Wednesday, January 17, 2018

CPPIB Investing in UK's Housing Shortage?

IPE reports, Lendlease and CPPIB team up to invest £1.5bn in UK BTR sector:
Lendlease and Canada Pension Plan Investment Board (CPPIB) have partnered to invest an initial £1.5bn (€1.7bn) in the UK build-to-rent (BTR) sector.

The partnership will begin with an investment of £450m in the next phase of new homes at Lendlease’s £2.3bn Elephant Park development in Elephant & Castle, London.

CPPIB will invest around £350m for 80% stake and Lendlease will invest the balance.

This partnership is in addition to the £800m that Lendlease has already committed to housing and infrastructure in the development and will accelerate the delivery of private rental and affordable homes.

Construction has already commenced, and the first homes in this phase are expected to be completed in 2020.

Following this initial investment, the partnership will also pursue opportunities within Lendlease’s wider residential urban regeneration activities in London and across the UK under a 50:50 joint venture.

It aims to help address the UK’s housing shortage, over time, providing thousands of homes in London and across the UK via the development, and long-term ownership, of BTR product.

Lendlease will develop, construct and manage the BTR homes on behalf of the partnership.

Dan Labbad, the CEO of Lendlease’s international operations, said: “In recent decades, structural shifts in the housing market have meant that demand has outstripped supply in the private rented sector, leading to a shortfall of homes in London and across the UK.

“Today’s announcement is a logical next step for us as a business and delivers on our strategy to grow our urban regeneration pipeline and accelerate the delivery of much-needed homes, by working with institutional capital partners to launch this new asset class for Lendlease’s investment platform.”

Andrea Orlandi, the managing director and head of real estate investments Europe at CPPIB, said: “This investment is a great opportunity for CPPIB to further diversify our European real estate portfolio, while at the same time addressing a need in the UK.

“Through this partnership, we are able to access a sector we believe is poised for long-term growth, and we are pleased to be able to do so with Lendlease, one of our existing top global partners.”

CPPIB is already a long-term global partner of Lendlease.
You can read CPPIB's press release on this deal here. Lendlease has a good description of Elephant Park on its website:
Lendlease is working in partnership with Southwark Council to deliver a GBP£2 billion regeneration programme on 28 acres of land in the centre of Elephant & Castle. Situated in London's Zone 1, our vision is to create Central London's new green heart.

Inspired by the strength of its past, we will re-establish Elephant & Castle as the most exciting new neighbourhood in London not only through what we're building, but also how we're doing it. Our approach to urban regeneration in Elephant & Castle is already setting new standards in sustainability, that will not only will make the Elephant a great place to live, but will play a vital role in tackling issues such as air pollution and carbon emissions, creating a positive impact beyond just the Elephant.

The regeneration comprises three sites:
  • Elephant Park Masterplan Almost 2,500 new homes on the site of the former Heygate Estate. Received outline planning permission in 2013 and will be completed in phases between now and 2025. The first two phases South Gardens and West Grove are in construction. 25% affordable housing.
  • Trafalgar Place 235 new homes, including 25% affordable housing and a local café. Completed May 2015.
  • One The Elephant 284 homes in a 37 storey tower and four storey pavilion building, adjacent to the councils new Leisure Centre. Completes June 2016.
Lendlease views the Elephant & Castle regeneration as a unique opportunity to work with a local authority to create positive change. We will harness the scale of the project to tackle head-on some of the most challenging issues that affect global cities like London.

The Elephant Effect is what will happen when we apply all our imagination, empathy and dedication, and get this right. To do this, we take a long term view to consider how our project will be used to enable sustainable outcomes, such as enhancing biodiversity in parks and buildings, improving public transport and cycle networks, and maximising the resource efficiency of homes. The approach to development and construction will also contribute to sustainable results, such as: utilising cross laminated timber building frames, providing interim site uses to during the construction phase, and working with our supply chain to trial new technologies.

The Elephant & Castle regeneration is one of 18 projects from across the world chosen to be part of the Climate Positive Development Programme. We have set a roadmap that will deliver a climate positive development by 2025, and through the programme, global projects will learn from our outcomes and best practice.

Elephant & Castle is also one of ten low carbon zones identified by the Mayor of London tasked with local production of cleaner better value energy to fuel local households and businesses. As such, we are developing plans for a combined heat and energy centre to power our sites and the surrounding area.
As you can read, not only is this project going to transform this London neighborhood into one of the most exciting ones, it is also respecting climate control principles, all part of CPPIB's environmental and socially responsible investing.

This is a mammoth project and one which will deliver excellent long-term cash flows and capital appreciation to CPPIB and its partner, Landlease. This is the value in finding a solid long-term partner in real estate that adds value to major projects like this.

It also seems this deal is coming at a good time as the British pound has strengthened considerably since Brexit:



Remember, CPPIB doesn't hedge currency risk so any strength in foreign assets due to capital appreciation and gain in foreign currencies works to the Fund's advantage over the long run even if there are short-term swings in currencies which can impact gains on any given year.

And in another major real estate deal announced last week, Cortland Partners, CPPIB and GIC Form Strategic Joint Venture in U.S. Multifamily Real Estate:
Cortland Partners, Canada Pension Plan Investment Board (CPPIB) and GIC announced today that they have formed a joint venture with a targeted equity amount of US$550 million to acquire and renovate 8,000 to 10,000 Class B multifamily units in the U.S. CPPIB and GIC will each own a 45% interest in the joint venture and Cortland Partners will own the remaining 10% interest.

Class B properties are generally well-maintained older assets with opportunities for improvements to the buildings for the benefit of tenants, ongoing maintenance and long-term appreciation. The joint venture has initially acquired three value-add, Class B garden-style communities located in high-growth markets of major U.S. metropolitan areas:
  • Lakecrest at Gateway Park, a 440-unit rental complex located in Denver, Colorado;
  • Aurum Falls River, a 284-unit rental complex in Raleigh, North Carolina; and
  • Waterstone Apartments, a 308-unit rental complex in Austin, Texas.
“Partnering with these first-class organizations solidifies our business model and proves that a Class B multifamily investment strategy reflects smart money,” says Mike Altman, Chief Investment Officer, Cortland Partners. “We look forward to expanding our relationship with CPPIB and GIC through this joint venture.”

The joint venture will pursue additional opportunities to acquire multifamily properties that are candidates for value-add strategies, primarily in major markets throughout the Southern and Southeastern U.S.

“The U.S. multifamily real estate sector continues to offer compelling risk-adjusted returns for the CPP Fund, driven by favourable population growth and employment trends,” said Hilary Spann, Managing Director, Head of Americas, Real Estate Investments, CPPIB. “By focusing on Class B asset opportunities, this joint venture enables us to add diversification to our U.S. multifamily portfolio, which is concentrated in prime urban locations. We are pleased to form this new joint venture with Cortland Partners, a vertically integrated operator and one of the largest multifamily owner-operators in the U.S., and GIC, a longstanding partner we know well.”

Lee Kok Sun, Chief Investment Officer, GIC Real Estate, said “This venture will pursue a value-add strategy to capture the strong demand and resilient return profile of the U.S. multifamily sector. We look forward to growing this venture with Cortland, an experienced multifamily firm with a sizeable presence in the Sun Belt target markets, and CPPIB, a partner who shares our long-term investment philosophy.”

About Cortland Partners

Cortland Partners is a global, multifamily real estate investment firm that leverages proprietary design and build supply chains with in-house construction, property, and facilities management services to unlock value in high-growth U.S. markets. Headquartered in Atlanta, GA, Cortland owns and manages over 45,000 apartment communities across the U.S. with regional offices in Charlotte, Dallas, Denver, Houston, and Orlando. Cortland also houses a global materials sourcing office in Shanghai, China and an international development office in London, U.K. Cortland Partners is a National Multifamily Housing Council (NMHC) Top 50 Owner and Manager and is ranked among Atlanta’s “Top 25 Largest Workplaces” (2017). For more information, visit www.cortlandpartners.com.

About CPPIB

Canada Pension Plan Investment Board (CPPIB) is a professional investment management organization that invests the funds not needed by the Canada Pension Plan (CPP) to pay current benefits on behalf of 20 million contributors and beneficiaries. In order to build a diversified portfolio of CPP assets, CPPIB invests in public equities, private equities, real estate, infrastructure and fixed income instruments. Headquartered in Toronto, with offices in Hong Kong, London, Luxembourg, Mumbai, New York City, São Paulo and Sydney, CPPIB is governed and managed independently of the Canada Pension Plan and at arm's length from governments. At September 30, 2017, the CPP Fund totalled C$328.2 billion. For more information about CPPIB, please visit www.cppib.com or follow us on LinkedIn, Facebook or Twitter.

