Respect The Trends In These “Widowmaker” Trades

“Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” -Sir John Templeton

There are a couple of trends out there in the markets right now that are becoming so-called “widowmakers.” Specifically, I’m referring to oil and long bonds.

Oil has been crashing while long bonds have been soaring. Oil is way oversold and long bonds are way overbought. They should both probably retrace a bit of their recent moves simply because they’re both so overextended right now.


See the massive inflows into the oil ETF in the chart above? That is not the sort of “pessimism” that forms a major bottom.

Conversely, in bonds…

Investors have been drastically underweight and heavily short bonds for over a year now. This is why I’ve been writing for some time that bonds may be more likely than stocks to see a “blow off” sort of move.

Now traders are clearly trying to anticipate a trend change in both of these asset classes. They are getting heavily long oil and they remain heavily short long bonds. Now, to be clear, I think they may revert a bit if only to work off their overextendedness (if that’s even a word).

But the big problem with these trades is that the trend is plain as day and traders shouldn’t forget, “the trend is your friend!” Oil is nowhere close to breaking out of its downtrend and long bonds are nowhere close to breaking down out of their uptrend.

Trying to anticipate these trend changes must have been inordinately painful for these traders over the past few months. And the odds are neither of these trends will actually change until we see some real despair in oil and some true euphoria in long bonds, as witnessed in ETF flows or some other similar indicator. At least, that’s what I imagine the brilliant Sir John would have told us.

Follow me on Twitter: @jessefelder


The Skyscraper Index Is Flashing Another Sell Signal

STOP! Before you flood my inbox telling me I’m an idiot to put any faith in such a stupid concept, know that this is just for fun. This is not anything to be relied on for any reason, unless you’re just curious about these things, as I am.

Now that I’ve gotten that out of the way, I find it fascinating that at this point in the business cycle we are once again witnessing a race to build a record-breaking skyscraper. The “Skyscraper Index” is a concept that suggests, “the world’s tallest buildings have risen on the eve of economic downturns.” Statistically speaking it may not be entirely accurate but I find the theme to be very intriguing nonetheless.

Although the index was only created in 1999, this concept dates back to time immemorial. In fact, the tower of babel should probably be the first instance catalogued by the index. In short, humans built a tower to the sky to celebrate their god-like powers (of uniting humanity under one language) and were soundly smote in response. This story can be found in many religions, actually. And ever since there have been many great monuments built during times of economic euphoria as a testament to our greatness. Only shortly thereafter do we realize it was not so much greatness as hubris.

Construction of record-breakers like the Singer Building and the MetLife Building coincided with the panic of 1907. The Empire State Building, the Chrysler Building and 40 Wall Street, were all built or launched just prior to the 1929 stock market crash and subsequent Great Depression. The World Trade Center and the Sears Tower opened just prior to the 1973-74 bear market. Today, we have two New York developers racing to build the tallest residential building in the Northern Hemisphere.

So where are we in the business cycle? I have no idea. Over the course of modern history, however, our economy has suffered a recession every five years or so. The last recession ended June of 2009, just over five years ago. (In and of itself, this does not suggest we are necessarily due for a recession but global growth is clearly slowing and I doubt the US will be entirely immune.) The longest expansions in American history lasted about ten years. It may be fair to say, then, that we are probably closer to the end than the beginning of this particular expansion. And regular readers should know where I believe we are in the financial market cycle.

Late in the economic cycle, then, in the financial capitol of the world, which has benefitted mightily from the greatest money-printing experiment in the history of the world, we have two real estate developers in a heated battle to build a greater testament to their own greatness than the next guy. To my mind, it is the height of financial hubris and a clear example of economic euphoria. And it’s all happening just as luxury apartment sales in New York are starting to slow. All in all, I wouldn’t be surprised to see this index correlate with yet another economic and financial market peak.



Can we please stop bashing forecasters already? There is a small but influential faction of bloggers/financial talking heads out there that love to bash everyone who doesn’t invest exactly along their prescribed investment philosophy which is usually some sort of “passive” methodology, writing off non-conformists to their style as “forecasters” (or, even worse, “active managers”).

