Make 'Soft Data' Great Again - Economic Confidence Rebounds To 16 Year Highs

The last time American consumers were this confident about the national economy was August 2001.

As a reminder, the market is not the economy... and a rising economic confidence on the heels of rising stock prices does not "forecast" the economy...

For those who believe there is more left in stocks to run, we note that economic confidence was rising to these levels in July 1997 - so you have about 30 months until the world implodes by that measure.

There"s just one problem with that exuberance...

"Soft" versus "Hard" Data again!!

Gold Surges, USDJPY, Yields Slide As Markets Finally Respond To Latest Set Of Economic, Geopolitical Shocks

With markets shut on Good Friday, even as the one-two knockout punch of the worst monthly core CPI print in 7 years hit...

... coupled with a miss in March retail sales, which suffered their biggest two month drop in 2 years...

... on Sunday night traders were desperate to catch up, or rather down to, the USDJPY which was the only instrument that traded through Friday"s data dump, and which at last check was trading at 108.34, nearly 100 pips below the Friday open, sliding further in early Japanese trading as the last holdouts on the reflation trade capitulate in panic, further pressured by fears over the rapidly deterioating situation in North Korea.

As one would expect, a surge in the yen means continued weakness in the dollar, and sure enough on Sunday night, Donald Trump"s recent bid for a weaker greenback has been the market"s command.

Predictably, and contrary to virtually every sellside analyst"s prediction for ongoing levitation in interest rates, US TSY yields have tumbled across the curve, with 5-year yields down as much as 5bps at 1.72%, lowest since Nov. 18, while the benchmark 10-year yield has slide 4bps to 2.20%, also the lowest since the election.

Perhaps the one asset class where the reflation revulsion has not been observed yet is S&P futures, as the E-mini stubbornly holds out to selling pressure and is barely lower on the session following Thursday"s sharp drop.

However, while equity markets may be ignoring the moves in FX and rates, gold is hardly waiting, and on Sunday night evening was trading above $1,290/oz, the highest price since the Trump electiomn... 

... and poised for a key double resistance breakout.

While the spike in gold is hardly a surprise in light of last week"s economic data and this weekend"s North Korean events, with spot not trading there was little opportunity for traders to take advantage of what many expected would be a sharp jump in the yellow metal. Except... that"s not quite true: as we noted on Friday, while spot may have be closed, physical vendors such as Ampex were happy to sell gold, and even better, at Thursday"s depressed price.

Gold arb trade: Physical dealers like Apmex are still stuck at Thursday"s gold price

— zerohedge (@zerohedge) April 14, 2017

Finally, before we forget, there was another asset class that was surging overnight: the Turkish lire, which has been on fire ever since Erdogan won the popular mandate to become dictator, and which just as Barclays predicted, would lead to a spike in the Turkish currency... if only for a the very near future.

SNAP Cracks Back Below $20

With a plethora of analysts pushing "buy" recommendations - enough to pump the stock back above its post-IPO open at $24...

It appears hope is fading fast once again for the so-called "camera" company as it drops back near its record lows below $20...

"Think 1999": Morgan Stanley Sees Huge 30% Surge In Stocks "Investors Cannot Afford To Miss"

With Morgan Stanley"s Adam Parker having left the investment bank to continue his career at Eminence Capital, it was up to his replacement, Michael Wilson to come up with the Initiation of coverage report for the "Classic Late Cycle." So, in keeping a stiff upper lip, and breaking away from the gloom that appears to have recently gripped his colleagues over at Goldman Sachs, Wilson had no choice but to keep a stiff upper lip and keep the Punch Bowl full (to paraphrase Bill Dudley"s famous March 30 speech).

So, projecting a remarkable dose of optimism at a time when dramatic changes are in store for not only the Fed"s balance sheet but the global credit impulse which is now negative, Wilson, who until recently was Morgan Stanley"s Chief Investment Officer of Wealth Management, writes that "although optimism is a late cycle phenomenon, history tells us the best returns often come at the end. It has taken eight long years to get here, but Wall and Main Street are finally starting to feel a bit better about the future."

What alse comes at the end is the crash, and those tend to make both Wall and Main Street feel a bit worse about not only the future but also the present.

In any case, the basis for MS" optimism is the economic recovery - which alas is entirely missing in the hard data, which tumbled after the NFP print to the lowest level in a year - and the Trump reflation euphoria - which the bank may have missed faded about a month ago and has been rapidly contracting to pre-election levels - and uses that to extrapolate a move as high as 3,000 in the S&P, or a 30% blow off top. 

Or, as Wilson puts it, "the end of the cycle is often the best. Think 1999 or 2006-07. In a low-return world, investors cannot afford to miss it." And while "not missing it", investors will preferably buy stocks using a Morgan Stanley broker,right?

And while we commiserate with Wilson for putting it all on the line in his first report, and timestamping his wildly bullish call in a report that will be passed around for years to come, especially if this is the top-tick, here is the summary of his outlook just to help with the .

The cyclical upturn that began a year ago has less to do with President Trump and more to do with the global business cycle that bottomed in 1Q2016. Trump simply “turbocharged” the cycle and stoked animal spirits on Wall and Main Street, with tangible effects on the real economy and markets. The title of our year-ahead outlook as CIO for Morgan Stanley Wealth Management on January 1st (see excerpt at end) was “Are You Ready for Euphoria?”– based on Sir John Templeton’s four stages of the investment cycle: "Bull markets are born in pessimism, grow in skepticism, mature in optimism and die in euphoria."

What follows next may be one of the most memorable, in retrospect lines, ever written in a research report:

The end of the cycle is often the best. Think 1999 or 2006-07. In a low-return world, investors cannot afford to miss it.

So... buy stocks just at the peak of the bubble, as was the case in both 1999 and 2007, and pray for the best? Don"t worry, though, Morgan Stanley will tell you just when to sell, before it all crashes.  

