Friday, April 20, 2018

Market Worried About Oil and Rates?

Thomas Franck of CNBC reports, Wall Street doesn't care about your good earnings right now:
Companies have been crushing earnings so far this quarter, but a strange trend is developing: Those that beat expectations are seeing their stock prices fall.

Since the earnings season kicked off last week, shares have returned, on average, a loss of 0.12 percent on the trading day immediately after companies posted their quarterly results, according to data from Bespoke Investment Group. Breaking that number down, the average opening gap following an earnings release is a pop of 0.29 percent, following by an open-to-close decline of 0.38 percent.

Historically, the average opening gap is a 0.1 percent move upward followed by an average full-day gain of 0.04 percent.

The gloomy open-to-close figures come despite the fact that 80 percent of companies that had reported as of Friday morning posted better-than-expected earnings.
You can read the rest of the article here where Franck uses the example of how Goldman Sachs (GS) and Procter & Gamble (PG) sold off despite better-than-expected results this week.

Nothing new to me, I told you last Friday, the market doesn't care about great earnings, it's looking way beyond this earnings season.

It's Friday, it's been another crazy week on Wall Street, there's a lot to cover today so let me get to the point and tell you what I think is spooking markets.

It's the bond market, stupid!: The backup in US long bond yields is what is making everyone so nervous. In particular, every time the 10-year Treasury yield gets close to the all-important 3% level, stocks get slammed hard (click on image):

It's all about oil, stupid!: You might be wondering why are US long bond yields rising, and here too I have an answer, it's mostly due to higher oil prices (click on image):

Higher oil prices have fuelled US inflation expectations higher and that is what is causing the recent sell-off in US long bonds (TLT) (click on images):

Now, I still maintain every time the 10-year Treasury yield approaches 3%, you should be buying US long bonds (TLT).

The rise in oil prices has also helped lift energy shares (XLE), which is something I covered in my blog comment on Monday going over whether it's time to invest in energy.

Admittedly, I've been underweight energy since the beginning of the year and totally missed the latest monster rally in energy, but I remain cautious which is why I have a hard time jumping on energy shares here (I basically think it's a powerful countertrend rally, not sustainable).

My friend Martin Roberge, analyst at Cannacord Genuity, has a different opinion, sending out a note earlier today explaining why he thinks a sector rotation into energy is underway:
The S&P 500 (~0.5%) and S&P/TSX (~1%) are both up this week fueled by strong earnings and commodity prices. Thomson Reuters’ blended S&P 500 earnings growth estimates reached 20% YoY in Q1/18 this week. Even when excluding energy (+69.9%), earnings growth estimates (18.3%) stand above levels reached in recent years. Thus, so far, positive EPS surprises outweigh fears related to trade tensions, geopolitics and rising bond yields. Regarding commodities, crude oil is up ~1% (more below) while copper advanced ~2%, supporting resource stocks this week. Importantly, a sector rotation seems underway considering that energy and materials are markedly outperforming the market since March lows. Undoubtedly, cracks in the tech space and in financials are helping this rotation. Otherwise, the CDN$ gave up early gains and is now down ~1% following the BoC statement where the central bank said it remains “cautious” about future rate hikes.

This week we highlight crude oil. While US President Trump denounced “artificially high” oil prices this morning, we see fundamental improvements justifying current levels. Indeed, the EIA reported Wednesday that crude oil, gasoline and distillate stocks declined 1.1MMbbl, 3.0MMbbl and 3.1MMbbl, respectively. Also, demand for gasoline hit a record level at 9.9MMbbl/d, leading to much higher refinery runs than what seasonal patterns suggest. In a nutshell, as our Chart of the Week illustrates, strong demand and tight supply should allow total petroleum inventories (788.9MMbbl) to cross below their 5-yma (788.6MMbbl) soon. This is an important milestone considering that crude oil traded much higher following similar crosses in 1999, 2002, 2007 and 2011, registering 52.7% returns on average before the next interim price peak (second panel). Also, this time around, OPEC countries seem determined to maintain supply cuts, eyeing the $80/bbl mark. In all, given prospects for higher oil prices and that Canadian oil transportation bottlenecks are expected to clear in H2/18, the ongoing rally in energy stocks does not seem to be another false start (click on chart).

