December 29, 2016

Carl Icahn warning on ETFs

What is dangerous are those ETFs that consist of relatively illiquid instruments--for example, municipal bond funds, junk bond funds and/or small-cap funds in biotech and in other areas--that are expected by many investors to be liquid.

But, an ETF cannot be more liquid than its component holdings.

So, when liquidity dries up--particularly in illiquid asset classes and industry-specific or market ETFs--there can be dangerous dislocations and markets easily can be disrupted. And these disruptions can have a tendency to build on themselves.

We have seen these sort of flash crashes of illiquid ETFs in the past; they are now starting to occur with greater frequency.

They almost never occur when markets are rising. They usually occur when stocks are sold off hard.

And, sometimes that sort of hard selloff/crash can be further exacerbated, as we have witnessed, by panicky ETF holders. When this occurs, the ETF manager can be forced to sell illiquid holdings in order to rebalance the portfolios. When selling intensifies, this causes illiquid ETFs to fall further.

In its extreme, this response even could cause selling in the more liquid ETFs as investors more broadly panic and sell.

Bottom Line

The risk of ETFs is that too many assume their ETFs are as liquid as or more liquid than their component holdings--not that they are inherently too popular, as Carl Icahn has suggested.

December 27, 2016

Shorting the NASDAQ

My trade of the year for 2017 is to short the PowerShares QQQ Trust ETF (QQQ) , which tracks the Nasdaq 100 index.

Here's my investment thesis for this play:

The Nasdaq 100 Already Has Rallied
QQQ already has risen from about $96 a share at the market's February 2016 low to around $120 today. That's about a 25% gain in 10-1/2 months, which beats the Dow Industrials, the S&P 500 and other key indices.

A Trump Presidency Brings Uncertainty
Tech companies in particular need a predictable, forecast-able, non-threatening U.S. trade policy and a consistent set of rules for their health and profits. But for now, that doesn't look like it's in the cards under the coming Donald Trump administration.

Indeed, Trump's relationship with Silicon Valley (save for Peter Thiel) appears to be strained, with tech pioneers and executives conspicuously absent from the president-elect's initial cabinet choices and other political appointments.

Sour Apple
Apple is the Nasdaq 100's largest components, representing about 10.8% of QQQ's holdings. But, of course, I'm of the view analytically that Apple Is Crapple.

Other Techs Seem Overvalued
Beyond Apple, other Nasdaq 100 components that I see as overbought include:

-    Microsoft, which makes up about 8.6% of the index.

-    Amazon, which has about a 6.4% weighting.

-    Cisco, which accounts for about 2.7% on QQQ. I've previously written that I'm bearish on Cisco on an intermediate-term basis.

Non-Tech QQQ Stocks Look Iffy, Too
Some non-tech QQQ components could weigh down the ETF in 2017 as well. These include biotech and health care companies such as Amgen, Biogen, Celgene, Express Scripts and others, which all could suffer if Trump tries to limit drug-price increases.

Comcast also represents a relatively large QQQ weighting (about 3%), but the cable giant could suffer from continued "cord cutting" by consumers.

Tax Cuts Won't Help QQQ Stocks
Trump's plan to lower the effective U.S. corporate tax rate won't materially benefit QQQ components.

After all, large tech and health care firms in the Nasdaq 100 already generally pay low effective rates (under 20%). That's far lower than the 35% statutory rate that Trump is talking about reducing.

The Bottom Line
The Nasdaq 100 has had a stellar year in 2016, but the index's prospects for 2017 have deteriorated for reasons listed above.

As a result, my 12-month risk range for QQQ is $124 on the upside and $105 to $110 on the downside vs. the ETF's current price of around $120. Shorting here would make you about 12.5% if QQQ goes down to my $105 target, but only cost you some 3.3% if the security hits my $124 upper price range. That's nearly a 4-1 positive ratio.

That's why I suggest shorting QQQ for 2017, with a $125 stop on the position.


December 19, 2016

Doug Kass on Bertrand Russell

I always have admired the writings of British philosopher Bertrand Russell, who died in 1970, 14 years before the Russell 2000 Index was created and compiled.

The Russell Index, his "namesake," now may be priced to perfection.

While respecting the strength of the last month's stunning and almost parabolic move and recognizing that the only certainty is the lack of certainty, the markets to this observer are overvalued on almost every basis and the reward versus risk is substantially tilted toward the downside.

