by investors forced dealers to buy bonds to hedge their books, dragging both CDS and cash spreads tighter in the process. From 2003-2006, global delta-adjusted CSO issuance ran around $300bn/year; in 2007, this increased over $600bn.

As for today...

But the comparable number today is the buying from global central banks. This too produces an “irresistible force” driving spreads tighter, which investors feel powerless to resist. And the volumes are much larger still, averaging around $1.2tn/year (Figure 15) relative to CSOs’ $3-600bn. Admittedly this is spread across asset classes, with the CSPP in isolation amounting to only €80bn – but to take the latter number would to our minds grossly understate the additional demand created in credit. While it’s essentially impossible to isolate an undistorted credit spread in either case, the fact that the increasingly finite demand of central banks is what has facilitated such tight spreads in the first place is hardly reassuring.

In other words, the same thing verbalized as the chart shown up top shows in very simple terms: it"s all frontrunning the ECB"s corporate purchases/

What does this mean for returns?

The post-adjustment 8.5bp of additional spread on the current index relative to the 2007 tights equates to less than 0.5% of index return – from the point where spreads are back to the tightest level on record. And that was a level that with hindsight was driven by leverage and unrealistic assumptions about credit quality – of banks, of corporates and of sovereigns. The aftermath was not a pretty sight.

The conclusion for both the economy, and market, is troubling especially at a time when central banks are preparing to reduce their balance sheets:

With asset prices displaying a high degree of correlation with central bank liquidity additions in recent years, that feedback loop makes the economy, upon which both corporate profitability and bank net interest margins depend, more reliant on central banks holding markets together than almost ever before. That delicate balance may well be sustained for the time being. But with central banks beginning to move, however gingerly, towards an exit, is it really worth chasing the last few bp of spread from here?

Between record high valuations, FOMO, and confidence that central banks will come to the rescue once again, not to mention the MSCI World Index and the DJIA both hitting yet another all time high, the answer appears to be a resounding yes.

5 Charts That Scream "This Is It"

Authored by Stephen McBride via GarretGalland.com,

Before yesterday, the S&P 500 and DJIA hadn’t seen a 1% drop since October 2016. For some perspective, Hillary Clinton was the presidential frontrunner the last time markets fell 1%. This was the longest such streak for both indices in over 20 years.

In February, the DJIA recorded its longest “winning streak” since 1987. It closed 2,000 points above its 200-day moving average for the first time ever.

Also in February, the combined market cap of the S&P 500 topped $20 trillion for the first time. Its market cap has increased by over $2 trillion since the election—staggering.

Like we discussed last month, with a proliferation of “record” highs in 2017, where are market valuations at today? The five charts below paint the whole picture best.

Chart #1: S&P 500 Price/EBITDA

Today, the S&P 500 price/EBITDA sits at an all-time high.

Source: The Credit Strategist

This tells us that the current rally can be largely attributed to “valuation expansion.” Indeed, around 60% of the gains since 2009 have come from this source. At the same time, earnings growth has been anemic.

From 2012–2016, annual earnings growth was just 0.49%. In comparison, from 1995–1999, growth was 9.5%.

Chart #2: CAPE

Another commonly used metric is the cyclically adjusted, price-to-earnings ratio (CAPE).

Currently, the CAPE is 73% above its mean. Besides its reading before the 1929 crash and dot-com bubble, the ratio is at its highest level on record.

Source: Robert Shiller

Chart #3: Total Market Cap/GDP

Warren Buffet’s favorite valuation metric, total market cap relative to GDP, currently stands at 130%—a 129% increase since 2009. This rise also brings the ratio to its highest level since 2000.

Source: Gurufocus

Chart #4: NYSE Margin Debt

High levels of margin debt lead to increased volatility as more people are forced to sell due to margin calls.

In January, margin debt hit another record high. The two previous tops were one month and three months prior to the respective 2000 and 2008 market crashes.

Source: Advisor Perspectives

Chart #5: The Complacency Index

Margin debt making another “all-time high” signals the cycle is in late stages when complacency takes hold. And surprise, surprise, that too is at all-time highs.

Source: Bloomberg

In the past, when the complacency index was high, stocks invariably saw big corrections shortly thereafter.

