April 30, 2015

12 stock market factors for 2015

While no one knows where the market or the global economy are headed, I remain convinced that the following additional 12 key "big picture' factors could weigh on markets and on the real economy over the balance of the year:

 -   Multiple and unpredictable outcomes: There have likely never been in history more numerous market and economic outcomes, some of which are adverse and most of which are being ignored by market participants.

-    Stuff happens: Black Swans appear to be happening with greater regularity.

-    Weak growth ahead: Central bankers' aggressive monetary antics have only produced subpar global economic growth.

-    Borrowing from the future: Zero interest rate policy (ZIRP) has borrowed past and present sales from the future, underscoring the challenge of future economic growth.

-    Unknown consequences of policy: No one knows the consequences of an extended period of ZIRP "punch bowls," which often result in aberrant behavior and hangovers.

-    Making no sense: Indeed, if there were no consequences to zero interest rate policy, interest rates could have been held at zero forever – in the past as well as the future.

-    Stop looking up, start looking down: Monetary overkill (in duration and in the level of interest rates) may produce the adverse consequences of malinvestment and has resulted in the hoarding of cash and reduction in spending by the disadvantaged savings class.

-    Uneven and less dependable growth: The "exclusive prosperity" of the haves (vs. the have-nots) is politically unstable, leads to more uncertainty (and unexpected outcomes) and will likely have a negative and more volatile impact on our social system, on the global economy and on our markets.

-    Tom Friedman has the ticket: Our world has never been more flat, more networked and more interconnected; as such, the notion of an "oasis of prosperity" is not likely rooted in fact.

-    Trouble ahead, trouble behind: Terrorism and religious radicalism (political and economic) will be more of a threat in the future than in the past.

-    Treacherous technology: In a paperless (and "cloudy") world, investors and citizens are not likely as safe as the markets assume.

-    Lack of coordination: Geopolitical coordination is at an all-time low and isolationism seems likely to be a mainstay in the time ahead.

From www.thestreet.com/story/13118658/3/kass-identifies-12-big-picture-factors-that-may-weigh-on-markets-economy.html

April 28, 2015

US stock market in contrast to Real economy

A sage observer once remarked, "Speculation is going on when someone else is making money, and you and I aren't." Speculation (prompted by Fed policy) has been ripe, as hot money has raised the price of financial assets even in the face of disappointing progress in the real economy.

The U.S. stock market has lived a charmed life since the Generational Bottom in March 2009. Corporate profits have risen, inflation has been quiescent and valuations (price-earnings ratios) have expanded as stocks have more than tripled, while rising geopolitical tension, sovereign debt issues and other macroeconomic concerns have been ignored and dismissed.

How forgiving has the market been? The steady rise in stock prices has occurred despite a 1% annual shortfall in the rate of global Real GDP growth in each of the past three years and with consensus forecasts for 2015 S&P 500 earnings dropping from over $135 per share to below $120 per share in the last nine months.

For months I have suggested that a combination of fundamental and technical factors are conspiring to lend credence to the view that a broad and consequential topping process is being put in for both the stock and bond markets.

Now, more than ever, I continue to believe this to be the case.

Zero, and even negative, interest rates tend to lengthen (and distort) acceptable investor time frames. The tsunami of global speculation has been engineered by the world's central bankers who have, in the simplest sense, bought time for self-sustaining growth to appear.

Central bankers have added $10 trillion of new credit over the past six years. Taking a longer perspective, the stock of globally traded financial assets has increased to nearly $200 trillion today from $7 trillion about 25 years ago.

But slowing economic growth, a flattening in the yield curve, an acceleration of U.S. dollar strength and weakening business fixed investment offer indications in the near term that investors are growing impatient and time frames are likely shortening. 

Speculative capital, abetted by central bankers' largesse, has overwhelmed everything in its path -- regardless of sluggish macroeconomic conditions -- as natural price discovery in the capital markets has been distorted by zero interest rates and through the massive liquidity provided by quantitative easing.

But that distortion might now be ending and time frames might be shortened as the above signposts intensify. Away from the deteriorating fundamentals, the technicals also seem to be eroding.