About GIC

GIC is a leading global investment firm with well over US$100 billion in assets under management. Established in 1981 to secure the financial future of Singapore, the firm manages Singapore’s foreign reserves. A disciplined long-term value investor, GIC is uniquely positioned for investments across a wide range of asset classes, including real estate, private equity, equities and fixed income. GIC has investments in over 40 countries and has been investing in emerging markets for more than two decades. Headquartered in Singapore, GIC employs over 1,400 people across 10 offices in key financial cities worldwide. For more information about GIC, please visit www.gic.com.sg.
You will recall last March I discussed why CPPIB and Singapore's GIC were betting big on US college housing, so I'm not surprised to see these two huge funds partner on this particular deal.

Lastly, in another huge deal announced this week, CPPIB and Goldman Sachs Asset Management LP led an investment round of more than $950 million for Enfoca, a Peruvian private-equity firm.

There is more detail on this deal from this press release:
Enfoca, a leading private equity fund manager based in Lima, Peru, today announced the completion of a General Partner-led secondary transaction in which a new investment fund managed by Enfoca purchased exposure to the portfolio companies of three Enfoca-managed funds by providing a liquidity option to the existing Limited Partners (LPs). The new fund also obtained commitments for new capital to develop the portfolio.

Canada Pension Plan Investment Board (CPPIB), which made a capital commitment of US$380 million, and Goldman Sachs Asset Management LP’s Vintage Funds (GSAM) led the transaction. The three largest Peruvian pension funds, Integra, Prima and Profuturo, which have invested with Enfoca since 2007, are also committing new capital to the fund after taking advantage of this opportunity to obtain partial liquidity for their existing investments with Enfoca. In aggregate, the transaction represents a total capital commitment of over US$950 million and sets a new benchmark for General Partner-led liquidity alternatives in the LatAm private equity market.

Through a competitive bidding process, the transaction provided Enfoca’s existing LPs with a liquidity option with attractive returns on their original investments. The transaction gives the new LPs the opportunity to invest in a unique high-growth portfolio of Peruvian mid-market companies and also provides Enfoca with access to capital for new investments and continued growth of the portfolio, as well as an extended duration to realize the portfolio’s potential. Enfoca will serve as the General Partner of the new fund and will manage the portfolio post-closing.

“We are pleased to deliver liquidity for our existing LPs with attractive returns in a landmark transaction for the LatAm private equity market, while introducing CPPIB, a sophisticated global institutional investor, and GSAM, a successful global private equity investor, to our fund. The significant unrealized value in the portfolio provides our new investors with unique access to sectors in the Peruvian market and the Andean region that have experienced rapid growth,” said Jesús Zamora, Co-Founder and Chief Executive Officer of Enfoca.

“This sizable transaction supported by our new investors represents an important milestone for Enfoca and provides our portfolio with greater flexibility and access to capital,” said Jorge Basadre, Co-Founder of Enfoca. “We thank those LPs who are exiting our fund for their support over the years and look forward to working closely with our new and continuing investors as we grow our businesses in the future.”

“CPPIB is delighted to partner with Enfoca and GSAM in this direct secondary transaction, which allows us to benefit from their deep market expertise and track record in Peru,” said Michael Woolhouse, Managing Director, Head of Secondaries & Co-Investments, CPPIB. “Through this transaction, CPPIB will gain further access to this growing market and increase its overall investment in Latin America, one of our strategic focus regions.”

Steve Lessar, co-head of Goldman Sachs Asset Management’s Vintage Funds, said, “We are pleased to be partnering with Enfoca and CPPIB to invest in a portfolio of market-leading, consumer-oriented companies with meaningful growth prospects driven by a strong Peruvian economy. We have been impressed with Enfoca’s investment strategy and look forward to investing additional capital to support the growth of these portfolio companies.”

Park Hill Group LLC served as financial advisor and Davis Polk & Wardwell LLP and Payet, Rey, Cauvi, Pérez Abogados served as legal advisors to Enfoca.

About Enfoca

Enfoca, founded in 2000, is a private equity fund manager based in Lima, Peru. Enfoca manages funds with more than US$1 billion in assets, investing in Peru and other Andean region markets. Enfoca targets companies that operate in sectors that Enfoca believes are positioned to benefit from growth in the economy and consumer spending, such as healthcare, media, education, housing and consumer goods. For more information about Enfoca, please visit: http://www.enfoca.com.pe/

About CPPIB

Canada Pension Plan Investment Board (CPPIB) is a professional investment management organization that invests the funds not needed by the Canada Pension Plan (CPP) to pay current benefits on behalf of 20 million contributors and beneficiaries. In order to build a diversified portfolio of CPP assets, CPPIB invests in public equities, private equities, real estate, infrastructure and fixed income instruments. Headquartered in Toronto, with offices in Hong Kong, London, Luxembourg, Mumbai, New York City, São Paulo and Sydney, CPPIB is governed and managed independently of the Canada Pension Plan and at arm's length from governments. At September 30, 2017, the CPP Fund totaled C$328.2 billion. For more information about CPPIB, please visit www.cppib.com or follow us on LinkedIn, Facebook or Twitter.

About Goldman Sachs Asset Management LP’s Vintage Funds

The Vintage Funds invest in the secondary market for private equity, providing liquidity, capital and partnering solutions to private market investors and managers globally. With over $26 billion in committed capital, the Vintage Funds have been innovators in the secondary market for over 20 years. The Vintage Funds are managed by the Alternative Investments & Manager Selection (“AIMS”) Group within Goldman Sachs Asset Management. The AIMS Group provides investors with investment and advisory solutions across hedge fund, private equity, real estate, public equity, fixed income and environmental, social, governance and impact-focused investment strategies. For more information, visit: www.gsam.com
Below, an interview with Chris Baines (environmentalist) and Carlo Lorenzi (London Wildlife Trust) on the benefits of having inner city nature on your doorstep.

I also embedded an interview with Lendlease Project Director for Elephant & Castle Pascal Mittermiaer on their world leading plans for sustainable 'healthy homes' and green spaces at Elephant Park, utilising innovative materials such as cross-laminated timber.

Third, Sustain's Sarah Williams talks about the growing popularity of inner city grow gardens and the benefits of growing your own food, no matter where you live.

Lastly, welcome to West Grove, the next chapter of Elephant Park, Central London’s greenest new place to live. West Grove is set around two landscaped courtyards in two distinct neighbourhoods, Highwood Gardens and Orchard Gardens. West Grove is ideally located to enjoy the independent shops on Elephant Park’s new central shopping street, as well as the brand new park at the heart of the development. The estimated completion date for West Grove is Spring/Summer 2018.

It looks like paradise in London. You can watch more clips on Elephant Park here. This is another great long-term investment for CPPIB, one that will benefit all Canadians.




Tuesday, January 16, 2018

Time to Take a Closer Look at Hedge Funds?

Linsay Fortado of the Financial Times reports, Hedge funds produce best returns in 4 years:
The global hedge fund industry last year produced its best returns since 2013, driven by strong performances from managers who bet on stocks.

Figures tallied by HFR, the research group, this week show that hedge funds across all strategies produced returns of 8.5 per cent in 2017, better than the 5.4 per cent recorded in 2016. Equities hedge funds — which include long-short funds, growth and value funds and sector-specific strategies — were up 13.2 per cent, their best showing in four years.


Advisers say it is too early to be sure this return to form will assuage investors’ concerns about high fees and mediocre long-term profits. But a cautious optimism has returned to the industry after the outflows of 2016 — the worst year for flows since the financial crisis — and many managers posted robust, or even eye-poppingly good, returns.

“In 2017 hedge funds as a strategy finally justified their cost of capital,” said Scott Warner, a partner at the fund of hedge funds Paamco. “But to really start to drive money back into the asset class, we’re going to have to see a more sustained period of performance.”

Long-short equity funds, which can make both positive and negative bets on stock price movements, were some of the best performers of the year, helping to retain money that investors had been rapidly shifting towards cheaper, passive and more liquid products.

Some of the biggest long-short equity shops had funds that returned double-digits last year. Some smaller managers did particularly well: Whale Rock Capital and Light Street Capital returned 36.2 and 38.6 per cent, respectively, off the rise of technology stocks including Alibaba.

Tiger Global, one of the largest long-short managers, had returned 27.5 per cent as of the end of November.