Regarding economic statistics this week, in Canada, the BoC left the overnight rate unchanged at 1.25%. The central bank underscored changes in mortgage rules, depressing home sales and transportation bottlenecks which likely triggered an unexpected drop in exports in Q1/18. The BoC also cited risks tied to trade tensions but overall remains data dependent, which puts today’s inflation and retail sales reports under the spotlight. Headline inflation hit 2.3% in March, boosted by gasoline prices. Meanwhile, the three measures of underlying inflation (CPI-trim, CPI-median and CPI-common) averaged 2% in March, in line with the BoC target. For their part, retail sales increased 0.4% MoM. But Statistics Canada revised past sales estimates down, suggesting sales during the holiday shopping season were far lower than previously thought. In the US, retail sales advanced 0.6% MoM in March, fueled by car sales, to settle at 4.5% YoY. Also, building permits and housing starts rebounded in March, up 2.5% and 1.9% MoM respectively. But higher multifamily housing units mask a marked slowdown in the single-family segment. In Europe, the ZEW Economic Sentiment Index declined to 1.9 (from 13.4), confirming the ongoing growth lull. Ditto for Japan, where exports grew 2.1% and imports fell 0.6% YoY in March, much below expectations. Last, in China, while GDP growth (6.8% YoY in Q1/18) topped expectations and retail sales advanced 10.1% YoY (from 9.7%) in March, industrial production growth moderated to 6% YoY (from 7.2%).

Next week, we will focus on flash PMIs in Europe and the ECB. Given the ongoing growth slowdown in Europe, we expect ECB President Draghi to put the emphasis on downside risks and uncertainty. In the US, we await Q1/18 GDP, new and existing home sales and durable goods orders. In Japan, the BoJ is on deck. The central bank is not expected to dial back on its ultra-loose monetary policies anytime soon. Meanwhile, the Tokyo CPI, retail sales and industrial production should help gauge inflation trends and underlying economic strength.
Next week is a big week. If the ECB surprises the market and cuts its stimulus, I expect the euro to finally start declining versus the US dollar and that might spell the end of the long US dollar (UUP) sell-off (click on image):

And if the US dollar starts picking up steam from these levels, that might put an end to the powerful rally we've seen in commodities (DBC) lately (click on image):

But one commodity trader I know told me that Goldman has been telling clients since the beginning of the year that commodities would be the place to be in 2018 based on this chart  (click on image):

How sustainable is the rise in oil prices?: Now, people will see the charts above and think, "wow, maybe there is a lot more room for commodities to keep gaining here."

However, it's worth noting most of the rally in commodities is driven by higher oil prices so it's also important to take a step back here and THINK of the fundamental ramifications:
  • Higher oil prices lead to higher gas prices and in a debt-laden economy, higher gas prices pretty much wipe out Trump's tax cuts for most Americans, which is why he came out to tweet against OPEC on Friday morning. I found it interesting that Minister Mohammed bin Hamad Al Rumhi of Oman came out shortly after to state oil prices probably won't rise much beyond recent highs near $75 a barrel this year (of course, OPEC is petrified of Trump nor does it want oil prices too high to risk a global recession).
  • More importantly, the Fed has raised rates six times and will continue to raise for the foreseeable future, global PMIs are rolling over, which means a global economic slowdown is ahead, so even if oil prices keep creeping up this summer, it will only add fuel to the fire by tightening financial conditions even more.
  • The yield curve hasn't inverted yet but investors can't ignore it and as AIMCo's CIO Dale MacMaster told me yesterday, the forward yield curve has inverted which is worrisome.
All this to say, those playing the "sector rotation" into energy (XLE) or metals and mining (XME) thinking this is a sustainable rally really need to ask themselves some tough questions as to how sustainable this rally in cyclical energy shares really is.