Change and extreme price moves have become contagious lately, possibly worsening the technical picture.

Among the more important concerns I've highlighted recently is that former laggards are leading, which historically is not a signpost of gathering strength.

With depressed stocks leading the rally, there were few new 52-week lows as the S&P 500 approached its peak early last week, but there was also a contraction in new highs. Back in February and March there were 80 to 85 new highs on a daily basis; in the recent rally this fell to 30 new highs, on average.

But change doesn't stop there, as we can witness it in the seemingly successful double bottom in oil prices and in the euro; a potential double top in the U.S. dollar; a reversal to the upside in commodities and 4% to 5% drops in China and German markets last week.

The only thing not changing much has been bond yields -- though U.S. fixed-income yields have been rangebound (not so much in Germany, where the 10-year bund has traded down to a 0.05% yield).

But we might soon see this reverse, too, as a climactic move of higher prices and lower yields in Europe might be in the later stages. This could be very good for my short U.S. bond position, as I suspect an anchor to our rates might just be eliminated.


April 20, 2015

Bank shares could outperform

Over the last several years, the banking industry has been encumbered by the expenses associated with regulation and fines, tepid loan demand and historically low interest rates (and contracting net interest margins).

As well, Dodd-Frank has mandated a reduction in leverage, which, in part, has laid the groundwork for a multiplier-less recovery in which the Fed's injections of liquidity have not found their way into lending.

These conditions have weighed on banking industry valuations. But with rates likely bottoming and legal expenses and fines slowing down, I have argued that a healthy cocktail of expanding net interest margins and lending are about to be served up. 

Importantly, of late both M2 growth and velocity have begun to turn up. At the same time, commercial and industrial loan growth has begun to accelerate. This increased lending is getting little attention and bank stocks have been laboring. That lending rise is also having a positive multiplier effect on the money supply, which has begun to accelerate over the course of this year.

M2 (year over year) is now increasing at a rate of more than 6%. The 13- week rate of increase is even better at 7.2%, which is positive for the economy and banking. 

With most of the drop in energy prices and the strong U.S. dollar having run its course, the system is primed with money and M2 growth and velocity should start to increase.

In this setting, bank profits should expand nicely and bank shares could embark on a lengthy period of outperformance. 

April 17, 2015

Markets operate in cycles

I start each day with these three questions:

  -  In a paperless and cloudy world, are investors and citizens alike as safe as the markets assume we are?
  -  In a flat, networked and interconnected world, is it even possible for the U.S. to be an "oasis of prosperity" and a driver, or engine of global economic growth?
  -  With geopolitical coordination of the G8 at an all-time low, if the wheels do come off, how slow and inept will the reaction be?

Financial and economic markets are cyclical - the big bear is not likely in front of us but a little bear might be. Market participants are at the most dangerous point in which fundamentals are being dismissed. Indeed, TINA (there is no alternative) is often back in the market commentary these days. 

Market rationalizations, associated with the stubborn persistence of higher stock prices, is likely late in the acceptance period when investors set up for being disappointed. To me, it's only a matter of time until the market fades from the highs. But I don't know where the highs lie. As John Maynard Keynes wrote, "The market can stay irrational longer than you can stay solvent."

I take these words seriously and, tactically, I am determined not to be too anticipatory and to be more reactionary.

While I have a lengthy list and menu for analysis and selection on the buy side, with 24 stocks on my Best Ideas long list and only five stocks on my Best Ideas short list, I would continue to be cautious in adding incrementally to equities.

As always, my greatest market headwind is fundamentally based. 

April 13, 2015

Investing inspiration and ideas from Kass

The investment mosaic is a complicated one, and no one rule always works. How-to books may sell copies and make money for the authors, but they don't usually make the readers much money. There is no substitute for hard work in delivering superior investment returns. There are 86,400 seconds in a day, it's up to you to decide what to do with them. As I have repeatedly written, there is no secret sauce, magical elixir or special stock chart that provides clarity to our investment decisions -- rather it is a byproduct of hard-hitting research.