“There was really good stock selection both on the long and short side,” said Jon Hansen, a director of hedge funds at Cambridge Associates, an investment consulting firm. “When managers were right in 2017, they tended to be rewarded for that on both sides of the book.”

Activist funds performed strongly, too. TCI, the London-based activist, was up 28.2 per cent for the year. Marshall Wace, Lansdowne, Cevian Capital, Teleios Capital, Brenner West and Naya Capital all had funds with returns in double digits for 2017 as a whole.

The revival in fortunes came just in time. Bob Leonard, a managing director at Credit Suisse’s investment bank and its global head of capital services, said equity long-short had been “on a lot of people’s watch lists” for possible redemptions.

But, while investors who are currently invested in equity long-short funds that outperformed are likely to stay, they are still unlikely to add to the allocation, he said. All equity funds were buoyed by rising stock valuations, as the S&P 500 rose 19 per cent last year.

“Some are thinking that equity valuations are getting a bit stretched, and no one knows when or how this ends, but some institutional investors are taking chips off the table,” Mr Leonard said.

“As long as investors continue to think or feel like we’re getting a bit pricey in the developed markets, strategies like global macro is top of mind,” he added, because these are funds that can shift money between whole markets. “If you’re going to add equity long-short, you as a manager need to really prove to us how this is going to be diversified and uncorrelated.”

Macro funds managed returns of just 2.3 per cent in 2017, according to HFR, but that was better than the 1.0 per cent of the previous year. Relative value funds, which trade mainly in the credit markets, returned 5.3 per cent, less than the 7.7 per cent in 2016.


Despite the industry’s overall higher returns of the past year, investors are still wary of hedge funds. The high fee structure — traditionally a 2 per cent fund management fee and a 20 per cent performance fee — came under fire.

Funds responded by reducing fees, and the money that still flowed into the sector was consolidated mostly at the largest funds. Hedge fund closures outpaced the number of funds that opened in 2017 for the third year in a row, claiming several veterans of the industry. John Griffin’s Blue Ridge Capital, Neil Chriss’s Hutchin Hill Capital and Eric Mindich’s Eton Park Capital all shuttered, while Paul Tudor Jones closed one of his funds.

Don Steinbrugge, chief executive of investment consultant Agecroft Partners, predicted that while the amount of money managed by the industry would continue to grow in 2018, the number of hedge funds closing down would also rise.

“The hedge fund industry remains oversaturated,” he said in a note to clients. “We believe approximately 90 per cent of all hedge funds do not justify their fees . . . Some large managers are simply too large to maintain an edge.”

After investors pulled $70bn from hedge funds in 2016, $2.9bn in fresh capital trickled in over the first nine months of 2017. A final figure for the year will be out later. Mr Warner said managers at Paamco are “not seeing huge investor demand to pile back in, but an abatement of the pressure to redeem has occurred.”

Added Mr Hansen: “We went through a stretch where there was a lot of negative sentiment about hedge funds. That seems to have abated.”
The Financial Times' Opinion Lex also put out an op-ed, Hedge funds: many hypey returns:
Just in time for Stevie Cohen’s hyped-up reinvention, hedge funds are back. Sort of. On Monday, trade title HFR, published returns for 2017. Profits last year were the best since 2013, led by groups that bet long and short on stocks. Still, the gains trail the cheap, passive strategies that have proliferated of late. Some big pension schemes have quit hedge funds, turned off by the costs and weak performance.

Hedge funds are useful when they embody their name: as hedges against tricky, volatile markets in a diversified portfolio. But until markets are experiencing real turbulence and pricey, active management proves to be a buffer, it is premature to proclaim a hedge fund renaissance.

The overall HFR hedge fund index returned 8.5 per cent in 2017, its best in four years. The S&P 500 was up a fifth. After years of trailing key benchmarks, masters of the universe such as Eric Mindich and Paul Tudor Jones, on one portfolio at least, have thrown in the towel. In 2016, the latest data available, hedge fund closures topped 1,000, a figure not seen since the financial crisis. Pension funds such as Calpers and NYCERS (New York City public employees) have pulled the plug on hedge fund allocations in recent years.

Not all customers are jaded. The famed Yale University endowment now allocates more than a fifth of its money to hedge funds. Over the past 20 years, hedge funds have returned nearly 10 per cent annually for Yale, with little correlation to the broader market. Yale has pushed back against criticism of high fees, arguing that these are justified by performance.

Unlike many institutions, it has had the skill (or luck) to pick top funds in advance. Since Yale is not offended by big fees, it can consider the revival fund Mr Cohen is now launching. Rather than a shopworn “two and 20” structure, Mr Cohen plans to reprise his old management fee of 2.9 per cent, taking up to 30 per cent of investment gains. The greatest feats of hedge fund managers are in marketing, rather than investment.
A brief comment on hedge funds as I had a discussion with a friend of mine earlier on asset allocation and whether it's worth investing in hedge funds given how well stock markets have performed since 2009.

First, have a look at the S&P500 annual total return historical data courtesy of Ycharts.com (click on image):


You will notice the two worst years going back to 1988 were 2008 (-37%) and between 2000 and 2002 (-9%, -12%, and -22%). No surprise as these periods followed the subprime mortgage bubble and the tech bubble.

The second thing you will notice is since 2009, the S&P 500 (SPY) has been up a lot and the returns for Nasdaq stocks (QQQ) have been even better. In fact, since bottoming in March 2009, the S&P has more than tripled and the Nasdaq-100 is up more than fivefold.

Given these impressive index returns, it's hardly surprising that investors aren't too concerned about hedge funds or have shunned them altogether. Why bother trying to find a good hedge fund when many top managers are struggling to deliver alpha and when you can just buy the S&P500 or Nasdaq-100 and forego all those hefty fees to external managers?

But wait a minute, the good times won't last forever, and if we get a string of bad years, surely then hedge funds will prove to be very useful for large institutions looking for uncorrelated returns, right?

Maybe but that remains to be seen. Most hedge funds have a lot of beta embedded in them so if markets get clobbered, I guarantee you the majority of L/S Equity and even activist funds are going to get clobbered too. Perhaps not as much as the index (after all, they hedge a portion of their assets) but they will experience serious drawdowns (as they charge hefty fees).

So what? As long as they're outperforming markets on a relative and risk-adjusted basis, who cares if hedge funds run into trouble?

I agree but a big asset allocator doesn't care because he or she knows once markets come back, hedge funds will once again be left in the dust. Also, why pay fees to external absolute return managers who might be performing well relative to their peers but are still severely underperforming the S&P 500 over a long period?

"Yeah but Leo, you're a smart guy, the future won't look like the past, you just wrote a comment questioning the great market melt-up of 2018, stating central banks have juiced these markets and you know things will eventually calm down and when the storm hits, it will be with us for a very long time."

I know all this and my gut is telling me even though macro gods were in big trouble last year, maybe this year they'll finally come back strong.

But there is something else that I'm fully aware of. A lot of the big pensions and other large institutions that read this blog don't really care about hedge funds. Why? Because they prefer long-dated private markets like private equity, real estate and infrastructure where they can put a lot of money to work and generate the long-term returns they are seeking to meet their long-term actuarial target rate-of-return.

Still, some of the more sophisticated shops like Ontario Teachers' and CPPIB have a sizable allocation to external hedge funds and just like Yale, they want to find uncorrelated returns, a high Sharpe ratio in alternative strategies that are fairly liquid (especially compared to private markets).

Other less sophisticated pensions have turned their back on hedge funds and that has proven to be a wise decision since 2009. I'm less sure about latecomers to this trend like North Carolina’s treasurer Dave Folwell.

All this to say when it comes to hedge funds, I'm very careful weighing the pros and the cons. You will hear all sorts of good and bad arguments for and against them but given where we are in the cycle (see my Outlook 2018), I would be actively looking to build long-term relationships with top hedge funds, big and small.

As far as Stevie Cohen and his new hedge fund, I stated this on LinkedIn:
The S&P 500 was up 22% last year which explains why so many funds closed shop. Paying 3 & 30 to any hedge fund manager sounds nuts but Stevie Cohen isn’t just anyone, he’s one of the best traders in the world. If anyone can deliver alpha in a brutal environment, it’s him. If he’s not performing well, I guarantee you others are performing miserably.
Would I invest in Cohen's new fund and pay 3 & 30? You bet but I wouldn’t give him rock star treatment and I'd demand we meet face to face at least once if not twice a year (nothing personal, I wouldn't give any external manager rock star treatment, it's not my style and nor is it your job when allocating to external absolute return managers). 

What about other hedge funds? I like many of them, some well known, some less well known but you're not paying me enough to share this information with you. Do your own due diligence and discover some gems out there, keeping in mind the macro context we're headed in right now.