My pal David Rosenberg, chief economist and strategist with Gluskin Sheff, shares my view that the market is being over optimistic:

"If you were to do a fair-value estimate of the multiple against where it is today, you could actually then back out what the implicit earnings forecast is. And right now, it's 30%. That is the implicit earnings increase that is priced in. So if you're buying the equity market today, just know that you're buying an asset class writ large that is expecting a V-shaped +30% bounce in earnings growth over the course of the coming year. Trouble is, that it is a 1-in-20 event -- and normally that 1 in 20 happens early in the cycle, not late in the cycle .... Actually, six quarters of negative comparisons. I mean, if the earnings recession is behind us and if there are Trump tax cuts ahead of us -- even if I allow for the full brunt of corporate tax cuts -- and if I allow for whatever nominal GDP growth is going to be, I still can't get earnings growth much above 10%. 15% is a stretch, but you might still get there. But even that doesn't get you to a 30% earnings expectation."
 --Welling on Wall Street

So, what is the best short? Perhaps it's the Russell Index.

"When all the forecasters and experts agree, something else is going to happen." --Bob Farrell's Rule #9

* Over the last year the Russell Index has materially outperformed the broader indices: Since mid-December 2015, the Russell Index has doubled the performance of the S&P Index (up 24% compared to 12%). As Bertrand Russell noted, "extreme hopes are born from extreme misery" -- at least if you have been short iShares Russell 2000 ETFIWM! (Note: In its history, the Russell Index never has been as extended relative to the Bollinger Bands.)

* The recent widening in relative performance (Russell vs. S&P) may be a function of the president-elect's policies toward protectionism and against globalization; the timeliness and extent of impact might be overestimated.

* The Russell Index is more richly valued than the broader indices. The 2016 price/earnings multiple for the Russell Index is 32x and 25x 2017 estimates (before any new effective tax rate) on non-GAAP earnings. The S&P Index is trading at 19x 2016 non-GAAP and 17.5x 2017 estimates. However, the S&P multiple of GAAP is 26x -- there is no currently available GAAP multiple of the Russell.

* As interest rates gap higher, the cost of capital is rising for small and medium-size companies: This is occurring at a speed far faster than many previously thought. Large, multinational companies have better and cheaper access to capital through the markets and/or on their cash-rich balance sheets. (Note: This morning's move in the 10-year U.S. note yield to more than 2.50% may be a tipping point).

* The rate of growth in the cost of commodities and services is starting to accelerate. This hurts smaller domestic companies that are less diversified compared to the larger companies. Remember, mono-line smaller companies often have less pricing power than their larger brethren. (Note: This morning's $2.35 rise in the price of crude oil to nearly $54 also may be a tipping point).

* Smaller capitalized, domestically based companies are not beneficiaries of possible repatriation of overseas capital. As Russell wrote, "Sin is geographical!"

* The president-elect's infrastructure plans likely will be slow to advance. There will be some opposition from both parties, members of which will be looking for a revenue-neutral and not "budget-busting" fiscal jump-start. At best, this is a 2018-2019 event. Moreover, the build-out could benefit some of our larger companies (e.g., Caterpillar(CAT) and United Rentals (URI) ) over smaller companies. In the broadest sense, however, infrastructure build-outs rarely contribute to sustained prosperity; just look at the sophisticated and state-of-the-art infrastructure in Japan.
That build-out has failed to bring sustainable economic growth to that country. The same can be said for Canada, which is mired in a 1% Real GDP growth backdrop despite Prime Minister Trudeau's large infrastructure spending of years ago.

* The president-elect's immigration policy -- building a wall, limiting in-migration and exporting those who are in our country illegally -- are not pro-domestic growth and could hurt small to medium-size companies.

* The president-elect's China policy and broader protectionism policy could end up hurting the sourcing (impacting availability and cost) of many smaller companies, potentially squeezing profits by lowering margins and reducing sales.

Bottom Line

"All movements go too far."  --Bertrand Russell

My view is that the Russell may soon stop crowing and I am moving toward a more aggressive short of that Index.

via realclearmarkets

December 12, 2016

Market's optimism of the Trump stock market rally could be premature

Trump faced numerous objections this year (many similar to what Quayle faced), but many of his supporters have compared The Donald to the late President Ronald Reagan. But next week, I'll chronicle the substantive differences that I see between Reagan and Trump, as well as highlight the different circumstances that existed at the Reagan administration's beginning vs. what Trump faces today.

Since the Great Recession, the Federal Reserve's Zero Interest Rate Policy and quantitative easing have stabilized our country's economy and led to modest annual real GDP growth. But the Fed acts unilaterally. By contrast, fiscal stimulus requires the joint action of Congress and the president -- a more complicated and nuanced process.

To this observer, the market's current leap of faith that the Trump administration seamlessly will jump-start the U.S. economy through fiscal initiatives, tax cuts and the elimination of burdensome and expensive regulations may be misplaced, just as market optimism surrounding the Reagan administration was misplaced and premature.

On the latter score, it is important to remember that during the three-month period from the time Reagan was elected in November 1980 to his inauguration in January 1981, market euphoria took the S&P 500 8.5% higher. However, the market fell dramatically from January 1981 through August 1982, declining by 28% from the 1980 election and by 20% from Reagan's 1981 inauguration.