By most metrics, equities look pricey. But even with the bull market now eight years old, sentiment continues to be extremely bullish. So, what are the takeaways from these lofty valuations?

Lower Future Returns and Higher Downside Risk

To quote Warren Buffet, “The price you pay determines your rate of return.” In a nutshell, this sums up what today’s valuations mean for investors.

High valuation metrics aren’t indicative of an imminent market crash. What they do tell us is that we must lower our expectations of future returns.

While the correlation isn’t perfect, this chart shows a higher CAPE ratio usually means lower future returns.

Source: Bloomberg

With the stunning run-up in markets since 2009, investors can’t reasonably expect returns to continue at double the long-term average. At a time of exuberance, it’s important to remember markets are cyclical.

The other takeaway from today’s valuations is that when the drawdown does come, it will be severe. As this chart from Star Capital shows, downside risk tends to increase as market valuations become excessive.

Source: Star Capital

Given current market levels, investors may want to lower their future expected returns. It’s important to note that “record highs” are records for a reason. It’s where previous limits were reached.

With that in mind, how should investors approach the markets today?

Adopt a Contrarian Investment Strategy

While markets continue to make new highs, investors should proceed with care. This is the second-longest period in stock market history without a 10% correction. As detailed above, the higher valuations go, the worst the subsequent drop.

The average decline during the last five bear markets was 33% - the next one could be much worse. Of course, markets could rise another 50% from here before falling. But given their run-up since 2009—is it a risk worth taking?

*  *  *

Learn More About the Contrarian Value Strategy in Our Free Report, 3 Proven Strategies to Invest in Uncertain Markets Like These - In this report, we detail three strategies investors can use to find value in today’s generally overpriced markets. Click here to learn more about this proven investment system that will change how you invest forever.

Dow Dragged Lower By UnitedHealth After Government Sues Largest US Health Insurer

The Dow Jones "Industrial" Average is suffering one of its worst intraday declines in weeks as a result of a 3.6% drop in UnitedHealth shares, which are sinking on news that the DOJ joined a whistleblower lawsuit against the insurer filed by a former executive claiming the country"s largest health insurer overcharged Medicare hundreds of millions of dollars.

The company denied the allegations, with UnitedHealth spokesman Matthew Burns saying in a statement that "we reject these more than five-year-old claims and will contest them vigorously." 

Alleging insurance fraud, the lawsuit which was filed in 2011 and unsealed on Thursday, claims UnitedHealth Group overcharged Medicare by claiming the federal health insurance program"s members nationwide were sicker than they were, according to the law firm Constantine Cannon LLP. Overnight, the DOJ also joined in allegations against WellMed Medical Management Inc, a Texas-based healthcare company UnitedHealth bought in 2011.

The lawsuit by whistleblower Benjamin Poehling, a former UnitedHealth executive, has been kept under seal in federal court in Los Angeles while the Justice Department investigated the claims for the past five years. Constantine Cannon posted the lawsuit online when it was unsealed on Thursday.  No total damages were specified in the lawsuit.

UNH"s drop is the biggest contributor to the DJIA"s intraday slide, accounting for nearly 80% of the total point loss in the index.

Despite the lawsuit, Wall Street"s sellside analysts - most of whom are bullish on the company - have quickly come to its defense, via Bloomberg

Oppenheimer (Michael Wiederhorn)

• DOJ claims center on UNH’s efforts to improve coding, date back to 2011


• While headlines aren’t positive, these processes take a long time and “typically result in manageable settlements”


• Expects UNH will get past this overhang, sees weakness as buying opportunity


• Rates UNH outperform, PT $186

Leerink (Ana Gupte)

• Risk is overblown; recommends buying UNH, Humana, WellCare and other Medicare Advantage (MA) stocks on weakness today


• Expects Trump administration will favor private MA plans with deregulation and more industry-friendly policies


• Rates UNH outperform, PT $195

Credit Suisse (Scott Fidel)

• DOJ joining whistleblower case is negative headline, especially since market has been bullish for prospects for MA under Republican leadership


• Even so, regulatory scrutiny isn’t new issue and Centers for Medicare & Medicaid Services has said MA revenue should benefit from more accurate risk coding


• Rates UNH outperform, PT $180

Evercore ISI (Michael Newshel)

• While DOJ joining case adds to risk, complaint doesn’t have “any particularly damning new evidence”


• Believes many of coding optimization practices described are common to industry


• Rates UNH buy, PT $185

The unsealed lawsuit is below:

The "Other" Dow Theory Is Waving A Red Flag

Via Dana Lyons" Tumblr,

While the Dow Industrials remain near all-time highs, the Utilities are well off of their highs; this has signaled trouble in the past.