For example, in L/S Equity, I don't want sector neutral guys and gals, I want top stock pickers or amazing traders like Cohen. In global macro, I want to see alpha generation across stocks, bonds, and currencies. As far as hedge fund quants taking over the world, some of them are going to get clobbered while others will weather the storm.

Whatever you do, if you're going to invest in hedge funds, make sure you have a solid team that knows how to sit down with these fund managers and conduct a proper operational, investment and risk management due diligence. If you need help from an external consultant, get it, but it's always wise to hire talented people who know to talk the language of hedge funds.

That's all for me. Please don't email me telling me how great hedge funds are on a risk-adjusted basis or how awful they are and only a fool would invest in them instead of the S&P 500 ETF (Buffett and Munger's argument). I'm getting old, have been around the block a few times and have no patience for stupidity from people who only see black and white when it comes to hedge funds.

Below, it's been a wild day in the markets where the Dow briefly broke above 26,000 for the first time and was up 283 points at session highs before reversing course ending the day down 10 points. Rich Ross, Evercore ISI, and Michael Bapis, Bapis Group at HighTower Advisors, discuss the big moves in the markets today with CNBC's Brian Sullivan.

And CNBC's Leslie Picker reports on what to expect from hedge funds this year. I'm not sure I'd expect much, some will perform well but most will get clobbered. Pick your hedge funds carefully.

Monday, January 15, 2018

The Great Market Melt-Up of 2018?

Michael P. Regan and Lu Wang of Bloomberg report, Are You Missing Out on the Great Market Melt-Up?:
Make no mistake, fear is running amok on Wall Street these days—fear of missing out.

As the S&P 500 got off to its best start to a year since 1999 and the Dow Jones industrial average topped 25,000, it’s clear that fear of missing out—FOMO—has jumped to the top of the fear charts with a bullet. It’s risen above worries about North Korea’s “Rocket Man” and the unpredictable U.S. president who revels in provoking him. It’s blown past lingering concerns about the European Union coming apart at the seams. It’s even eclipsing the most popular talking point of fear merchants everywhere: marketwide valuations that in many cases are approaching the highest they’ve ever been.

Is this such a bad thing? Maybe yes, probably no. Unlike other FOMO-driven rallies of the distant and not-so-distant past—from Dutch tulip bulbs in the 1600s to dot-com stocks at the turn of the century to the Great Bitcoin Craze of 2017—there’s little debate that there will be something legitimate to miss out on in the stock market in the near term, rather than the hazy distant future.

Forget about the economy. The massive tax cuts President Trump signed into law on Dec. 22 will probably boost gross domestic product growth by a few tenths of a percentage point, but that’s not what investors are excited about. As economists gently inch up GDP estimates, equities strategists may find themselves stepping over one another to jack up their forecasts of different parameters: the benefits to corporate profits, the subsequent cash returns to shareholders, a return of confidence and greed to the collective investor psyche—and good ol’ FOMO. The wholesale dismantling of Obama-era regulations adds a hard-to-quantify, but real, fuel to the fire.

The average estimate of strategists surveyed by Bloomberg on Jan. 8 is for the S&P to end just below 2,900 by next New Year’s Eve. If the rally continues at anywhere near the breakneck pace with which it started the year—up almost 3 percent in the first four sessions of 2018—it will hit that yearend forecast before Groundhog Day. Some measures of upward momentum in the market are at the highest in half a century or more, and often the strong momentum generates more strong momentum.

When price gains get downright ridiculous, it’s referred to on Wall Street as a “melt-up,” perhaps because these self-perpetuating rallies tend to be followed by meltdowns. This is the uncomfortable prospect that many investors are contemplating. For those of us old enough to remember the dot-com boom and bust, it’s tempting to assume the market will never become that irrationally exuberant again. Of course, many current market participants were in grammar school then. Old-timers need to consider that the market’s collective memory may be shorter than their own.

Jeremy Grantham, co-founder and chief investment strategist of asset manager GMO LLC in Boston, who’s been following markets for five decades, is an old-fashioned value investor who finds himself in the “interesting position” of looking beyond valuation metrics, instead studying previous melt-ups to try to figure out how long the current party will last. The takeaway, by his analysis, is that the S&P 500 would need to surge as high as 3,700, or 34 percent, in 18 months to qualify as even the tamest “classic bubble event” in history.

Grantham defines a bubble as having “excellent fundamentals, euphorically extrapolated.” His description is sounding more familiar every day. Earnings growth for S&P 500 companies is forecast to accelerate to almost 15 percent in 2018, according to estimates compiled by Bloomberg. Economic indicators are strong and beating estimates; the average GDP forecast for 2018 has risen to 2.6 percent, from 2.1 percent on Election Day 2016. Credit markets are healthy. Business, consumer, and investor confidence is off the charts.

Yet most of the measures investors use to evaluate stocks are dizzying. The S&P 500 trades at 2.3 times its companies’ sales, a hair below its dot-com peak. Price-earnings ratios are also sky-high: Goldman Sachs Group Inc. estimates the median stock in the index has been more richly valued for only about 1 percent of the benchmark gauge’s history. What’s known as the cyclically adjusted p-e (CAPE) ratio, at more than 33, is above its level before the crash of 1929—indeed, it’s higher than at any moment in history, excluding the dot-com debacle.

Some of these valuations can be explained away, for those willing to try. The CAPE ratio, often called the Shiller p-e after Yale economist Robert Shiller, uses 10 years of earnings in its calculations. Considering the decimation of profits during the financial crisis, the calendar alone will pull that valuation metric lower as the catastrophic years of 2008 and 2009 drop out of the math. Another standard, known as the PEG ratio, used by investors such as Fidelity Magellan Fund legend Peter Lynch, divides p-e ratios by expected profit growth. The current PEG of 1.4 is above average but well below a record of more than 1.7 in early 2016.

“Yes, markets are arguably expensive by history, but this environment of accelerating not only earnings but also economic strength is what’s catching the market’s attention right now,” John Augustine, chief investment officer for Huntington Private Bank in Columbus, Ohio, recently told Bloomberg.

It’s hard to know to what degree stock prices already reflect the benefits investors expect from tax reform. Goldman Sachs’s basket of companies with high tax rates has outperformed low-tax stocks by almost 10 percentage points since the middle of October. But taxes are complicated, and there could well be more positive than negative surprises as the details are sorted out. Consider the $37 billion boost to book value that Barclays Plc analysts estimate Warren Buffett’s Berkshire Hathaway Inc. will enjoy because of reduced tax liability on its appreciated investments.

Yes, 2018 will probably see more complaints that tax reform didn’t benefit the little guy as much as it could have. Yes, there will be complaints about how much of the windfall is spent on share buybacks, dividend increases, and mergers and acquisitions. Yes, there will be complaints about the eventual consequences of a swelling federal budget deficit and the massive, business-friendly deregulation under way. These are worthy, important topics for society to debate. The stock market, though, is all id and no superego, and most CEOs will continue to abide by its demands to reward shareholders first and foremost.

Stocks are always risky, and euphoric rallies like this may be the riskiest. How long FOMO reigns at the top of the fear charts is anyone’s guess. Tax cuts may overheat the economy, finally lighting the inflationary fuse and pushing interest rates higher quickly enough to induce a recession. There’s also a “live by America First, die by America First” concern that’s worth considering if Trump’s protectionist trade policies provoke retaliatory responses from trading partners.

Two recent reports out of China highlight this risk. What may sound like a minor tweak in the way Beijing fixes its exchange rate created big ripples in the currency markets —and stocks don’t often react well to big ripples in other markets. Many traders took the exchange rate tweak as a signal that the People’s Bank of China wasn’t pleased that the yuan had strengthened 7 percent against the dollar since the election of Trump, whose platform included harsh rhetoric about China keeping its currency weak. The following day, on Jan. 10, Bloomberg reported that senior officials in Beijing were recommending the nation slow or halt purchases of U.S. Treasuries, sending 10-year yields to their highest level since March and causing a rare weak open in the stock market.

In the near term, there’s a risk that the coming earnings season will result in corporate outlooks that aren’t quite as euphoric as the share-price gains that preceded them. And we’ll probably spend another year worrying if we’re one tweet away from nuclear war, or one Robert Mueller indictment or midterm election away from impeachment proceedings that will paralyze Washington.