First of all, there is no such thing as “passive investing.” Picking an asset allocation is, by definition, active investing. Second, there are problems with passive investing they just don’t want to discuss but back to the topic at hand…

Yes, I agree that most forecasts are almost worthless. Just take a look at how many analysts and market gurus were calling for higher interest rates on the long bond in 2014 (nearly all of them), for example. The only “worth” in these sorts of forecasts was in their contrarian message – buying long-dated treasuries turned out to be a great trade.

But I think it’s absolutely imperative to realize that EVERYTHING is a forecast – even a so-called “passive investment portfolio.”

If you tell me to own a total stock market fund over the next decade (or any index fund, for that matter) you are making a forecast about what sort of return you expect it to generate over that time. Clearly, you wouldn’t tell me to own this sort of fund if you believed that stocks were likely to fall 40% over the coming decade (like the San Fran Fed recently suggested may be a real possibility). No, you believe that I will likely receive a positive return, after inflation, or why take the risk of owning equities at all? It’s a forecast, plain and simple.

At the end of the day, then, trashing forecasters is simply a way of saying that THEIR forecast is not as valuable as YOURS. And if you want to make that argument then I’d like to know WHY you think yours is better rather than just bashing the other guy’s.

Ultimately, to be truly honest with individual investors and our own forecasting ability, we should be telling them that the most successful models suggest that, from current prices, they will likely receive a negative real return over the coming decade from equities. And at 1.75% on the 10-year treasury, they can’t reasonably expect anything more from that asset class. Those are forecasts based purely on facts and statistics and it’s probably the best we can do.

But you can’t play this game without making a forecast. In fact, you can’t even sit out of the game without making one because even that decision is a forecast (that cash is likely to do better than any other asset class). So, with all due respect, please STFU about it; it’s disingenuous. Stop bashing forecasters and instead tell us why you believe YOURS is so much better than anyone else’s.


Has Demand For Stocks Dried Up?

We all spend a great deal of time analyzing valuations, technical patterns and sentiment in trying to determine if it’s a good time or bad time to buy or sell. I try to constantly tell myself, “keep it simple, stupid.” In that vein, there’s a much easier way of looking at the markets even if it means taking a very long-term view.

My friend @jesse_livermore recently wrote a terrific piece about the ultimate arbiter of market prices: supply and demand (go read it). This basic economic principle applies just as much to the financial markets as it does other prices. In fact, you can make a great case that the Fed limiting supply of Treasuries over the past few years has been a major factor in their incredible surge.

By the same token, there’s one chart that has stuck in my mind over the past year or so since it peaked. And that is the chart of total margin debt – more specifically, the chart of net credit balances in brokerage accounts:

NYSE-investor-credit-SPX-since-1980Chart via Doug Short

As you can see, we are currently witnessing the largest negative balance in brokerage accounts on record (second-most ever relative to GDP). Looking back over the past couple of decades it’s plain to see that stock prices have either benefitted or suffered from ebbs and flows in supply (stock for sale) and demand (stock for purchase).

The runup during the internet bubble benefitted from a massive amount of demand for equities fueled by rapidly expanding margin debt. Stocks peaked due, in some degree, to investors maxing out their ability to borrow and demand essentially dried up. Eventually, those shares they acquired during the bubble became supply and there was no new source of demand to soak it up. Prices were roughly cut in half.

Conversely, after the financial crisis, all the excess cash in brokerage accounts was converted to demand for equities which fueled the boom in prices during the beginning of the bull market. Then investors began to borrow and the growing margin debt once again pushed prices higher still. Now here we sit with record negative balances in brokerage accounts.

The simplest conclusion we can draw from the current levels of negative balances then is that there is currently record low potential demand for equities. In other words, the fuel for higher prices is running dry, if it hasn’t already (as I mentioned earlier margin debt levels peaked almost a year ago). Long term investors would do well to make a note of this and consider it in their long-term plans.

In the shorter-term, though, it’s probably worth noting that, on the flip side, there is also “record potential supply” for equities which can cause problems all on its own. Just take a look at what has happened recently to the price of oil. Massive new supply comes online (from the shale boom) and the price collapses about 60% in only 6 months time.

Now, I’m not saying the stock market will collapse. I’m just saying that should this potential “supply” come to market it could make for some very turbulent trading. (Another component of growing supply for equities comes from the IPO market, which last year nearly matched the record set in 2000.) And the potential for “demand” to save the day is very limited, at best.