Think 2000 and 2008.

The humor continues:

Equity valuation remains undemanding in a low interest rate world. Equity risk premiums (ERPs) have been exceptionally elevated in the post-crisis era of lower growth and inflation, but we may be leaving that era, which means ERPs can and should normalize. Our 12-month base case S&P 500 target is 2700.

Secular Stagnation may be over, further supporting our expectation for falling equity risk premiums. Productivity may have bottomed, fueled by the end of trends that caused the slower growth in the first place: consumer overindebtedness (housing), the oil bubble"s tax on consumers, war on terror, demographics, and bad policy (regulation, lack of fiscal/monetary coordination).

Exceptionally loose financial conditions encourage the shift toward investor euphoria. Meanwhile, our proprietary institutional and retail data suggest US equity positioning is not extreme, and market technicals are in very good shape.

To all investor who can read that with a straight face, congratulations. And perhaps just to lend credibility to his forecast, here is the matrix of Wilson"s recommendations, which sees a worst case of 2,100 in the S&P, a base case of 2,700, or over 300 points higher by EOD, and a blow off top forecast of not less then 3,000 or 30% higher from current levels.

And just to cement his "credibility", Wilson shows another chart demonstrating he is totally proficient with goalseeking in Excel sensitivity tables:

MS then narrows down its preferences to the following sectors:

Our sector/style preferences reflect our pro-risk, late-cycle thesis. Financials, Industrials, Energy, and Technology are all overweight. We are underweight Real Estate, Telecom, and Staples. We are neutral Health Care, Materials, Consumer Discretionary, and Utilities. We have a preference for small/mid caps.

An appropriate trade idea here would be to do the opposite of what MS recommends.

Perhaps most importantly, here is what Wilson believes are the risks to his call:

Risks:

1. We are late cycle and the Fed is further along than appreciated. This tightening cycle began in 2014 with the tapering of QE, which means there may be less headroom for actual rate hikes this cycle than assumed;


2. Commercial Real Estate and Autos are canaries in the coal mine that could spill over into broader credit markets;


3. Oil prices fall further and/or take longer than expected to recover—the Energy sector is the single largest incremental driver of S&P 500 earnings growth this year;


4. ECB tapering is not expected but it could happen this summer when political risks diminish in Europe.

As an amusing aside, as part of his "initiating coverage" report, Wilson shares a brief comment "on what we endeavor to provide as Morgan Stanley"s US Equity Strategist."

First, the role of US Equity Strategist at Morgan Stanley has quite a storied history. As a 27-year veteran of the firm, no one has more respect for that history or the position itself. We will do our best to live up to it. Second, our philosophy about equity markets is fairly simple – get the rate of change on earnings growth right; pay attention to valuation when it matters but don’t obsess over it; appreciate the importance of sentiment and positioning and always respect what the market is telling us. In short, trust one’s fundamental work, but verify it with the market"s signals. Third, we only exist to serve you, our client. To that end, I hope that my dual role of US Equity Strategist and Chief Investment Officer, embedded in a best-in-class global Research Department and informed by a leading institutional equity and wealth management business, will provide the strategy team – and our clients - with unique and profitable insights.

Unique profitable insights like calling an up to 30% spike at a time when the market is currently trading at 20x forward operating earnings according to Goldman...

... a number which would rise to 25x under Morgan Stanley"s bullish scenario.Clearly when Wilson  says "pay attention to valuation when it matters but don’t obsess over it" it is more focused on the latter.

Finally, while investors are welcome to trade like it is 1999, don"t forget what happened just one year later...

US Stock Funds Suffer Biggest Outflow Since 2015 As Bond Inflows Soar

According to Bank of America"s Michael Hartnett, citing EPFR data, in the latest week through April 5, there were $7.4BN in outflows from equities, the largest in 40 weeks. This consisted of $3.6bn in ETF outflows - largest in 40 weeks & first outflows YTD vs. $3.8bn mutual fund outflows.

By size & style: 3rd straight week of outflows from US value funds ($1.7bn), largest outflows from US growth in 10 weeks ($2.0bn); $0.9bn outflows from US small caps & chunky $10.3bn outflows from US large caps (largest in 82 weeks)

By sector: inflows to tech ($0.8bn, 5 straight weeks), materials ($0.2bn), utilities ($0.3bn), real estate ($0.2bn), infrastructure ($0.1bn); outflows from energy ($0.6bn, largest in 29 weeks),
financials ($0.3bn), consumer ($0.2bn), healthcare ($0.1bn)

At the same time, bonds recorded $12.4 BN of inflows, the highest in 8 weeks, with Treasuries posting largest inflows in 10 weeks as the "great reflationary rotation" crumbled once again. Curiously, this took place prior to the FOMC Minutes warning that stock prices are "too high."

By geography, the focus was entirely on the U.S., where stocks saw the largest outflow since 2015, or in 82 weeks, as $14.5 billion was redeemed. This was offset by Europe which had its second straight week of inflows ($900m); Japan drew $300MM while $2.4BN entered Emerging Markets.

An amusing chart shows that while tech funds attracted $800m of inflows, thee has been a surge of inflows into "robot funds."

A separate analysis from Lipper showed largely the same, as investors yanked the most money from U.S.-based equity funds since December during the latest week, on fears stocks may be overpriced given the many roadblocks in implementing U.S. President Donald Trump"s economic policies, according to Reuters.

Lipper adds that nearly $12 billion drained from the stock funds in the seven days through April 5, including $7 billion SPDR S&P 500 ETF, a fund actively traded by investors ranging from institutional investors making speculative bets to retail buyers. Retail investors pulled back for another week, as stock mutual funds continued a streak of net outflows that has lasted the better part of the last two years. The outflow totaled $7.4 billion during the week. Meanwhile, U.S.-based funds invested in stocks abroad took in $1.1 billion during the week.