For now, FOMO is the biggest fear investors need to grapple with. That could change quickly, and anyone with the gumption to think they can time the market will need to be on alert. Fear, like love, has inspired much great work—and a lot of mediocre results—from poets and investors alike. For investors, the best advice about today’s market comes from the 19th century poet Ralph Waldo Emerson: “In skating over thin ice our safety is in our speed.”
Indeed, one can argue that it isn't euphoria but fear of missing out (FOMO) that is driving this market melt-up.

I've long argued there are two big risks keeping risks managers and senior managers at large institutions up at night given how markets just keep soaring higher:
  1. The risk of a meltdown, unlike anything we've ever seen before, making the 2008 crisis look like a walk in the park.
  2. And more worrisome, the risk of a melt-up, unlike anything we've ever seen before, making the 1999-2000 tech melt-up look like a walk in the park.
I've also stated it's the second risk that petrifies risk managers and porfolio managers because it forces them to keep chasing risk assets (not just stocks but corporate bonds and other risk assets) higher even if valuations are stretched.

Also worth bearing in mind, these markets aren't like other episodes for the simple reason that central banks around the world have been directly or indirectly buying risks assets to reflate them, contributing to creeping market euphoria as well as the silence of the VIX and the silence of the bears.

Why did central banks actively engage in non-traditional monetary policy to such a large extent? Because they fear the buble economy is about to burst and have done everything to reflate risk assets in a foolhardy attempt to prolong the bull market and avoid a prolonged period of debt deflation.

In effect, the financialization of the economy, meaning an economy heavily leveraged to asset inflation, has led to the excesses of the markets which David Rosenberg is warning of:
My recommendation is to take a good hard look at the charts below and come back and tell me that we are in some stable equilibrium. The excesses are remarkable and practically without precedent. This is not a commentary as to whether the economy is doing well or not well, or whether fiscal stimulus at this stage of the cycle will be impactful. It is to say the following:
  1. The US economy has never before been so dependent on asset inflation for its success. The ratio of household net worth to disposable income has soared to a record 673%, taking out the 2006-2007 bubble high of 652% and even the dotcom peak of 612% posted in 1999. This surge in paper wealth has enabled the savings rate to decline to a decade low of sub-3%, a move that has made the difference between 3% growth and 1% growth in the real economy.
  2. Financial assets now comprise a near-record 70% of total household assets. Past periods of such excess in the late 1960s (Nifty Fifty) and late 1990s (tech mania) did not end well. Where is Duddy Kravitz when you need him? We are in one of these rare periods of time when financial assets now exceed hard assets like real estate on household balance sheets by a three-to-one margin.
  3. While US households did not participate in this cycle in classic mutual funds, they did so via passive ETFs and their exposure to equities has only been topped once before and that was during the tech bubble of the late 1990s. The equity share of U.S. financial assets is now up to over 36%, surpassing the prior cycle peak of 34% back in 2007; the share of total assets also is at a 17-year high of 26%.
This is not to say anything more than the elastic band looks extremely stretched and the charts below show that we hit similar peaks in the past just ahead of a turning point, and right at a time when investor complacency and bullish sentiment was around where these metrics are today (click on images).





I want to finish off this section with a question and a thought. The question is how can this possibly be viewed as the most hated rally of all time when US household exposure to equities has rarely been as high as it is currently. And the thought is merely a piece of advice to heed Bob Farrell’s rule #4 – exponentially rising markets usually go further than you think, but they do not correct by going sideways.
Scary stuff but when you think about it, with bond yields at record lows, it's hardly surprising to see US household exposure to equities rising to levels we haven't seen before.

And when it comes to potential bubbles, I keep reminding myself of that old market saying attributed to Keynes (or Gary Shilling), "markets can remain irrational longer than you can remain solvent".

All you youngsters and some of you old fogies need to remember that quote because it basically means markets move to their own tune, trends can last a lot longer than anyone expects, especially when central banks are actively trading in markets.

However, in my outlook 2018, Return to Stability, which I hope you all read by now, I went over the wise insights of Cornerstone Macro's François Trahan and provided you with a framework on how to think about the year ahead and why you might want to temper your enthusiasm on stocks and other risk assets.

Are there risks to this scenario? Sure, global growth can continue surprising everyone to the upside and this will boost cyclical shares a lot higher.

In fact, in his Outlook 2018, Martin Roberge who writes The Quantitative Strategist for Canaccord Genuity here in Montreal, wrote that he thinks synchronization will persist in global growth which leads him to overweight global cyclical shares like energy (XLE) and underweight stable sectors like staples (XLP).

[Note: I highly recommend you contact Canaccord Genuity's Montreal office and get a copy of Martin's outlook which goes into a lot more detail and provides industry recommendations and contrarian plays which have historically outperformed the market. His market research comments are excellent and well worth reading.]

No doubt, if you think global growth synchronization will persist, you need to be buying cyclical shares like energy (XLE), metals and mining (XME) and financials (XLF) here.

In fact, if you believe global growth will persist, you should even be looking at sub-sectors of energy (XLE) like oil and gas exploration (XOP) and oil services (OIH).

I am watching these charts closely but as I keep warning, don't confuse a tradeable rally with something which will persist over the next year (click on images):





The charts tell me this rally can continue but I remain highly skeptical that global growth synchronization will persist over the next 12 to 18 months.

I'm not dogmatic, however, as I know Pierre Andurand, one of the most bullish oil hedge fund managers and one of the best commodity traders, is still bullish on oil (admittedly, for supply and demand reasons) and the Healthcare of Ontario Pension Plan (HOOPP) likes the energy sector here over the long run.

I have to admit, when I look at the coal ETF (KOL), I too wonder if there is a lot more economic momentum in the pipeline:


However, given the flattening of the yield curve and the real danger that it inverts if the Fed continues hiking and global PMIs start weakening, I remain very cautious on cyclical sectors and high beta stocks (read my Outlook 2018).

But markets can remain irrational longer...you get the picture, nobody knows what will happen but as I keep warning you, as stocks keep posting record highs, downside risks keep mounting, so hedge accordingly by buying good old US long bonds (TLT) or your portfolio will risk sustaining devastating losses.

At that point, FOMO will become FUBAR, and it will be too late to kick yourself for not taking some money off the table to hedge for downside risks.

Don't worry, there is no imminent danger on the horizon, at least not one I see, but you need to prepare for a bumpier ride ahead.

One last macro point that's been irking me. We can very well see a temporary pickup in US core and even headline inflation (if oil prices rise further) as the US dollar has weakened over the last year and continues to be weak relative to the euro and yen.

Don't confuse a cyclical inflation scare due to currency depreciation with something more structural which can only happen through wage gains. The USD depreciation leads to temporary higher US import prices, not sustainable higher inflation.

Conversely, as the yen and euro strengthen, it leads to lower import prices there, exacerbating deflationary pressures that still persist in their respective economies.

These cyclical swings cannot persist for long because eventually, it will mean deflation will come to America, and then it's game over for risk assets (public and private) for a very long time.

You all need to be extremely careful interpreting macro data and inflation pressures. Global deflation hasn't disappeared, not by a long shot.

Anyway, that's another topic for another day, but I'm a little disappointed at how people interpret macro data, including the so-called scare that China is getting ready to sell US Treasuries (BULLOCKS! China's current account surplus necessarily means it is financing the US capital account surplus and will continue to do so for a very long time).

Below, one of Wall Street's most bullish forecasters, Canaccord Genuity's Tony Dwyer, is out with a near-term correction call, but he's not letting it interfere with his 2018 bull case for stocks.

"What we found is when the yield curve is flattening, it's actually a monster buy signal," the firm's chief market strategist said on CNBC's "Trading Nation" this week.

I respectfully disagree on this last point as the evidence is very convincing, when the yield curve is flattening, it doesn't augur well for stocks and other risk assets.

Also, Ben Luk of State Street Global Markets says a stronger dollar could weigh on Asian equities, but Japan seems to be moving ahead regardless. I see the US dollar rallying over the next year and this will impact commodities, commodity currencies and many emerging markets.

Lastly, Hugh O'Reilly, president and CEO of OPTrust, says managing risk through diversification is key for the pension plan. Listen to Hugh, he's very wise and understands the value of diversification.



Wednesday, January 10, 2018

Outlook 2018: Return to Stability?

Corrie Driebusch and Sam Goldfarb of the Wall Street Journal report, Everything Went Right for Markets in 2017—Can That Continue?:
The Dow Jones Industrial Average posted its second-biggest yearly gain of the past decade in 2017, rising a surprising 25%.

The market notched the most closing highs for the index in a single calendar year. Volatility swooned to historic lows and many global stock markets finished the year at or near records or multiyear highs.