Back in May 2015, we wrote a series of posts on divergences in the equity market. The series was partially inspired by the considerable attention being paid to the prevailing divergence between the Dow Jones Industrial Average (DJIA) and the Dow Transportation Average (DJT). Of course, the relationship between those 2 indices form the basis of the popular “Dow Theory”. And while there are multiple stipulations to the Dow Theory, its crux is based on the confirmation or divergence between the 2 indices. And the failure at that time of the DJT to confirm the new high in the DJIA was concerning some market observers.

Upon a study of the historical relationship between the 2 indices, our assessment was that the Dow Theory, or at least that part of it, was a bit overrated. It’s not that it was wholly irrelevant. Indeed there were multiple examples of divergences signaling major cyclical tops in the markets. And, in fact, that May 2015 occasion marked a significant intermediate-term top prior to the considerable market weakness over the subsequent eight months. However, we found the divergences to be just too unreliable as a market signal.

On the other hand, there were other divergences occurring at the time that we felt were more worthy of investors’ concern. One such divergence dealt with the sister index of the DJIA and DJT, i.e., the Dow Jones Utility Average (DJU) (as an aside, for all you Dow Theory disciples, we are not applying the actual Dow Theory rules to the DJU, just the divergence statistics). The DJU was also badly diverging at the time and since we had similar historical data as the DJIA and DJT, we thought we would take a look at those such divergences. As it turns out, large divergences of the Utilities historically demonstrated much more reliability as a harbinger of trouble than the Transports, according to our study.

We bring this up today because while the DJIA continues to hang up near its highs, the DJU is once again diverging, sitting well off of its 52-week highs. Thus, we revisited the 2015 post and updated the divergence study. Specifically, we looked for any time that the DJIA traded at a 52-week high while the DJU was at least 10% below its own high. Since 1943, there have been 73 days matching this criteria (many of the dates fell in clusters; though the clusters were of similar numbers of days so we included all such days).

We will note that at last week’s DJIA 52-week high, the DJU was 9.4% below its high so it barely missed meeting this criteria. However, there were numerous occurrences in November and December that qualified. And once again, if recent history is any guide, this might be a problem down the road because the performance of the indices following such divergences has not been good (FYI, by “recent”, we mean since 1943; such divergences prior to that were not as damaging.):

As the table shows, in the intermediate-term following these divergences, returns on both the DJIA and the DJU were exceptionally weak. After 3 months, the DJIA was lower by a median -4.1%, with 80% of the occurrences showing losses. The DJU was also down a median of -4.1% after 3 months, with 75% losers. 6 months after the events, median returns were even worse for the DJIA and DJU at -4.9% and -7.5%, respectively. And even out to 12 months, the majority of these divergences saw both indices lower.

So while the recent simultaneous, confirming highs in the Dow Industrials and Transports has Dow Theorists quite bullish at the moment, the lesser-watched relationship between the DJIA and the Utilities is not quite so positive. Will this divergence be a sign of trouble again this time? There are no guarantees. However, if the historical pattern holds true, we can expect the weakness to begin soon as it has been over a month since the November-December occurrences.

*  *  *

More from Dana Lyons, JLFMI and My401kPro.

Another Reason Not To Sell Bonds...Yet

Submitted by Lance Roberts via RealInvestmentAdvice.com,

Since the November election of Donald Trump, the investing landscape has gone through a dramatic change of expectations with respect to economic growth, market valuations and particularly inflation. As I noted two weeks ago, there is currently “extreme positioning” in many areas which have historically suggested unhappy endings in the markets. To wit:

“Much like a ‘rubber band,’ prices can only be stretched so far before having to be relaxed to provide the ability to be stretched again.