"There"s a whole lot of uncertainty right now, which is never good for the equity markets," said Pat Keon, senior research analyst for Thomson Reuters Lipper. Keon said the United States" response to conflict in Syria and North Korea has intensified jitters over policy even though market returns have been strong.

Matthew Bartolini, head of SPDR Americas Research at State Street Global Advisors, said outflows likely include both long-term investors who are trimming their winning bets and shorter-term investors shifting to other markets, something suggested by Jeff Gundlach in his latest webcast.

Investors" worries also included March U.S. auto sales data, which this week came in far below expectations.

Finally, while active investors continue to suffer, passive vehicles such as ETFs are unable to hold the inflows: As Bloomberg"s Eric Balchunas calculates, in the first quarter Vanguard alone took in $121 billion, amounting to an unprecedented $2BN per day, and was 46% better than any other Q1, Should the inflows into ETFs continue, Vanguard is on pace to rake in a record $480Bn for the year.

Uncertainty And The Humility Of Forecasting An Unknowable Future

Authored by Charles Hugh-Smith via OfTwoMinds blog,

While we"re being reassured that all these grandiose promises are resting on trends that are as reliably predictable as the tides, the next easily predictable crisis will very likely reveal the trends are speculative bubbles that will predictably burst in a devastating reversion.

Certainty and uncertainty come in a variety of flavors. "Certainty" seems rather definite, but lurking beneath certainty is the more scientifically verifiable notion of probability: the probability of outcomes can be high enough to qualify as certain and low enough to qualify as unlikely.

We can"t know with perfect certainty that our neighbor hasn"t invented a death-ray and may decide to test it on us due to that simmering feud over his dog Fluffy"s antics on our yard.

But we can make an assessment of the probability of this occurring, and conclude the probability is low with a high degree of certainty.

This assessment should change, of course, if we hear strange noises in his shop and notice shrubs in his back yard are now charred in peculiarly symmetric circles--and we learn he previously worked at a national lab on high-energy weapons but was dismissed for pursuing crazy ideas about developing handheld death-ray devices, i.e. phasers. (Star Trek fans, please raise a cheer.)

This brings us to a critical distinction between low-probability events, i.e. known unknowns a.k.a. highly unlikely "long-tail" events, and unknown unknowns, a.k.a. "black swans" made famous by author Nassim Taleb.

What is a known unknown? Death qualifies as a known unknown: we know with a high degree of certainty that the vast majority of living things eventually die (even cancer cells die once their host dies)--but the timing of their individual natural death is inherently uncertain, due to the great number of inputs, variables and causal factors intrinsic to life.

Statistically, there is a high degree of certainty that any dynamic data series will eventually revert to the mean. Spikes in asset prices will typically drop back to the trendline, but the timing of this reversion is intrinsically uncertain due to the unpredictable interactions and feedback loops inherent in complex systems of dynamic inputs and causal factors.

Thus statisticians who are tracking a tulip-bulb (or South Seas Company) like bubble in a speculative asset can forecast the eventual collapse of the bubble, but not the date and time of the reversion.

This collapse (reversion) can be forecast with a very high degree of certainty. (If tulip bulb prices had continued rising with no reversion, tulip bulbs would now cost $1 trillion each).

There are causal mechanisms that explain this eventual collapse: the market eventually runs out of "greater fools" willing to outbid other buyers seeking to buy tulip bulbs, and sellers deciding to cash in their gains overwhelm the few buyers still in the market.

Once the speculative frenzy driven by certainty of staggering profits evaporates into a fear of equally staggering losses, the bubble loses its momentum and prices revert to the long-term trend (often after briefly falling below the mean, requiring a reversion higher).

The bubble in tulips could not be forecast like a reversion to trend. We can forecast that humanity"s attraction to speculative frenzies will not disappear, but we can"t predict the next manifestation of this human trait.

Then there are the unknown unknowns--the stuff that can"t be forecast except as a generalization, i.e. that there are unknown unknowns that will crop up with some regularity-- a regularity we can"t forecast with any certainty.

All this should nurture a profound sense of humility in all who dare to forecast an inherently unpredictable future. While humans love a good speculative frenzy that promises unearned wealth for everyone who gets into the game, they also love the illusory certainty of comforting forecasts based on past trends.

Thus we are reassured by long-term forecasts that claim a high degree of certainty that our comfortable lifestyle and all the promises issued by governments and pension plans will come to fruition as promised without any untidy or distressing reversions, phase transitions, collapses triggered by highly unlikely events (those pesky known-unknowns) or even peskier unknown-unknowns).

We are now facing an unpredictable collision of these conflicting sources of certainty and uncertainty. On the one hand, we"re constantly assured our status quo is durably permanent, and all the lines that assure us all the promises that have been issued will be met without any sacrifices or disruptions have been extended with handy pencils and rulers.

But on the other hand, we"re also assured that a certain number of unlikely events will occur despite the low probability we calculate. We"re also assured that unknown-unknowns black swans) will crop up and surprise everyone from time to time.

Can both of these assurances be true? Can we be assured that the odds of something completely upsetting our apple cart of predictable comforts, entitlements, pensions, etc. are so low we needn"t worry about them, and also be assured that highly unlikely events and unanticipated events (black swans) will arise from time to time, threatening the comfortable certainty of all these systemic promises?

The answer is "yes and no." We can say that based on current trendlines, the future should be predictable with a high degree of certainty, but these trendlines could be completely disrupted by low-probability events and/or black swans.

The question boils down to: are "current trends" the bubble equivalents of the tulip bulb craze? Please glance at this chart of skyrocketing federal debt before answering.

In essence, while we"re being reassured that all these grandiose promises are resting on trends that are as reliably predictable as the tides, the next easily predictable crisis will very likely reveal the trends are speculative bubbles that will predictably burst in a devastating reversion. The wise approach forecasting the future with a profound humility, while the soon to be bankrupted foolish are confident in their grasp of what"s knowable, unknowable and predictable.