It’s a sharp change from what many money managers and analysts anticipated at the start of 2017. At the time, many expected what they called a “sideways market,” where the overall levels of major indexes would remain little changed at year-end. Instead, the S&P 500 posted its best yearly gain since 2013.

Some of them acknowledge they were surprised by a confluence of market-supporting trends. They didn’t expect corporate earnings and revenues to grow at such a fast clip. They didn’t anticipate the economies of all 45 countries tracked by the Organization for Economic Cooperation and Development to be on pace to expand, an uncommon synchronicity. They certainly didn’t predict the Dow would rise for nine consecutive months, its longest streak of monthly gains since 1959, even in the face of geopolitical turmoil in Washington and around the world (click on image).


“There was no knocking the market off its perch,” said JJ Kinahan, chief market strategist at TD Ameritrade. “A couple times it wobbled, but we never saw a wild rush of sales in the market. Every dip was marked with big buyers.”

Heading into 2017, many analysts and investors expected moderate gains for the S&P 500. Goldman Sachs Group Inc. forecast in a January 2017 report that the index would rise to 2400 in the first quarter before fading to 2300 by year-end. Credit Suisse also estimated in early January that the index would close out 2017 at 2300. The S&P 500 closed at 2673.61 Friday.

Underpinning the index’s 19% climb in 2017 has been corporate-earnings growth, which is on pace to post its largest increase since 2011, as measured by earnings per share. At the end of the first quarter, analysts polled by FactSet were expecting companies in the S&P 500 to post 9.1% earnings growth in that period. Instead, companies grew their earnings by 14%, FactSet data show. That expansion has continued, albeit at a slower pace: In the second quarter, earnings for companies in the S&P 500 rose 10% from the year prior, and in the third quarter that growth was 6.4%.

“We’re seeing a peak rate of growth,” said Bob Doll, senior portfolio manager and chief equity strategist at Nuveen Asset Management. However, that doesn’t mean investors should rush to sell stocks, he said—even if growth slows in the next year or two, there is still upside potential, he said.

Mr. Doll, who said his own predictions for the S&P 500’s 2017 rise fell short, also attributed the outsize gains to the synchronous economic expansion around the globe. The U.S. recovered from the financial crisis more quickly than other countries, but that changed in 2017 as others caught up. The result is global stock indexes near records or multiyear highs, from Japan’s Nikkei Stock Average to the U.K.’s FTSE 100. The MSCI All Country World Index is also near a record.

The steep gains of 2017 have some analysts worried that the rally could wane in 2018, particularly if volatility, which hit historic lows this year, ticks up as many predict. Stocks are trading at above-average multiples of their past 12 months of earnings and government bonds have been sending cautionary signals about the U.S. economy’s prospects, something that could end up jolting indexes in 2018.

The yield on the benchmark 10-year Treasury note, often seen as a gauge of investors’ sentiment about the economy, closed at 2.409% on Friday, down slightly from 2.446% at the end of 2016 in defiance of analysts’ predictions that it would soar in 2017 with a surge in growth and inflation. Its premium relative to the two-year note yield has been cut by more than half over the past year (click on image).

Though analysts have debated its significance, a shrinking gap between short and long-term Treasury yields, known on Wall Street as a flattening yield curve, has often been a warning sign for investors. Five of the past six times the two-year yield surpassed the 10-year yield, known as an inverted yield curve, the economy subsequently entered a recession, according to data from the St. Louis Fed.

With few other signs of recession, however, many investors say there are reasons to doubt the yield curve’s signals, which some argue have been distorted by easy-money policies from central banks in Europe and Japan pushing yield-seeking investors into U.S. government bonds, driving down the yields on longer-term debt.

Still, many investors and analysts expect the curve to continue its flattening in 2018, given signs that the Federal Reserve will keep raising interest rates even if inflation remains stuck below its 2% annual target. That could push up the two-year yield, which is more sensitive to expectations for central-bank policy.

That, plus a potential deceleration in economic growth, could set up 2018 to be a tougher year. A bright spot some analysts point to is corporate tax cuts, which could boost earnings growth and stock prices. Yet, some analysts say they are worried the potential benefits from the tax bill are already priced into company shares, limiting upside in 2018.

“We’ve gotten used to things being very good,” said Brad McMillan, chief investment officer for Commonwealth Financial Network, who added that he doesn’t expect either big declines or big gains in 2018. “We don’t need the tailwinds to turn into headwinds, we just need a couple to go away to find ourselves in a very different market environment.”
In my last comment of 2017, I explained why I doubt 2018 will be a repeat of 2017, and went into detail on why the big rally in technology shares last year isn't a particularly good sign for markets this year (a big rally in large cap tech shares is a sign of Risk Off markets).

However, early in the new year US stocks started the year off with a bang, breaking new records, and strong economic data around the world is buoying global shares to new highs as well.

This is why some market observers think despite coming off a great year, another huge rally in stocks is in the offing this year. Thomas Franck of CNBC reports, A Merrill Lynch indicator that predicted last year's surge sees another 19% gain in 2018:
Stocks could pop nearly 20 percent in 2018 according to a contrarian indicator from Bank of America Merrill Lynch which predicted last year's surprising surge.

The investment bank's so-called Sell Side Indicator measures the average equity allocation recommended by its fellow Wall Street bank peers. The indicator shows Wall Street is still not very bullish on the market at all and until they recommend clients own even higher levels of stocks, the market will continue to gain.

"Historically, when our indicator has been this low or lower, total returns over the subsequent 12 months have been positive 93 percent of the time, with median 12-month returns of 19 percent," according to a BofA Merrill Lynch Global Research report (click on image).


In September 2016, the metric predicted a huge positive return over the next 12 months, a forecast that eventually came true and stood in contrast to the sentiment on Wall Street at the time. Now in early 2018, the model still remains upbeat.

2018 "could be the year of euphoria. Sentiment is now a more important driver of the S&P 500 than fundamentals, and sentiment suggests there is still room for stocks to move higher in the near term," wrote BofA Merrill Lynch strategists in the 2018 outlook press release in December.

To be sure, this indicator is only one input in Bank of America's bigger forecast model. Officially the bank predicts just a 5 percent rise in the S&P 500 to 2800 this year.

The strategist's target is just below the median 2,850 forecast of 13 other equity strategists surveyed by CNBC. That median projection is modest in comparison to the roughly 20 percent climb for the S&P 500 in 2017.

"We think euphoria is what's going to end this bull market and we're not there yet," Savita Subramanian, the bank's chief U.S. equity and quant strategist, told CNBC in December. "We're not at the point where the investment community is saturated in equities and there's nothing to do with stocks but sell."
And Annie Pei of CNBC reports, The most important chart for the market next year, according to a top technician:
In a year when equities across the world have rallied in synchrony, Ryan Detrick of LPL Financial has identified what could be the most important chart for the market next year, as it could signal that the global rally is far from done.

With the S&P 500 up 20 percent this year, on pace for its best year since 2013, emerging markets up 35 percent and Europe's STOXX 600 index up 8 percent, many market watchers have applauded 2017 as the year of global growth.

A big driver of the global markets rally has been earnings. Detrick, who is a senior market strategist, says that based on one chart, the global earnings outlook is still positive for next year.

"We've seen a resurgence of global earnings in 2017 with the S&P 500, emerging markets and developed markets all positive ... [that's the first time it's happened] since 2010," he said Thursday on CNBC's "Trading Nation."

"Fortunately we're looking at all three of them being positive again next year," added Detrick.


And even though Detrick says there could be more volatility in 2018, he also sees signs of strong fundamentals in the U.S. and abroad that he believes validates the momentum of economic growth around the world.

More specifically, he points to tax reform and the rally in industrial metals such as copper, up 31 percent this year and seen as an indicator of industrial demand, as two factors that could uphold earnings growth in 2018.

"We definitely think a lot of it could be priced in so far what we've seen this year, and we could have some more rocky volatility next year," said Detrick. "But all in all, we just upped our forecast for earnings from about $143 a share to just under $150."

"As we look out 12 to 18 months, there are still a lot of positives," he added. "We've got tax reform, which should continue to drive markets higher."

Within U.S. markets, Detrick says small-caps and financials are the best buys for investors, thanks to tax reform. He also encourages investors to look at emerging markets thanks to their moderate valuations, and he predicts they will continue to grow in 2018.
In fact, things seem so strong in the economy and markets that Forbes contributor Bryan Rich thinks this year will mark the return of 'animal spirits':
We are off to what will be a very exciting year for markets and the economy.

Over the past two years I've written this daily piece, discussing the big slow-moving themes that drive markets, the catalysts for change, and the probable outcomes. When we step back from all of the day to day noise that has distracted many throughout the time period, the big themes have been clear, and the case for higher stocks has been very clear. That continues to be the case as we head into the new year.