The Stock Market Is Just Noticing What The Bond Market Has Known For Months

…that growth is slowing, the credit cycle could have already peaked and risk appetites are waning.

Over the summer I attended a conference which featured Steen Jakobsen as one of the speakers. The one thing he said that really stuck with me is that long-term bond yields lead the economy by about 9 months. If that is true, economists are going to be dramatically lowering their expectations for growth over the coming 9 months as the 10-year treasury has seen its yield plummet over the past year (not to mention foreign yields which are now negative at maturities of up to 5 years):


What’s more, the yield curve (the difference between the 10-year and the 2-year treasury yield) has flattened almost back to the level it saw at the very bottom of the financial crisis:


For most of 2014, stocks completely ignored this warning from the treasury market of slowing growth. One asset class that hasn’t ignored it is the corporate bond market, specifically the riskiest sector of the corporate bond market. High-yield bonds have been sending a clear signal for months now that, after a long hiatus, risk is making a comeback and the long-benign credit markets may be shifting to something not so benign. In his conference call yesterday, Jeff Gundlach called this divergence between stocks and high-yield, ‘the most worrying signal coming out of the markets right now.’


Most equity bulls have written off the weakness in junk bonds as a reaction to the oil crash which they believe will be contained. Junk has anywhere from 14-18% exposure to energy. However, leveraged loans have only a 4% exposure to energy and they have been just as weak, if not weaker, than junk bonds. This tells me that this growing risk aversion goes beyond just the energy sector and has implications for all risk assets, including stocks.

I guess nobody told the stock market as much until very recently. For the past few years risk appetites in the bond market (willingness to venture out on the risk curve from treasuries to riskier fixed income instruments) have been very highly correlated with stock prices – I’m talking 98% correlated… until last summer, that is. Since then, virtually all other risk assets have declined while US stocks continued to make new highs.

Screen Shot 2015-01-14 at 7.34.48 AMSo to my mind the stock market weakness over the past couple of weeks is merely a function of equities playing catch up with all other risk assets. Stocks are just starting to pay attention to these messages of slowing growth, increasing risk and waning appetites.

In the short term, my model suggests the S&P 500 should be trading closer to 1800 than 2000, based solely on bond market risk appetites which, as I said, have been very highly correlated in the past. Having said that, bond market risk appetites are a moving target. They could recover and that would change this forecast. But should we be witnessing a cyclical end to the incredible hunger for risk assets we’ve seen over the past few years (inspired by ZIRP and QE) then I imagine this is only the beginning of the process. Yield spreads certainly have plenty of room to move wider still. We’ll just have to keep our eyes peeled, I guess. And keep them trained on the bond market which will likely tell the tale.


Are Stocks On The Verge Of Another Incredible 1999-Style Surge?

Over the past few months the “blow off” camp has gotten fairly crowded. First, Jeremy Grantham said that we are very nearly in bubble in the stock market currently. However, he believes that bubbles don’t just fizzle out. They usually end in an epic move that runs faster and farther than anyone could ever imagine. Specifically, he’s looking for valuations to come fairly close to what we saw back in 1999.


Then, a few months later, David Tepper said that because this year rhymes (of course, history never repeats) with 1998 we could see a 1999-style surge in the stock market in 2015. Today, like in the late 90’s, money is being made too easy resulting in yet another asset bubble, he says. He is also looking for valuations that reach levels close to what we saw back in 1999 (according to him, today’s p/e is a mere 16 compared to 1999’s 40 but there are much better ways to measure valuations, in my humble opinion).

Recently, Richard Russell wrote a piece in which he revealed that he believes we are are only now entering the third phase of this bull market. He reminds us that gains in the third phase are usually equal to those of both phases one and two. Stocks have roughly tripled since the 2009 low (700 to 2100) so his expectation is about 3,500 on the S&P 500, almost 70% higher than its current level.

Just this week, Jim Rogers hopped aboard the “blow off” bus by saying he believes the stock market is probably due for some sort of decline but if stocks decline to any significant degree, the Fed will turn the printing presses back on and like never before sending stocks to ridiculous heights.

So we now have at least four respected pundits predicting an amazing “blow off” run for stocks. Know that I respect each of these individuals greatly and in their own right. Rogers is a hero of mine and I have as much admiration for Grantham’s work as for anyone in the industry.