The chart below shows the long-term trend in prices has compared to its underlying growth trend. The vertical dashed lines show the points where extreme overbought, extended conditions combined with extreme deviations in prices led to a mean-reverting event.”

We can also witness the rather extreme extension of prices above the 200-dma. Such extensions, which are always combined with extreme overbought conditions, have typically not lasted long and have been a good indication to take profits in the short-term. This provides some opportunity to invest capital following a correction to some level of support.

---

Buy The Dip? Probably.

HedgEye had a good note on why the market keeps going up against what we would deem to be rational behavior:

“How does the rate of change of volatility (VIX) affect what’s getting “expensive” and “cheap”?

I think about that in terms of the volatility of volatility. It’s something you can readily measure and map with futures and options data.

Looking at the S&P 500’s (SPY) realized volatility,  for example:

1. 30-day realized volatility has been smashed to 6.6%


2. But, at 8.7%, implied volatility is trading at +29.2% premium


3. On a TTM z-score that implied volatility premium is +0.44x”

“So that keeps telling me that the highest probability outcome remains for lower-highs and lower-lows in VIX.

And that keeps happening in a US Equity market that is often called “expensive” (it is), but doesn’t get cheaper. Maybe someone from the orthodoxy of macro “valuation” experts can chime in on why this is happening.

I think it’s because consensus continues to position for a correction that would be deemed “rational”, as opposed to buying all dips in an irrationally profitable position that’s been complimented by prevailing growth and inflation conditions.

Can the U.S. stock market get more expensive? Absolutely.”

A “buyable correction” would suggest a correction back to recent support levels that keep the overall “bullish trend” intact. 

The chart below shows the recent advance of the market has gotten to extremely overbought conditions on a short-term basis and the ‘sell signal’ noted at the top of the chart, combined with the extreme overbought condition at the bottom, suggest a potential correction could take the market back to 2200. Also, note the negative divergence of the PMO oscillator despite the advance in the market. 

While such a correction would be relatively minor in the short-term, it would also violate the bullish uptrend that has held since the 2016 lows. 

However, putting this into an actual loss perspective, the following chart details specific support levels back to the psychological level of 2000. A violation of the 2000 level and we are going to start discussing the potential for a more severe market correction.

A violation of initial support level sets up corrections of 4.9%, 6.6%, 8.6% and 13.2% from the recent highs. With bullishness running at highs, and cash allocations at lows, the risk of a short-term reversal is high.

However, I am certainly not discounting the short-term ability for the markets to move higher as discussed in “2400 or Bust!.” This is particularly the case if fiscal policy is actually implemented, earnings improve more than expected or additional monetary policy is introduced. But it is the risk of loss that currently outweighs the reward.

However, there is another more extreme view that was put out by Matrix Trade yesterday:

“For the last seven years, we have tracked both the DJIA and SPX with very similar bull markets in both 1929 and its copy 1987 made famous by Paul Tudor Jones using very similar technology for arguably one of the greatest trades of all time. The US markets have now entered the last but most aggressive phase of the uptrend where sentiment takes over and where perma-bears give up all hope. They are now finally right in principle but not timing nor extent”

“We had wondered what would trigger such aggressive strength and volatility… until November 9th, 2016 when Donald Trump was elected. The subsequent change in the market dynamic not only provides the reasons for this move but also provides a very clear date from which to countdown very similar blowouts. As we have target areas for both percentage and a timeline to count up or down and indeed different indices to compare we will continue to monitor the price action exactly in line with these famous historic blowouts and crashes. Good Luck !”

Like a dealer at a poker table enticing players into a game:

“Step right up, place your bets and take your chances.” 

---

Another Reason Not To Sell Bonds…Yet

As I penned last weekend:

“If the market corrects, OR the economy hits a speed bump, OR something happens in the Eurozone, OR…OR…OR…the covering of short positions in bonds will cause an extremely fast drop in yields.

Sure, anything can happen. If yields on the 10-year Treasury break above 3% it will be coincident with a sharp rise in consumer spending, wages, inflationary pressures that are broad based and surging economic growth. In such a case it will make sense to reduce bond holdings in favor of equities.