As I've said, I think we're in the early stages of an economic boom. And I suspect this year, we will feel it--Main Street will feel it, for the first time in a long time.

And I suspect we'll see a return of “animal spirits.” This is what has been destroyed over the past decade, driven primarily by the fear of indebtedness (which is typical of a debt crisis) and mistrust of the system. All along the way, throughout the recovery period, and throughout a quadrupling of the stock market off of the bottom, people have continually been waiting for another shoe to drop. The breaking of this emotional mindset has been tough. But with the likelihood of material wage growth coming this year (through a hotter economy and tax cuts), we may finally get it. And that gives way to a return of animal spirits, which haven't been calibrated in all of the economic and stock market forecasts.

With this in mind, we should expect hotter demand and some hotter inflation this year (to finally indicate that the global economy has a pulse, that demand is hot enough to create some price pressures). With that formula, it's not surprising that commodities have been on the move, into the year-end and continuing today (as the new year opens). Oil is above $60. The CRB (broad commodities index) is up 8% over the past two weeks -- and a big technical breakout is nearing (click on image).


This is where the big opportunities lie in stocks for the new year. Remember, despite a very hot performance by the stock market last year, the energy sector finished DOWN on the year (-6%). Commodity stocks remain deeply discounted, even before we add the influence of higher commodities prices and hotter global demand. With that, it's not surprising that the best billionaire investors have been spending time building positions in those areas.
As I discussed in my last comment of 2017, I'm highly suspicious of the recent rallies in metals and mning (XME) and energy (XLE) indexes and think the rally in comodities in general is a tradeable rally but not something which is sustainable over the course of the year.

In my opinion, the key thing to watch for commodities and commodity and energy shares isn't the trillion dollar US infrastructure plan which has yet to arrive but whether the rout in the US dollar continues (click on image):


Looking at that weekly chart above, there could be more weakness ahead but it's at an interesting level and it could reverse course. And if the US dollar starts rallying from here, which is my call, it will put pressure on commodity prices and currencies, energy shares and emerging market bonds, stocks and currencies.

This was my long preamble to my much-anticipated outlook 2018, and this year I've gotten a lot of help from a friend, François Trahan, a top Wall Street strategist, someone I respect a lot because not only is he a super nice guy, he really knows his macro and market indicators very well and uses them to help top institutional funds manage money by positioning them in the right sectors.

I've said it before and I'll say it again: If you can afford his research, I highly recommend you contact the folks at Cornerstone Macro where François is a partner and subscribe to all their research, including his Portfolio Insights and Strategy. Cornerstone produces high quality, independent research which covers the economy and markets extremely well. It's not cheap but it's great actionable research which will help you assess the risks and opportunities that lie ahead in markets.

What I like about François is he's a macro guy like me and uses his insights to formulate a positioning story based on solid macro research. I emphasize positioning because that's what he and his team are really good at, namely, recommending stock sectors, not where the S&P 500 or the yield on the 10-year Treasury note is going to close at the end of the year.

A long time ago, François graduated from the BCA Research school of macro, as did I and plenty of others. He was there right before my time at this macro research firm but was smart enough to leave Quebec and go on to much bigger and better things on Wall Street where he did stints at Brown Brothers Harriman, Bear Stearns, ISI and Wolfe Trahan & Co. (now Wolfe Research) before founding Cornerstone Macro with other partners.

He has also co-authored a great little book with Kathy Krantz, another former BCAer, and they titled it "
The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground" (published it in 2011).

François was enjoying his holidays with his family in Quebec and was gracious enough to call me so we can catch up and discuss markets. He spent almost two hours (on two separate calls) with me to go over his views, what went right and wrong in 2017, and where he thinks we're heading.

I love talking markets and so does he which is why our conversation was long but I tried as much as possible to let him speak, even if I interjected on occasion as I just wanted him to go on and explain everything on his mind. I want to publicly thank him for taking the time to discuss his views with my blog readers.

Before I proceed, it's important to note that François's outlook comment came out earlier this week and I waited till now to share my outlook comment as I think it's only fair his clients see it first.


Also, an important legal notice to all my blog readers: The charts below are copyright material of Cornerstone Macro and I have explicit permission to use them for this blog post. Anyone forwarding these charts or using them in a presentation without explicit permission from Cornerstone Macro will be prosecuted to the full extent of the law (I'm not kidding here, be careful).

You'll recall last year in January, François was in Montreal for a CFA luncheon which I covered here. At the time, I fell into Consuelo Mack's trap stating he was the "most bearish he's ever been".

I now realize this was a mistake as the truth is François isn't known as a perma bear or perma bull, he makes Risk On and Risk Off calls on markets and uses a disciplined macro framework to recommend sector positioning. That's what he's really good at.

In 2015, he told me he was bearish but at the beginning of 2016, he turned bullish ("Risk On") as "inflation had come down and there was a turn in the business". He recommended clients go overweight cyclical sectors like energy (XLE), financials (XLF), and industrials (XLI) and underweight less cyclical sectors like healthcare (XLV), consumer staples (XLP) and utilities (XLU).

In 2017, he recommended clients prepare for "Risk Off" markets and got his sector and factor level recommendations right but missed the global economic synchronicity that led to big rallies in Eurozone and Japanese stocks.

But his clients were happy because his highest conviction call was large-cap growth (XLK), which really outperformed the overall market, and healthcare (XLV) which also did well. Both these recommendations were to position for Risk Off markets.

It's confusing to those of you who think when investors buying large-cap growth stocks (like FANG stocks) means they're bullish but Risk On and Risk Off have nothing to do with bullish or bearish, but how you want to position your portfolio in terms of sectors given the risks out there.

The fact that the S&P Technology index (XLK) had a stellar year last year, up almost 40%, shows you that most investors were positioned for Risk Off markets, so don't confuse a rally in large-cap growth stocks with bullish investor sentiment.

Now, every year, François and his team publish a brutally honest review of their investment recommendations which comes out in mid-December. As he told me: "There is zero arrogance and we are extremely harsh on ourselves, maybe overly harsh, when reviewing our recommendations.”

Below, I embedded a brief recap of the investment themes they discussed in this review and a summary of their 2017 investment recommendations (click on iimages):





It's important to read this full report to really understand what went right and wrong in 2017. The worst themes in 2017 were in asset allocation as they were too negative on the stock market and too bullish on the US dollar.

They were surprised by the strength in foreign data and this impacted their asset allocation calls (click on image):


But they got the macro factors (ie. size and style) right and positioned their clients early on in large-cap growth, and it's this sector positioning which their clients value the most. Their asset allocation recommendations are equally excellent but not always easy, especially in a year like 2017 when Eurozone's PMIs did very well on the back of the ECB's massive stimulus, something François openly admits he and his team underestimated.

Along with large-cap growth to capture Risk Off markets, another one of their best themes last year was to overweight stable earnings like healthcare (XLV).

Again, if you're a client, take the time to read their 2017 year-end review of their investment recommendations very carefully, it's excellent.

When looking at 2018, François and his team state the following on the intro to their outlook:
The big story of 2017 when it comes to equities was the dominance of growth. We are not only referring to the Growth Index here, albeit it performed quite well, but rather to the broader “growth” theme at large. In essence, all things associated with growth were clear winners last year. This is often seen in a world where economic prospects are beginning to, or about to, top out. If one excludes the December tax-infused pop in most PMIs, what you saw in 2017 was a broad topping process of leading indicators at very high levels. As such, the Technology sector, with 83% of its market-cap in Growth, led the market. Moreover, stock-selection factors such as long-term growth and high price-to-book generated a lot of excess performance.

The key question as we begin 2018 is whether this growth dominance can continue, and if not, what will replace it? Interestingly, the evolution of market themes in recent years and how they relate to the business cycle was actually quite textbook. The diagram above illustrates the main themes we have all experienced with a rough outline with the typical cycle. In the coming pages, and in tomorrow’s conference call, we will make the case for “stability” as the BIG story of 2018 equity leadership.
In his outlook and subsequent conference call, François and his team spent a lot of time going over the yield curve and explaining why the Fed funds rate is relevant again.

[Note: All clients should take the time to carefully go over his outlook piece and watch the conference call going over numerous key themes]

In our conversation, he told me he is going back to his more traditional indicator, the Fed funds rate inversed, advanced by 18 months as now that the Fed moved off the zero bounds, this indicator is useful once again.