Having said that, I strongly believe that the more popular a prediction becomes the less likely it is to come to pass. And this “blow off” thesis is getting fairly popular now. More importantly I’d like to try to examine what factors would have to align for this thesis to work.

First, the credit markets, which I have been watching very closely, would have to rebound. The high-yield market has been showing signs of weakness since mid-summer last year. This makes sense as that area of the bond market has about a 14% exposure to companies directly affected by the oil crash. Leveraged loans, however, only have a 4% exposure and have been just as weak as high-yield so we can’t just write off the waning risk appetites there to the energy sector. I believe both would have to improve significantly for stocks to have any chance of a “blow off.”

Screen Shot 2015-01-08 at 8.36.59 AM

Second, the global markets would have to avoid any significant fallout from the crashes in oil and in some emerging market currencies. There is a chance, though I have no idea how to put any probability on it, that there could be significant ramifications from the sharp moves we have seen recently in these areas.

Third, because sentiment and valuations go hand-in-hand, investors would have to become even more bullish than they are today. This would mean allocating an even greater percentage of household assets to equities, a statistic that is already fairly stretched and looks to possibly be peaking. It would also mean they would have to take on even more margin debt which, in relation to GDP (or inflation-adjusted, take your pick) is already far higher than what we saw at the peak of the internet bubble.

ALANMARGINDEBTChart from CrossCurrents via CNBC

Fourth, baby boomers would have to, at the very least, maintain their current equity exposure. If this retiring generation decides at some point that they have too much exposure to equities it could create an incredible headwind for the markets. In fact, the San Francisco Fed recently suggested the S&P 500 could finish as low as 1,290 a decade from now, 40% lower than its current level.

Finally, market participants must to continue to have full faith in powers of the Fed to manage not only the stock and bond markets but the economy and the dollar, as well. This is not a given. I believe that the Fed is not as powerful as the markets currently give them credit for being. If stocks began to fall in response to some dislocation in the currency or commodity markets the Fed may be hard-pressed to create a fix. Investors should have learned this lesson in 2008 when the markets essentially ignored every effort on the part of the Fed to reign in the financial crisis.

Ultimately, a number of things have to align nearly perfectly for the stock market to see another 1999-style surge. I do, however, envision one major possible driver of an equity blow-off. Should investors, both foreign and domestic, decide that Europe, Japan and emerging markets are not the best place for their money and that the US is the right place, we could see a continued surge in the dollar and increasing demand for our investment assets.


But what might make them move so dramatically out of those markets? I think the most likely reason would be a dislocation in one or more of them. In that case, which asset class here would most likely benefit? Risk assets, like stocks and high-yield? Or risk-free treasury bonds? I believe investors looking for a safe haven would most likely pick the latter. This is one reason I wrote a couple of months ago that treasury bonds could be about to blast off. They have already risen 10% since then but in this scenario that could be only just the beginning.

As I wrote earlier, I have tremendous respect for these guys who are looking for a “blow off” in stocks. They could very well be proven right, yet again as they have many times during their careers. All in all, however, I think there are a lot of things that need to go exactly right for a “blow off” in stocks to materialize. What’s more likely, in my mind, is that we see a “blow off” in the bond market, something almost nobody expects right now.


The Most Bearish Bear You’ll Find Anywhere: The FED

In a new economic letter recently released by the Federal Reserve Bank of San Francisco (h/t @dvolatility), a pair of researchers forecast a price-to-earnings ratio for the S&P 500 of a mere 8 in the year 2025 (due to retiring baby boomers’ waning risk appetites). This compares to 17 at the end of last year.

Let’s take this prediction out to its fullest conclusion. Assuming 3.8% earnings growth over the next decade (the long-term historical average according to Robert Shiller) we would achieve an earnings number of 156.76 for the S&P 500 in the year 2025.

Applying the 8.23 multiple to those earnings we get a price level of 1290 for the S&P 500. Yesterday the index closed at 2090. Ultimately, this research concludes then that stocks could very well witness a decline of 800 points over the coming decade, or about 40%, as baby boomers retire and shift their portfolios to a more conservative stance.

Have you heard a more dire prediction from ANYONE?