However, given the fact we are already in the 3rd longest economic expansion in history, combined with the second highest levels of valuation on stocks, the odds of such an outcome are extremely low.” 

But here is another reason to stay long bonds.

Currently, as noted by ZeroHedge on Friday:

“With political and economic policy uncertainty at record highs and equity market valuations near record highs, we have one question: which market – interest rates or stocks – is right about ‘risk’ ahead?”

Currently, there are record shorts on volatility which suggest there is little expectation of a market correction currently. In other words, everyone is now on the long-side of the proverbial “boat.” 

So, why own bonds? 

As shown in the chart below, interest rates are negatively correlated to the volatility index. With the extreme net short positioning in bonds, a market correction would spark a rotation from “risk” to “safety” pushing rates towards 2%. However, such a reversal would also trigger a panic-driven short-covering trade which would likely push rates even lower towards 1.5%. 

That thought was also discussed recently at the Macro Man blog:

“We still think that Mr. Bond will have a soft landing this time. In fact, now that the Inaugural is behind us, with all of its ‘Sound and Fury signifying nothing’, Mr. Market will likely undertake a more cerebral evaluation of the likelihood of 4, 5 and 6% US GDP in 2017.

A renewed safe haven bid for Mr. Bond and other fixed income assets seems certain before long, as Real Money and commercials have increased their net longs. The speculative community remains extremely short bonds, providing a mechanism to accelerate any recovery in fixed income once it gathers speed, eventually forcing a surprising number of concealed shorts to return to a more neutral positioning in Treasuries.”

Currently, we remain long bonds as a hedge until the abnormalities are reversed.

Barron's: Next Stop Dow 30,000... On One Condition

The financial magazine which has made an art out of calling for big, round numbers in the Dow Jones Financial Index (as a reminder over 20% of the Dow"s surge since the election is due entirely to Goldman Sachs), most recently with its "get ready for Dow 20,000" call from just over a month ago, has done it again:

While there are still those - pretty much anyone who still cares about fundamentals - who are scratching their heads at Dow20K, according to Barrons "the Dow hitting 20,000 was no fluke. Today’s stock prices are well supported by solid prospects for corporate earnings and economic growth." 

In fact, Dow 30,000 is just around the corner... well by 2025. All President Donald Trump has to do, according to Barron"s, is "avoid stumbling into a trade war—or a real war." Some of the profound insight behind this forecast so reminiscent of the infamous "Dow 36,000" prediction which hit just around the time of the last market bubble.

Clearly, part of the propulsion behind stocks has been the Trump administration and its flurry of business-friendly edicts. If Trump can succeed in reducing regulation and lowering corporate taxes, stocks should surge further this year. An additional 5% or even 10% gain in 2017 wouldn’t be surprising. Our projection of 30,000 by 2025 is based on our analysis of historical data provided by Jeremy Schwartz, director of research at WisdomTree. This data, which looks at stock market returns for rolling five-year periods dating back to 1871, suggest stock market gains will fall below the market’s typical annual gain of 6% after inflation in the next five years before accelerating above the average in the years after that.

Then again, perhaps Dow 30,000, which would require China to inject in at least another $30 trillion in debt in the next decade without somehow hitting the Minsky moment tipping point, is not so certain: it all depends on whether Trump can avoid war, either literal of metaphorical:

"a few of the new administration’s policies pose a serious threat to the economy and stock market. The most evident one last week was the trade spat with Mexico, with the White House at one point floating the idea of a 20% border tax on Mexican goods entering the U.S. If Trump gambits like this were to trigger a trade war, the world economy would suffer. The Dow would have a hard time getting to 30,000 by 2025."

Alternatively, one can make the argument that a trade, or real war, would guarantee hitting the Dow 30,000 that much quicker: after all, it would force the Fed to resume QE, monetizing not just bonds, but ETFs, equities, and everything else in capital markets in order to preserve confidence in the global financial system.