"Be a dreamer. If you don't know how to dream, you're dead." -- Jim Valvano

A variant view and second-level thinking are necessary reagents to good investment returns. In The Most Important Thing: Uncommon Sense for the Thoughtful Investor, author Howard Marks addresses these two subjects.

In investing you must find an edge (or, as Michael Steinhardt calls it, a variant or differentiated view) by often thinking of factors/ideas that others haven't thought. Importantly, you must also avoid being too early -- especially if your investor base has a different time frame than yours.

Second-level thinking trumps first-level thinking in delivering returns. As Howard puts it, First-level thinking says, "It's a good company: let's buy the stock." Second-level thinking says, "It's a good company, but everyone thinks it's a great company and it's not. So the stock's overrated and overpriced: let's sell." First-level thinking says, "The outlook calls for low growth and rising inflation. Let's dump our stocks." Second-level thinking says, "The outlook stinks, but everyone else is selling in panic. Buy!"

I am often asked by investors (and others) why I don't usually listen to company executives or the guidance of their investors relations departments. To me, it is preferable to speak to people in the supply chain or to company competitors, for (to paraphrase Warren Buffett) managements often lie like Ministers of Finance on the eve of devaluation.

You gotta know yourself, too. Wall Street is not a great place to "find yourself." (There is a reason why there is a cemetery on one side and a church on the other side of the New York Stock Exchange building.) Psychology can be important; it often trumps cause-and-effect relationships that have been in place historically. Above all, have confidence in your own analysis (as long as it is thorough), even if your view is at variance with the consensus.

"Don't give up, don't ever give up." -- Jim Valvano

Learn to survive under adverse market conditions by avoiding large losses, and learn how to prosper during good times. Generally speaking, by maintaining discipline and stopping out your losses, you can live another day in your investing life. It is not batting averages or on-base percentages that count in this game; it is how you control the risk in your portfolio. As an example, short positions can be hedged by owning cheap out-of-the-money calls, and long positions can be hedged by owning cheap out-of-the-money puts -- especially in a low-volatility setting. 

April 8, 2015

Doug Kass shorting Bonds

This piece is committed to expanding on my original bond short thesis.  

Financial markets are cyclical. While bull and bear markets are inevitable, the timing of an inflection point is often not easy to diagnose. Most often predicting a non-consensus trend change is not a popular view. Indeed, taking an outlier position (like shorting the bond market) can often even be business or portfolio destructive. So an appropriate weighting becomes an important ingredient to any variant strategy, if you want to live and tell the tale!

Bonds have been rising in price and yields have been moving lower in price since 1981. "Like the snowball rolling down the side of a snow-covered hill" (The Temptations, "It's Growing") investors in fixed income have developed muscle memory and have grown inured to the bull market in bonds.  But we shouldn't lose sight that, while a long-running investment trend tends to gather force and its persistence and duration leads more people to think that it will never end, in its later stages, a trend is inherently risky and, ultimately, unstable.   

This is the second time I have aggressively employed a short bond strategy. Back in 2012-2013, I called shorting bonds as (potentially) the "Trade of the Decade" and chronicled my analysis in a lecture I gave at the Kellogg School of Management at Northwestern University and in a talk I gave in Omaha, Neb., at the Value Investing Congress. 

As the rate of global economic growth began to decelerate, my expectations for economic growth were consistently revised lower. By 2013, my growth expectations were well below consensus  and I abandoned my view of higher interest rates.  An important factor in my changed view were the weakening prospects for growth in China, Japan, and, especially in the eurozone (where I expected bold monetary efforts aimed at materially lowering sovereign debt yields). Both of these observations and conclusions were outliers at the time and differed from consensus views. Indeed, in late 2013, I underscored that bond equivalent areas of the market -- particularly closed-end municipal bond funds -- represented the most attractive segments of the U.S. stock market (and the asset class performed mightily).   

Let's now return to my current view of shorting bonds.

In Monday's analysis on Real Money Pro, I made the outlandish claim that "if history rhymes, I can see U.S. Bond yields rising without any material upside revision in economic expectations."

Yesterday, I even suggested that the yield on the 10-year U.S. note is discounting U.S. real GDP growth of only +1.2% -- truly an audacious and out of mainstream statement.