Mike Tyson Vs. The Grilled Cheese Truck

Authored by Simon Black and Tim Price via SovereignMan

It was just over two years ago that “The Grilled Cheese Truck, Inc.” began trading in the US stock market under ticker symbol GRLD.

GRLD was exactly what it sounds like– a truck that sells grilled cheese sandwiches.

Yet despite a history of heavy losses, the stock market valued the company at an extraordinary $107 million.

Skeptical investors would have been sharp to call that the peak of the market.

Yet the irrational exuberance continued.

Earlier this year, Snap Inc., a profitless mobile app which offers its shareholders ZERO voting rights, went public with a $28 billion valuation.

That too seemed like the peak of the market’s insanity. But that turned out to be a premature feeling as well.

Now we see none other than Iron Mike Tyson shilling for a Vanuatu/Latvian brokerage firm, enticing small investors with offers of 400x leverage.

It seems all we are lacking at this point is a Fortune magazine cover with a “DOW 100,000” headline.

Maybe it is the peak. Or perhaps the gains will continue.

Fortunately our job isn’t to make precise predictions; it is to assess risk and avoid taking any which (a) is unnecessary, and (b) fails to offer returns that vastly compensate for the probability of loss.

We have pointed out before that the US stock market’s average Price / Earnings ratio is at highs typically not seen except prior to spectacular declines.

See the chart below, which shows the “Cyclically Adjusted” Price-to-Earnings ratio, or CAPE, at 29. The long-term average is 17.

Since 1880, the CAPE has only been at this level twice before– the first time prior to the Great Depression, and the second time prior to the dot-com crash.

To us, the prospect of gaining an additional 10%… or even 30% in US stocks pales in comparison to the prospect of losses from a major correction.

As Alhambra Investment Partners point out, investment analysts were forecasting back in October that US companies in the S&P 500 would generate $29 in earnings for the 4th quarter of 2016.

As the Q4 earnings reports started rolling in last month, the estimate dropped to $26.37.

Since that time, with now almost all companies now having reported, the current figure is $24.15 – a decline of 8.4% in just four weeks.

That’s bad news for passive “index” investors who are, by default, exposed to every single one of the companies in the S&P 500– most particularly the expensive ones.

Most people don’t realize this, but the S&P 500 does not equally weigh its 500 constituent companies.

In fact, the price of the #1 weighted stock (Apple) influences the S&P 500 index over 240x more than the least weighted stock (Autonation).

In general, more expensive stocks count more than inexpensive stocks.

So if you buy a traditional index fund, you are allocating the majority of your capital to popular companies, and very little capital to overlooked gems that are inexpensive and undervalued.

This is the opposite of what value-oriented investors should be doing.

As Ian Lance of RWC Partners points out,

“Passive [index] investors in 2000 were allocating large chunks of their money to bubble stocks like Cisco, Sun and Yahoo, and also to accounting frauds like Enron and Worldcom which were on their way to zero.”

We have little experience gambling, but we’re pretty sure that you can’t prosper by betting on every number at the roulette table.

That’s essentially what index investing is. And, like casino games, the market is rigged against individual investors.

You’re already fighting an uphill battle against high-frequency traders and dishonest bankers. Overpaying for expensive, popular assets doesn’t help.

Never forget that the world is a big place.

And if your stock market is irrationally overvalued, you have the freedom to allocate your time, effort, and capital to more attractive, undervalued investments elsewhere.

Germany (DAX); Monster bullish breakout test in play, says Joe Friday

Below looks at the DAX index from Germany over the past decade. The DAX index looks to be creating a bullish continuation pattern, that the Power of the Pattern feels, is important to investors in Europe and the St

CLICK ON CHART TO ENLARGE

The lower left of the chart above reflects what an ideal “Cup & Handle” pattern looks like. These patterns historically take place in bull markets and are viewed as “continuation patterns.”

Below looks at the DAX/SPY ratio over the decade and why the ratio could be forming an important pattern too.

CLICK ON CHART TO ENLARGE

Since the lows in 2003, the DAX has been much stronger than the S&P 500. Since 2008, the ratio has traded sideways, reflecting that the DAX and S&P have been traded off being stronger than another, no clear winner. At this time the ratio could be forming a reversal pattern (bullish inverse head & shoulders pattern) near the bottom of a 6-year trading range.

Joe Friday Just The Facts; A breakout above the top of the Cup & Handle pattern would send a bullish price message to the DAX. Strength in the DAX has historically been a positive for stocks in the states.

Bulls in Germany and the States have fingers crossed that the DAX breaks above 2015 highs!

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Energy Sector; Two Thirds chance they rally here

Below looks at the performance of the S&P 500 Sectors, looking back 5-years. The winner for the lowest performance is the Energy Sector (-1.42%). XLE is lagging the S&P 500 by almost 70%, in just 5-years. “Time for them to rally?

CLICK ON CHART TO ENLARGE

 

Below looks at the Energy ETF (XLE)/S&P 500 ratio over the past 17-years and why we find this pattern worth looking closer into.

CLICK ON CHART TO ENLARGE

The pattern above presents a nice entry point, with a stop below the support test at (2).  Another test of support in this space is taking place in the UGA chart below.

CLICK ON CHART TO ENLARGE

From a long-term trend perspective, no doubt the trend in both of the charts above is down (lower highs and lower lows and below long-term moving averages). If one is a trend follower, we doubt these ideas are of interest to you.

If one likes to buy low in hard hit sectors with tight stop loss parameters, we find both of these charts very interesting at this time, due to being out of favor and testing key support levels.

If you would like to test drive all of our research for 30 days, send us an email and we"ll get you the details.