The Bottom Line

To many, Trump's stump speech and campaign slogan "Make America Great Again" mirror Reagan's successes in righting the U.S. economy, developing a stronger military force, rejecting globalization and overcoming our chief adversary, Russia. Trump's election win, like that of Reagan, also comes at a time when many Americans feel downbeat as the gap between wealth and income inequality has continued to widen in what I term "The Screwflation of the Middle Class."

But as I'll discuss next week, the Trump administration faces an entirely different set of circumstances that Reagan did 35 years ago. Like Reagan, Trump possesses a charismatic personality (and at times a less-than-precise grasp of facts), but Washington was different in those days. Bipartisanship often flourished.

As Chris Matthews wrote in "Tip and The Gipper: When Politics Worked," politics and ideological differences were set aside at 6 p.m., particularly between Reagan and Irish-American Democratic leader Thomas P. "Tip" O'Neill. In time, Reagan cut meaningful deals with the Democrats, such as the revision of the Social Security program.

Unfortunately, the times they have changed and partisanship now rules the day. The adoption of crucial legislation is no longer a seamless process, as the animus between Democrats and Republicans is a thick and almost impenetrable fog of mistrust.

So, comparisons between Trump and Reagan and the economic and social conditions that exist today vs. then fall short -- and the legislative and executive outcomes may differ meaningfully.

December 5, 2016

Donald Trump and Ronald Reagan economic policies

A surprising amount of spontaneous optimism has spread over the markets following the Trump election victory. Specifically, interest rates have climbed swiftly and economic and profit forecasts have been lifted based on the expectation of successful pro-growth policies to be implemented by the Trump administration.

However, one of the most pressing headwinds will be those higher interest rates. It is a headwind that will be compounded by the size of the federal government's debt, which will be close to $20 trillion in January 2017. And that does not include another $3.5 trillion of local and state debt.

Back in the Reagan administration, tax cuts increased the deficit, but when combined with the Clinton/Gingrich budget controls, debt was falling and economic growth accelerated. Debt as a percentage of GDP fell. But the abandonment of budgetary controls (tax cuts rose at the same time spending programs grew) in the Bush administration put us back into deficits The Great Recession led to an explosion in the deficit, growing by nearly $10 trillion in eight years.

The total federal debt has risen by more than $1.3 trillion in the last year (+7%); this includes off-budget debt.

The larger our debt, the harder it is to grow--just look at Japan and Europe. 

The U.S. debt to GDP ratio is more than 120% (it was only about 30% when Reagan was elected). Today, total U.S. debt--which includes private and business debt--totals $68 trillion, or under 400% of GDP. But nearly 95 million individuals are not in the labor force. As my pal John Mauldin writes, there are 43 million living in poverty, 2 million prison inmates, 43 million on food stamps, 57 million Medicare recipients and 73 million Medicaid recipients.

There also are more than $100 trillion of unfunded municipal liabilities that ultimately must be paid off.

Over the last 10 to 15 years, the U.S. economy has been growing at about 2% in real terms. More recently the rate of growth has slowed to only 1.5%. Add in inflation and nominal GDP growth is approximately 3.25%, compared to 7% growth in total debt.

The Heavy Lifting Lies Ahead

The Republicans' economic growth policy is founded on the notion that their initiatives will produce enough GDP growth to negate the growing deficit.

However, history indicates over the last 110 years that the U.S. economy has entered recession within one year of the end of every two-term presidency. If this occurs again, the lifting will be next to impossible.

Practically speaking, the implementation of Trump policy will take time and will require much more than just eliminating waste. Moreover, despite the stated goal of reducing health care costs, demographics (the aging Baby Boomers) will cause ever-more spending of a Social Security kind.

Finally, with a stated objective of reducing individual and corporate taxes, revenues and growth will occur with a lag, producing a rise in the deficit and worsening debt problems, particularly if interest rates rise.

I fear the gap between lower taxes and offsetting revenue increases will be wider than many now believe.

Bottom Line

Conditions today are materially different than they were 50 years ago, or even 35 years ago when Ronald Reagan became president.

When Reagan assumed the presidency, stocks were inexpensive. Back then, the stock market's capitalization as a percent of GDP was 40%; it's close to 200% now. Arguably, stocks are now expensive.

When Reagan became president, interest rates were falling; now they are rising. When Reagan won election, there was large pent-up demand. In 2016, zero interest rates for seven years have borrowed from future growth. When Reagan entered office, baby boomers were entering the work force; today they are retiring.

The heavy lifting of coherent tax and spending policies aimed at producing a smooth path of economic growth will be a meaningful challenge to the Trump administration, especially considering the length of the current expansion and with the historic precedent of recessions soon following two-term presidents.

Balancing the U.S. budget with an already swollen deficit in order to create a clear path to growth is easier said in a campaign promise than executed over the next few years.