What rate of U.S. real GDP growth is being discounted in current yields?

Consider my calculations.

Over the last six decades, the yield on the 10-year U.S. note has averaged about 6%, basically in line with the nominal GDP growth in our country (Nominal GDP = Real GDP plus The Rate of Inflation). 

Domestic and global GDP growth has been slowing for some time relative to consensus expectations, in part due to structural headwinds. Let's assume the secular rate of economic growth has been permanently impaired -- and that growth will be somewhat slower in the future than in the past. Besides, efforts on the part of the ECB (and others) are turning interest rates into a negative yield ground and expanding yield differentials. For example, German 10-year Bunds yield an astonishing 173 basis points below U.S. 10-year yields.

I have been expecting this relationship since late 2012 -- and it has occurred in spades. This policy serves as a gravitational pull taking down interest rates worldwide in a flat, network and interconnected world.

I am presuming that these two major variables -- slowing global economic growth and the institution of ever lower (and even negative) interest rates by monetary authorities -- will serve to shift the relationship between the yield on the U.S. 10-year note and nominal GDP from 1.0x (as has existed in the last 60 years) to about only 0.7x. This seems to be a conservative and realistic assumption in calculating what rate of domestic economic growth the U.S. bond market is discounting.

Assuming the 0.7x (above) figure is reasonable, and given the current 10-year U.S. note yield of 1.89%, in order to calculate the rate of U.S. growth being discounted in the 10-year we need only one more input: the current core rate of inflation. Former Federal Reserve Governor Kevin Warsh appeared on CNBC's Squawk Box this week. In his appearance, Warsh stated that core U.S. inflation (as measured by the Fed) in the U.S. approximates +1.5%. Let's go to the tape.

Here is my equation to calculate what is the rate of growth in U.S. real GDP that is being discounted in the bond market:

The 10 Year US Note Yield = A Theoretical Multiplier x Nominal GDP (Real GDP(X) + Core Inflation)

In mathematical terms:

1.89%= 0.7 x ((X) + (+1.5%))

The solution (what rate of GDP growth is being discounted):


With the U.S. bond market (as measured by the 10-year note yield) discounting only +1.20% U.S. Real GDP growth, I am  of the view that owning any U.S. note or bond is like picking up nickels in front of a steamroller.

Besides being statistically (and even absurdly overpriced), bonds may be vulnerable to two fundamental events over the next few years that could make shorting them an outstanding investment and more than just a trade:

1. There could be an unscripted burst of prosperity, in which the U.S. actually gets its economic "mojo" back and returns to 3%+ Real GDP growth.

2. Market participants could Lose Their Faith in the world's Central Bankers. I call this the "Ah Ha" Moment.

Bond holders around the world may now be holding "certificates of confiscation" -- as they were known in the 1970s and early 1980s. At that point in history (1981), with bond prices continuing their uninterrupted decline, investors gave up on the asset class -- just at a time when they shouldn't have. Today, the movie is in reverse: bond investors have grown far too comfortable with the 34-year bull market move and have embraced the "safety" of the asset class.

But, safety is a tricky investment concept. Safe assets are often the assets that most investors view as hopelessly risky. Unsafe assets are often the assets that investors view as having no risk -- like bonds -- as my previous muscle memory metaphor applies.

In summary, I am of the view (and this was expressed in my 15 Surprises for 2015) that the three-decade Bull Market in bonds will end this year and that the bond market is currently discounting U.S. Real GDP growth of only +1.2%. It is even possible that we are now about to enter a period that resembles 1946 to 1981, when bond prices tumbled and interest rates persistently rose. Though I think the previous 35-year rise in rates will be more subtle in the next few decades, the difference could be this time compared to the first decade of the rate rise (1946 to 1956) -- when rates only rose by 100 basis points -- that the initial movement will be more. I suggest this to be the case because dealers no longer carry large inventory of corporate debt -- a residue of legislation that followed The Great Decession (Dodd, Frank) -- so air pockets might occur if many try to get out at the same time.

Here is my basic thesis in shorting US bonds, as expressed a few days ago.