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Strong markets struggling at breakout levels of late

The S&P 500, Banks, Small Caps and Transportation indices continue to climb higher, as the long-term trend remains up. The two charts below, look at performance over the past month and how each index is testing long-term breakout levels.

The chart below looks at how the above mentioned indices have performed over the past 30-days.

CLICK ON CHART TO ENLARGE

These key markets are a little soft the past 30-days. The Power of the Pattern below looks at where this softness is taking place.

CLICK ON CHART TO ENLARGE

Multi-year trends remain up for each of the indices above, as they create a series of higher lows and higher highs.

Each are testing key breakout levels at each (1), where a little softness has taken place the past month. Transports index (lower right) could be creating a pattern similar to what it did in 1999 and 2007. The odds of Transports creating an identical pattern to the 1999 and 2007 highs is low for sure. If Transports would turn weak at (1), bulls might want to keep a tight stop on positions.

Great news for the bulls if these breakout at (1). If they would breakout, each should attract buyers. Bulls don’t care to see weakness start taking place at each (1). Will be very interesting where each of these are 30 days from now!

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Equity Research Faces "Major Disruption" As Study Finds "Less Than 1%" Of Reports Are Actually Read

What if we were to tell you that for the bargain basement price of just $10,000 per hour you could buy yourself the privilege of a 1-hour conversation with an equity research analyst from a top-notch investment bank, would that be something that might be of interest to you?  While we hate to be overly pessimistic, we"re gonna go out a limb and guess that most of you answered in the negative to that question.

As we pointed out a few weeks ago, the traditional I-banking equity research model is about to undergo a radical transformation courtesy of the new Mifid II regulations set to go into effect in 2018 in Europe.  Among other things, the new rules require i-banks to break out the pricing of equity research charged to buyside clients, which up until now had been provided "free of charge" but effectively covered by trading commissions.

The problem, as anyone who has ever been flooded with a daily barrage of 1,000s of reports can attest, is that while the supply of equity research is seemingly endless, the demand may not be quite as pervasive as the bulge bracket banks once thought. 

As Reuters points out today, just the top 15 global investment banks produce over 40,000 research reports every single week.  Unfortunately, only about 1% of those reports are actually read by investors on any given day and we suspect even that estimate is generous.

For example, about 40,000 research reports are produced every week by the world"s top 15 global investment banks, of which less than 1 percent are actually read by investors, according to Quinlan.

More than 30 analysts cover HSBC (HSBA.L) (0005.HK) on a regular basis, though only 11 of them have a rating of three stars or above even though it is a key factor of consideration by many global fund managers.

Meanwhile, the fairly massive supply/demand gap for research seems to be driving a wide bid/ask spread between what investment banks require to cover the costs of their expensive analysts and what their buyside clients are willing to pay for the end result.  In fact, a recent survey of fund managers by consultancy Quinlan & Associates found that analyst headcounts at banks would have to fall by 30% by 2020 in order to eliminate all of the costs that funds simply wouldn"t be willing to absorb (a.k.a. the "crap" as one fund manager put it).  Per the  Financial Times:

“The figures are all over the place at the moment. Some [quotes] are fair and reasonable, and [with others] we thought: there is no way we are paying that — they will have to recalibrate their business models or part ways with us altogether.”

“This is the biggest problem,” he said. “It will cause a lot of problems in 2018 because no one has worked out how much the research is worth.

“There will be a lot of c**p that clients won’t pay for and that is when the big cuts [to the analyst workforce] at the global banks will come. The feedback from many [in asset management] is that the price of research is too high and not granular enough.”

Meanwhile, with the large global banks looking to charge clients $300,000 - $500,000 per year to cover their bloated equity research budgets, the more nimble, independent research providers could be on the verge of some major share gains.

A period of severe turmoil is facing the securities research industry as a regulatory overhaul threatens the way investment research is done.

Online portals, in particular, are set to gain market share at the expense of major "bulge bracket" investment banks, reaching a forecasted market share of $1.4 billion or 15 percent of the global investment research industry spend by 2020 - from less than 1 percent last year.

"The global investment research market is on the cusp of major disruption," said Benjamin Quinlan, CEO of Hong Kong-based Quinlan & Associates and author of a report on the challenges facing the research sector.

Frankly, we"re not sure how the hedge fund industry will survive without an army of 23-year-old equity research analysts writing hourly updates instructing managers to BTFD.

"Don't Say You Haven't Been Warned"

Authored by Jeffrey Miller via Miller"s Market Musings,

So after a long period of basically no volatility, we finally got some - in a hurry.  In case you were out, the S&P 500 (SPX) finally had a down day of more than 1%.  But that’s not the real story.  Look in bankland, where we have been cautious ever since the rip higher on the Trump Trade (lower taxes, higher rates, lower regulations).  The KRX (KBW Regional Bank Index) fell over 5% on Tuesday - yes, the bank index took a dive of 5% in one day.  And it didn"t bounce.  The SPY was up a bit on Wednesday, but marginally, while the dollar continued to weaken versus the Yen and Euro.  The big questions being asked all revolve around whether the dip in the 10-year bond yield to under 2.40% is reflecting a weaker outlook for the Trump Trade, or, if it"s just an unwind of a massive 10-year bond short after the Fed hike last week was perceived as dovish. 

All Calvin and Hobbes comics courtesy of Bill Watterson and Go Comics.
 
The mini-rally in the 10-year bond could be the proximate cause of the banks selling off, but that is a little too old school - that implies that what is driving these stocks right now is a focus on fundamentals.  But as long-time readers know, fundamentals only matter in the very long term - in the short term, positioning, especially among the CTA/trend following/risk parity crowd, can become very important at inflection points.  These funds all tend to been leaning in the same direction at the same time, in size, and are designed to pull down risk and then flip the other way quickly on a steep decline.  In short, they are the embodiment of feedback loops that drove the big sell off in August 2015 and in early 2016.  But...this time I think we could be in for a bigger shock.  Just because the market didn"t follow through to the downside after Tuesday doesn"t mean we"re done.  Instead, this may be a preview of coming attractions, as the KRX falling 5% in a day is a warning sign, not an all clear sign.  Because these funds can be easily spooked – especially on a hike. 