[Note: In 2009, he moved away from this indicator to look at inflation. In particular, the ISM prices paid, inverted, advanced 18 months, to capture changes in monetary policy because ZIRP and QE impacted the traditional Fed funds indicator.]

There are actually four macro indicators that François uses:
  1. Fed funds rate
  2. Money supply
  3. Taylor rule
  4. Yield curve
All four indicators are pointing to an economic slowdown ahead but in the outlook and conference call, François, spent a lot of time explaining the importance of the yield curve and how he thinks it will move over the next year.

According to him, "the yield curve remains the single greatest macro indicator in the US" which is a consumer-led economy where credit is critically important.

With the Fed raising rates and core inflation pressures rising in the US, he thinks there is a real risk of an inverted yield curve because the global PMI is topping and weakening, and this will drive long bond yields lower.


He also stated the yield curve is not a leading indicator, it's a gauge of market policy which leads other components of the Leading Economic Indicators (LEI). "As such, it belongs in the policy bucket which leads other indicators."

What this basically means is in 2018, we can expect a slowing of leading US economic indicators, even if you factor in fiscal policy, and this has implications on portfolio positioning.
  • He expects a recoupling will occur in all three major economies to the path of lower pospects.
  • A shift of growth to stability which means focus on healthcare (XLV), consumer staples (XLP) and utilities (XLU). Profitability will be a dominant theme in 2018.
Below, you can click on the image to see a summary of their five highest-conviction investment themes for 2018:


And the chart below explains exactly which sectors they are recommending during this shift to a year of stability:


He stressed that he doesn't see any major shock in the near term and thinks growth in Europe and Japan will continue to be decent in the first half but the US yield curve will increasingly become the dominant theme of the year.

This means a slowing of leading indicators, economic data coming in below expectations, stocks will start moving down before this occurs despite the proposed tax cuts and repatriation of foreign profits.

Interestingly, he remains bullish on US long bonds (TLT) and thinks "we have yet to see secular lows on long bond yields."

This is my belief too but I told him I had a discussion with a trader I know who told me "tax cuts + infrastructure spending will lead to higher long bond rates and so will repatriation of foreign profits because it will lead to more stock buybacks and investment spending."

He responded:
I expect core inflation to accelerate ... bonds tend to be more sensitive to headline inflation which is expect to come down courtesy of lower commodity prices.

Most importantly the model Roberto uses disagregates bonds into three components and inflation is only one part. The growth component is already discounting the peak of the cycle so that will only work against you, same for the term premium if PMIs in Europe start to come in. If oil starts to come down then all three parts are pressuring yields lower. It is quite possible we get lower bond yields AND a core inflation scare all the same.

[in regards to what that trader told you] In my experience traders are great at trading but understand nothing of macro. All you are saying here is that this guy is consensus and regurgitating what's in the Wall Street Journal. I have heard that story 1000 times already. Since we all know it is happening why are yields not higher? They are a discounting mechanisms so if that story were true they would already be up.

There is a big belief out there that somehow the tax plan is not fully priced into financial markets which is insane to me. I think it's typical of what you see at the top of a cycle when people are only thinking about what can go right in the world and trying to find reasons for why the good times will last. It's the opposite of early 2016 when they could only think negative with China about to have a financial crisis etc.

Time will tell.
On China, he says the big investment boom is over and that it's an export-led economy. "China's PMIs follow exports, so we need to watch any slowdown in its trade, especially if the US dollar starts appreciating“ (putting pressure on the renminbi and forcing another massive devaluation there which will export more disinflation/ deflation throughout the world and clobber risk assets).

Interestingly, on Wednesday morning, Bloomberg reported that China may halt purchases of US Treasuries, sending long bond yields higher and disrupting markets. It's obvious to me that people don't understand that China necessarily runs a current account surplus (capital account deficit) to finance the US current account deficit (capital account surplus). In other words, it's much ado about nothing!

I leave you with some important charts as we begin the new year with some of my comments (click on weekly charts to enlarge; as of Tuesday's close):

Long US long bonds: I call this the sleep well at night trade. I know, Bill Gross and Jeffrey Gundlach are warning of a potential bear market in bonds (the latter stating the key levels for investors to watch are 2.63% on the 10-year Treasury yield and 3% on the 30-year), but given the weakening in the global PMI and ever-present deflationary pressures abroad, I continue to recommend buying US long bonds (TLT) on any backup in yields/ decline in prices.

In fact, if you ask me, now is a good time to load up on US long bonds:


Given my bullish views on the US dollar (UUP), I particularly like this trade for Canadian and foreign investors.

Buy more stocks? As far as stocks, as shown below, the S&P 500 (SPY) is on a tear, led by financials (XLF), industrials (XLI) and technology (XLK):





But given my fears of global deflation, lower long bond yields, a potential inverted yield curve, I expect stocks to sell off and hit financials and industrials particularly hard. Risk Off markets will still support technology but the shift there will be toward stability (like software).

Also, with the global PMI topping out and signalling a slowdown ahead, I remain weary of cyclical sectors leveraged to global growth like metals and mining (XME), energy (XLE), emerging markets (EEM) and Chinese shares (FXI):





Importantly, if the global PMI is topping out and pointing to a global slowdown ahead, you want to be underweight or even short these sectors, especially the ones that ran up a lot since bottoming early in 2016 (I would include industrials too as they are leveraged to the global economy).

Return to stability: Since this comment is called return to stability, below are more stable sectors like healthcare (XLV), utilities (XLU), consumer staples (XLP), REITs (IYR) and telecom (VOX):






All these sectors offer stability, a key theme of this outlook, as they offer stable earnings and solid dividends. However, it's important to note utilities, REITs, telecoms and other dividend sectors sell off when rates rise, which is normal and a buying opportunity.

Nevertheless, buying safer stocks still carries beta risk, less so than a high-flier like biotech but stocks are stocks, so if you want to lower the volatility of your portfolio, you need to increase your allocation to US long bonds.

Speaking of biotech (XBI), it's been on a tear too, and I made a great call recommending this sector to my readers right before the US presidential election:


But biotech is super high beta and this means when it swings, it swings hard both ways. I still like this sector and think there is something structural going on but you need to stomach a lot of volatility if you buy and hold these biotech stocks (great for swing trades, but they're very risky especially when buying individual companies).

Canary in the coal mine: Lastly, the canary in the coal mine, high-yield or junk bonds (HYG), which typically move down before stocks:


So far, I don't see any imminent threat but with credit spreads at record lows and stocks at record highs, you really need to keep an eye on junk bonds.

I have shared more than enough with my readers. I want to publicly thank François Trahan and urge all my institutional readers to subscribe to the research at Cornerstone Macro and really take the time to read his team's 2018 outlook and listen to the accompanying conference call, it's well worth your time.

Again, please remember some of the charts above are copyright material of Cornerstone Macro and I have explicit permission to use them for this blog post. Anyone forwarding these charts or using them in a presentation without explicit permission from Cornerstone Macro will be prosecuted to the full extent of the law (take this warning seriously).

I hope you enjoyed reading this comment and kindly remind all my readers to please support this blog and the work that goes into it via PayPal on the top right-hand side, under my picture.

It took me a few days to put this comment together, I will not publish anything else this week, will let you digest all the information here.

Below, market
optimism reaches 'potential danger' sign not seen since 1986 and Warren Buffett and Charlie Munger think things are getting bubbly out there. However, momentum tends to feed on itself, something Buffett alluded to.

In fact, Bill Miller, the legendary investor who once beat the S&P for 15 consecutive years before running into trouble, told CNBC the market can melt up 30 percent here. No doubt, there is still a lot of liquidity driving shares higher but momentum can shift abruptly so be careful chasing stocks, especially momentum stocks here.

Third, James Paulsen, The Leuthold Group chief investment strategist, and Tom Manning, F.L. Putnam Investment Management president and CEO, provide their outlook on the markets.

Paulsen thinks rising inflation will pose a risk on yields and markets but given long bond yields move with the global PMI, I wouldn't worry about a bond bear market even if US core inflation temporarily picks up (due to the lower US dollar). The global PMI is weakening and this will put pressure on US long bond yields over te next year.

Fourth, Tom McClellan, McClellan Market Report editor, gives his outlook on tech stocks and what he sees for the overall market.

Lastly, David Spika, GuideStone Capital Management, and Steve Massocca, Wedbush Equity Management, discuss how the bull run will play out in 2018 stating central bank policy going forward will prove to be a headwind for the market.

If I were the Fed, I'd be very worried of how to proceed going forward. Stay tuned, 2018 should be another interesting year! Don't panic, just prepare for a bumpier ride ahead and focus on stability.