Ironically, in the same Barron"s edition, we also read a more nuanced take of what Dow 20,000 really means from Randall Forsyth who notes says that "while the Dow is the gauge that regular folks use to keep track of the stock market, a columnist in the Financial Times condescendingly called the attainment of the 20,000 mark last week “fake news.” The flaws in the price-weighted DJIA are known to anyone who cares about such things, but it was the best method available to Charles Dow before the turn of the 20th century. As a result of its modus operandi, David Rosenberg, chief economist and strategist at Gluskin Sheff, observes that moves in Goldman Sachs Group (ticker: GS) have eight times the impact on the Dow as those in General Electric (GE).

So-called survivorship bias also has benefited the Dow. Since April 2004, Dave found that, if the eight companies that were replaced in the DJIA had been kept on, the blue chips would have been at just 12,885 now. That date, by the way, is the furthest back he could go to find former Dow companies that are still around. In the process, Apple (AAPL) was added in 2015, after a seven-for-one stock split that prevented the tech giant from having an outsize impact on the DJIA. While Rosenberg notes that tech stocks now account for a quarter of the Dow, up from 2% at the peak of the dot-com boom in 1999, the so-called FANG stocks— Facebook (FB), Amazon.com (AMZN), Netflix (NFLX), and Google parent Alphabet (GOOGL)—wait to be admitted to the blue chips.

Not surprisingly, President Donald Trump was more than willing to take credit for the Dow’s hitting 20,000 five days into his administration (arguably more deserved than President Barack Obama getting the Nobel Peace Prize months after taking office in 2009)—a reversal of his declaration that the market was in a “fat bubble” last September.

To a more dispassionate observer—in this case, Peter Berezin writing in the BCA Research Global Investment Strategy—the shift represented an evolution from undue pessimism about global growth to unbridled optimism.

And, as JPM has warned every single day in the past month, the next step in the market climbing the wall of optimism may be slippery:

The centerpiece of the Trump program—tax cuts and tax reform—can’t be enacted by executive order. That will take approval by Congress. However, the White House has widening rifts with GOP leaders, writes Greg Valliere, chief strategist at Horizon Investments and a four-decade Washington watcher: “Make no mistake—[House Speaker] Paul Ryan and [Senate Majority Leader] Mitch McConnell can’t stand Trump, and the feeling is mutual.”

While the Dow has been happy to stay above 20K for the time being, the next step may be determined by the Fed, which is meeting next week with the S&P over 200 points above where Janet Yellen warned sstocks are overvalued. As the Fed chair said in May 2015, "I would highlight that equity market valuations at this point generally are quite high," Yellen said.

"There are potential dangers there" Yellen said.

And the main one is that Yellen decides to finally pull the rug from under Trump"s market honeymoon. As Forsyth writes, "the FOMC could signal its readiness to raise its fed-funds target at the March 14-15 meeting. The fed-funds futures market puts only a 34.6% probability on a March move, according to Bloomberg’s analysis, instead pricing in the next boost for June and another in September, but not in December. The shock for the markets would be if the central bank actually delivers the three rate increases that it has signaled."

Trump was quick to take credit for Dow 20,000, and as long as stocks keep rising, nobody will complain or contest. But how will traders and politicians react after the first 5% or 10% correction, the first bear market, and soon thereafter, an economic collapse because without central banks injecting another $14 trillion in liquidity, real economic price discovery will finally happen. With Trump"s tendency to accelerate all timelines, we won"t have long to wait to find the answer.

The Smoothest Transition Ever (For Markets)

By most mainstream media accounts, the first weekend of the Trump Administration wasn’t good. Characterized as rocky, erratic, terrible, and full of false claims, the ‘not ready for prime time’ transition team is now the ‘not ready for prime-time administration.’ However, as Bespoke details, by at least one measure, though, the Trump Administration’s transition has been pretty smooth... the smoothest ever for markets.

The table below was from this week’s Bespoke Report newsletter and shows how the DJIA performed from Election Day through Inauguration Day for each newly elected President since 1896.  Along with the DJIA’s performance during each transition, we also show the maximum percentage decline the index saw from a closing high during each period.  

With a gain of 7.62% during Trump’s transition, the DJIA had its second best transition performance since 1896.

More importantly, with a maximum decline of 1.2% from a closing high, no other newly elected President has ever seen a less volatile transition period!

Call it whatever you want, but from the stock market’s perspective at least, the Trump transition was the smoothest ever.