The issue isn’t that there are funds that trend-surf.  The issue is that there are now a lot of them, and there has been a recent push into using these funds to “hedge” risk.  The idea is that any downturn will evolve slowly enough for these funds to sell into it – which has happened in the past.  But that was when the group was a lot smaller.  A recent Financial Times article detailed how pervasive this has become. According to the article, clients of Pension Consulting Alliance (PCA) typically allocate 10-20% of their assets to a “CRO program.” What is a CRO program?  “Crisis Risk Offset.” PCA apparently coined the term.  Now, full disclosure: I know a few people who work at PCA and they are all great folks (and neighbors).  This isn’t about them. It’s about allocating to momentum strategies in a size that may be too big to execute properly.  Portfolio insurance anyone?  If you recall, that didn’t work out well (see October 19th, 1987).  Will that (down over 20% in a single day) happen again?  Unlikely.  But we could easily get a situation where a garden-variety 5% pullback in the SPX quickly morphs into a fast 10-15% decline, as funds de-lever their equity longs or flip short.  See these charts of where we are in terms of equity exposure in various trend-following systems, and the size of these funds today. 

The problem with everyone leaning in one direction is that they scare easily.  When realized volatility has been near all-time lows, as it has been in recent months, the simpler versions of these strategies view assets as less risky, so they lever them up.  What the models fail to capture is the speed with which volatility can return.  If volatility slowly creeps back up, then the models work fine.  But if it suddenly spikes higher, the models fall apart, other investors quickly de-risk, and everyone is up all night looking for ghosts.  Don’t say you haven’t been warned.

This was one of the weirder weeks I’ve seen in awhile. Various proxies for U.S. interest rates were bouncing around based on each tweet and missive from D.C. about whether or not the new healthcare bill would pass.  When the bill was first pulled on Thursday, U.S. stocks fell, and rate proxies reacted as if all of the Trump agenda was in trouble (Trump policies are viewed as inflationary, so rates move up when he’s doing well and down when he’s not).  Look at the Yen this week – every time the Trump agenda looked vulnerable, it rallied.  And then that relationship quickly fell apart at the end of the day on Friday.  When the healthcare bill got pulled for good Friday, it took about 5 minutes for the narrative to shift from Trump failed to now tax cuts can happen sooner rather than later, and so the Yen fell sharply.  This is the world we live in today – traders are making up new and different reasons to scare themselves daily.  Should we care?  I’d say no, except we’re in unstable times (see the 5% selloff in the KRX on Tuesday for proof), and with lots of money in passive funds, ETFs and trend-following strategies, it won’t take a lot to get the markets heading down fast.

So what will be the catalyst to cause more than a 1% sell-off in the SPX?  While everyone is fixated with the non-bill in D.C., I think they are missing the big risk in the market, which is only getting bigger by the day.  Long-time readers can guess where this is going.  That’s right – China.  While we’ve been distracted in the U.S., China has been raising its equivalent of the Fed Funds rate and trying to stem a credit bubble there from ballooning out of control, while at the same time trying to make sure that if they do succeed in popping the bubble, it deflates slowly.  Good luck with that.  I’m not saying they won’t be able to do it.  I’m just saying that no country has ever pulled it off before.  The borrowing rates for their non-bank financial institutions (NBFIs) are rocketing higher (see the chart below) as they scramble for funds.  Evidently, the popular thing for these NBFIs to do is lend very long-term into risky ventures in order to generate higher yields, but borrow very short-term (under a year) because the funding is cheaper.  If this sounds just like our S&L crisis, version 2.0, you’d be correct.  I would have thought there are some things the Chinese may have wanted to avoid copying from the U.S., but apparently they’ll have to learn that lesson for themselves.
 
Take a look at the charts below.  You’re actually seeing defaults in China occur, and at an increasing rate (albeit from zero, as extend and pretend is the national motto in China, where everything is always awesome – it is always awesome, right?).  Remember, you’re also seeing short-term repo rates spiking.  A sign of renewed growth and inflation fears?   Ah, no.  It’s a sign of stress in the funding markets and increasing counterparty risks.  Put another way, credit is starting to fray in China right after the biggest increase in debt in the history of the world.

How will it end? I think Calvin has it pretty well figured out in the below comic strip.

?So to recap: the question investors need to ask themselves is what will happen if China’s issues start to manifest themselves in global markets (remember August 2015?  Me too.  We’re all in this together). The combination of large risk-parity funds and CTAs being quite long equities at the exact moment that China’s credit bubble is starting to show signs of stress could end quite badly.  The pension funds that have hired CTAs to sell into the next selloff will exacerbate what would have in the past been a normal correction.  And when retail investors who have been relentlessly told to invest their money in long-only index funds or ETFs wake up to a market that is down 10%, 15%, or 20% fast, are they going to hold on, or even buy more, or are they going to realize that their ship is just a plank, and decide to swim for shore while they can?  If history is a guide, we’re going to see lots of investors making a swim for it.

"It's The Inverse Of Keynes" - Earnings Season Was Very, Very Bad

Authored by Jeffrey Snider via Alhambra Investment Partners,

With nearly all of the S&P 500 companies having reported their Q4 numbers, we can safely claim that it was a very bad earnings season. It may seem incredulous to categorize the quarter that way given that EPS growth (as reported) was +29%, but even that rate tells us something significant about how there is, actually, a relationship between economy and at least corporate profits. Keynes famously said that we should never worry about the long run for there we will all be dead, but EPS has arrived at the long run and there is still quite a lot of living to do.

As late as October, analysts were projecting $29 in earnings for the S&P 500 in Q4 2016. As of the middle of the earnings reports last month, that estimate suddenly dropped to just $26.37. In the month since that time, with the almost all of the rest having now reported, the current figure is just $24.15 – a decline of over $2 in four weeks. Therefore, 29% growth is hugely disappointing because it wasn’t 55% growth as was projected when the quarter began.

It is also the timing of the downgrades that is important as it relates to both “reflation” and the economy meant to support it. All throughout last year, in the aftermath of the near-recession to start 2016, EPS estimates for Q4 (and beyond) were very stable, unusually so given the recent past. That shows us how analysts, at least, were expecting the economy to go once it got past “global turmoil.” It was the “V” shaped rebound typical for past cyclical behavior.

But it wasn’t until companies actually started reporting earnings that the belief was tested and then found severely lacking. With just $24.15 for Q4, total EPS was for the calendar year less than $95, the ninth straight quarter below the $100 level. More importantly, on a trailing-twelve month basis, EPS don’t appear to be in any hurry (except in future estimates) to revisit the prior peak of $106 all the way back in Q3 2014.

As noted last month, that means a great deal of consistency between earnings and economy. 

The recovery in earnings is as lackluster as the recovery in economy, a more constructed relationship where stocks are concerned. That leaves share prices, in general, operating on the far end of the probability spectrum; where everything has to go just right in the near future, including whatever may come out of Trump “stimulus” and economic policies. EPS, however, suggests, as the calculations for GDP potential, that that would be a very low probability outcome, including a high risk of “something” going wrong all over again just like it was in 2014.

For shareholders, that leaves them in a precarious position expecting something that just isn’t very likely. Worse, any objective review of economic prospects for years before suggested the very same, meaning that nothing has really changed in terms of the long run except actual reported earnings which are supposed to matter more.

Again, the primary problem was in fundamentally misreading and misinterpreting what QE was – it was not money printing no matter how many times the media repeats the assertion supposedly derived from the editorial standards for what constitutes good authority. What should have been considered to a greater degree was how these views on QE amounted to little more than confirmation bias. All the evidence to that point suggested QE wasn’t working and hadn’t worked, established strictly by the fact that there had already been a second years earlier (and then a third, and then a fourth). From this view, it was far less reasonable to expect EPS for the S&P 500 to ever get near $145.

Therein lies our stock market revisit with the dot-coms, not just in terms of valuations but more so the psychology of them. Stock investors wanted QE to work just as they wanted to believe in the late 1990’s Alan Greenspan was a genius who had engineered a “new normal” then of unparalleled, low volatility prosperity.

In a curious sort of way, overvaluation in this manner actually makes stock prices “stickier.” What I mean by that is that when stocks are so greatly and positively diverge from fundamentals it is very human to think and believe that there must be a reason they are that way, even if that reason isn’t immediately apparent or so often contradicted. From this standpoint of rationalization, why not QE3 or the maestro? Conversely, if stock prices are questionable then it must be because stocks themselves are rationally questioned.

It is the situation where “dumb” money makes all the wrong choices, selling at the bottom or near enough to it after having bought hand over fist at the top. Irrationally, when stocks are so stretched in valuation they can appear as the safest place to be.

In fundamental terms of earnings, there is only further confirmation of a lack of growth, both as a matter of the rebound from early 2016 as well as from the global slowdown in 2012. At $94.54, ttm EPS are almost exactly the same now as when QE3 started, and are only 6.8% more than Q1 2012 all those years ago! For that lack of growth, the stocks in the index are trading in the aggregate at more than 23 times posted earnings. It is the inverse of Keynes, where there is no consideration at all except for the long run and how some unknowable magic combination of policies will surely make it such a happy and prosperous place – even though none so far have come close.

World Out of Whack: Your Attention Please

By Chris at www.CapitalistExploits.at

Market dislocations occur when financial markets, operating under stressful conditions, experience large widespread asset mispricing.

Welcome to this week’s edition of “World Out Of Whack” where every Wednesday we take time out of our day to laugh, poke fun at and present to you absurdity in global financial markets in all its glorious insanity.

While we enjoy a good laugh, the truth is that the first step to protecting ourselves from losses is to protect ourselves from ignorance. Think of the “World Out Of Whack” as your double thick armour plated side impact protection system in a financial world littered with drunk drivers.

Selfishly we also know that the biggest (and often the fastest) returns come from asymmetric market moves. But, in order to identify these moves we must first identify where they live.

Occasionally we find opportunities where we can buy (or sell) assets for mere cents on the dollar – because, after all, we are capitalists.

In this week"s edition of the WOW: Beware The Attention Seekers!

I"m getting sick and tired of stupidity. No, really. There really are some proper morons out there. Just the other day I read in the Telegraph that living near a busy road raises your chance of getting dementia by 12%.

Being the sceptic grump that I am and taking very little at face value I was curious about this. After all, 12% seemed significant.

15 seconds later (I"m a bit slow) and my stubby fingers had met with my phone to reveal the medical journals stats on dementia. Lo and behold, there"s an 11% chance of getting dementia no matter where the hell you live. Further investigation revealed that the study in question actually showed that the risk of dementia caused by living near a busy road raised the odds TO 12%, not BY 12%. That little fact wouldn"t grab as many readers attention, though, now would it.

Key here is the abject failure to distinguish between relative and absolute risk.

Absolute risk is 11% and relative risk, if your pad overlooks a noisy highway with Mac trucks belching fumes out 24/7, increases this by a "whopping" 1.32%.

Think of it like this: Out of 100 people who are lulled to sleep at night by the comforting drone of 18 wheelers this "startling new research" reveals that 12 folks will be affected by dementia rather than 11. Now, I understand that there are those among us who desperately want that last 1.32% of longevity (you can find them scoffing the tofu at the buffet) but personally, I"m not so sure those extra days spent confusing my nurse, who"s changing my soiled diaper with my wife while being fed sludge through a straw are worth worrying about.

This sort of nonsense happens all the time.

It grabs our attention because our amygdala (that squishy almond shaped part of our brain that deals with fear) goes berserk trying to protect us from pain sending out "watch out, buddy" messages and getting us all lathered up with anxiety. There was a fascinating experiment done on this which I wrote about some time ago.

In any event, the headlines for this "startling" piece of trivia on dementia sound frightfully scary but are actually complete bollocks. The problem, of course, is that, unless you"re actually knowledgable in a particular area - in this instance medical research (which I"m not) - you"re likely to accept at face value what you see.

The same thing happens to folks evaluating financial markets. All too often there"s a vested interest or bias to selling a particular narrative. When your bread gets buttered running, say, a fixed income fund, it shouldn"t come as a surprise when you"re found searching for metrics supportive of more suckers investors plonking their hard earned dollars into your fixed income fund.

Other times, it"s a matter of simply looking at the trees failing to see that "whoah, we"re actually in a forest" and not using second order thinking.

Recently, I came across headlines screaming that the US stock market was due to crash. Whoah! The primitive part of my brain can"t help itself and kicks into action telling me to quickly find out more. How might I be at risk of being eaten by the lion it wants to know.

Reading through the article I noted that lo and behold, the author had some "little known" indicator that said it was so. Urghh! Listen there are NO, none, zero "secret" indicators OK? Nada! There are just indicators, and if you don"t know one that doesn"t make it "secret". It just means you don"t know it.

For shits and giggles I read the report and, to summarise, the "indicator" was this:

Household equity ownership was now at the same levels we"d experienced in the 1960s and in 2007. Notably, two previous market peaks. Investors holding equities in both of those periods got their shirts handed to them. Ergo, investors are again going to get their shirts handed to them. Run!

Not so fast hombre...

Let"s deal with the data first.

Sure, equity ownership in both 2007 and the 60s was around the 30% mark, which is where we"re at today. And sure, both periods experienced painful stock market crashes, but looking deeper, we find that equity ownership has reached these levels before, most notably in both 1998 and 2013.

Take a look at the S&P500 from 1990 through 2009 below:

As you can see the market ran another 60% from 2008 when equity ownership had reached these levels. Anyone short got hosed. Anyone long made 60%.

Then in 2013 anyone short took a beating as the market ran another 40%.

I"ll also point out that the 87 crash took place when equity participation was at just 18% and, in fact, we"ve had stock market crashes when equity participation was well below current levels.

So now we"ve got two instances where the market tanked at these equity participation levels. We"ve also got two instances where it did the opposite.

Heck, I could come out screaming that, "Hey! Look, equity participation levels indicate that we"re about to rocket higher, somewhere between 40% and 60% from these levels. Look here is the data (selective, of course). Get in now, by George."

Sheesh! I may as well flip a coin or go to Vegas and put it all on black because my odds are identical. Neither ideas impress me as a good ones. Both evaluations are just noise.

So using this as a "secret indicator" is a bunch of hogwash designed to get your amygdala all hot and flustered.

The problem is Joe Sixpack reads this, the mushy bit in his cranium does what it"s supposed to do (go haywire), and next thing you know, Joe"s shorting the market through some leveraged reverse ETF where not only is the risk that he"s wrong at least 50/50 but the cost to entry in this particular trade means that even if he"s right he doesn"t stand to make much money. And if he"s wrong he stands to lose a whole lot because those leveraged ETFs are terrible, terrible tools and Joe hasn"t done his homework to figure out how they work.

That is all as impressive as Miley Cyrus swinging naked on a wrecking ball - not so much.

Back to Basics

The way to think about this is taking it back to basics.

Let"s say you"ve got $1m portfolio. If you invest $300k into equities, then you"re at an equity participation level of 30%.

Fine, but what if you only invested $100k a decade ago and that $100k now (due to appreciation) sits at a 30% equity participation rate? Well, you"ve actually got another $900k in "spare cash" sitting on the sidelines. The 30% equity participation is a red herring.

Bull markets rarely end like that.

No, they end with Darren and Julie mortgaging the house, selling Bobby the family Labrador, and asking the oldies for a loan to invest. Once they"re fully invested with nothing left in the cookie jar you"ve got market exhaustion because there are literally no more suckers to come in.

Incidentally, at the tops of markets what we find is that mutual fund flows continue even as the market has turned. If we go back to look at the data, what we notice is that net inflows for dumb mutual funds money typically continue even after the market has turned. Darren and Julie via mutual funds keep buying into the peak...just as the 20% (Pareto"s law) begins to exit. The trade at this point is truly asymmetric as the boat is extremely one-sided. This is typically how bull markets end.

The other thing that isn"t even considered is where existing capital is invested.

Let"s go back to our theoretical $1m portfolio and say, for example, we"ve invested 50% into fixed income. So now we"ve got $500k invested. Let"s further say that we"re spooked by the fact we"re eking out a piddly 1% yield and concerned that lending our money to bankrupt entities might not work out too well in the long run. A simple rotation of just 10% from our fixed income basket into equities translates into a 17% capital infusion into our equity bucket. Looking at just one investment bucket is akin to looking at just one tree in the forest.

Clearly we need to look at more than just equity participation on it"s own before jumping to a conclusion.

Now, don"t get me wrong - I"m not supporting buying US equities here. Valuations are far from low, and history provides sufficient evidence that buying high in order to sell higher can lead investors from going from BMW to Suzuki pretty swiftly.

What I am suggesting is that you want to sit on the sidelines until you see favourable risk reward setups. The most favourable of all are where convexity exists and I don"t see any in US equity markets either long or short here.

What Do You Think?

Cast your vote here and also see what others think

- Chris

"The way to build long-term returns is through preservation of capital and home runs" — Stanley Druckenmiller

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