I still maintain that going forward, US long bonds (TLT) will offer the best risk-adjusted returns. The rise in oil prices and the rise in long bond yields only makes me more certain that a slowdown is ahead and I'd be jumping on US long bonds at this level, especially if the 10-year Treasury yield surpasses 3% which it might (but I still have my doubts).

To recap, I'm preparing for a second half global 'synchronized' economic downturn, and as such I'm recommending investors to trim risk in their portfolio by investing at least 50% in US long bonds (TLT) and overweighting consumer staples (XLP) and interest-rate sensitive sectors like utilities (XLU), telecoms (IYZ) and REITs (IYR) and underweighting cyclical sectors like energy (XLE), financials (XLF), metals and mining (XME), industrials (XLI) and emerging market shares (EEM).

I also think too many investors still don't understand the inflation disconnect and they're being sucked into a market phishing for inflation phools.

What else? It's critically important to understand inflation is a lagging indicator. An astute investor of my blog sent me a comment from Kessler Investment Advisors explaining how inflation is the caboose of the economy:
Inflation has once again become a hot topic of discussion. Core CPI has returned to 2%, oil is near $70 a barrel, and copper is well over $3 per pound. What is easily forgotten, yet not hard to show, is that inflation is the last of the lagging indicators. In fact, headline CPI is best correlated to the economy (coincident indicators) with a 21 month lag!

The chart below shows that inflation tends to reach its peak well after the recession has begun. In our most recent recession, from 12/2007 – 06/2009, CPI peaked in July of 2008, Copper peaked on 7/2/2008 and Oil peaked on 7/3/2008. This was in the middle of recession, a full year after interest rates had peaked and nine months after the stock market peaked.

While counterintuitive, it would not be unusual for inflation to continue climbing as we get closer to a recession as interest rates continue to fall. Interest rates are much more interested in the outlook for future inflation than what it has measured in the last 12 months. The lagging inflation surge of 2008 did affect interest rates negatively, but only temporarily (3 months), and within a much bigger primary trend of falling interest rates (see below).

Got that? Stop worrying about cyclical swings in inflation due to higher oil prices and a lower US dollar (which increases import prices) and remember, structural deflationary headwinds still persist.

Lastly, take the time to read Hoisington Investment Management's latest Quarterly Economic Review which John Mauldin posted on his website here. I agree with Lacy Hunt's analysis and his conclusion:
Important to the long-term investor is the pernicious impact of exploding debt levels. This condition will slow economic growth, and the resulting poor economic conditions will lead to lower inflation and thereby lower long-term interest rates. This suggests that high quality yields may be difficult to obtain within the next decade. In the shorter run, in accordance with Friedman’s established theory, the current monetary deceleration, or restrictive monetary policy, will bring about lower long-term interest rates.
But I don't want to sound all doom & gloom as it is Friday and there are some market strategists and analysts who think the world is just fine, growth will continue, and the rally in energy and commodities is sustainable.

Below, Alpine Macro's Chen Zhao discusses China's Q1 GDP. Chen raises many great points here that made me think maybe I'm reading China all wrong. Listen carefully, well worth it, he almost makes me rethink my bearish stance on commodities, Chinese (FXI) and emerging market shares (EEM).

Second, Pension Partners' Charlie Bilello tells Michelle Caruso-Cabrera that the rally in crude could be giving a signal to the Federal Reserve and bond market. I follow Charlie on Twitter and StockTwits, he posts great stuff on markets.

Lastly, Guy LeBas, Janney Montgomery Scott chief fixed income strategist, provides his outlook on interest rates and explains why oil is a short-term driver of rates. I couldn't agree more.

Hope you enjoyed reading this comment. Please remember to donate to this blog via PayPal on the top right-hand side, under my picture. I thank all of you who take the time to donate, it's greatly appreciated.

Thursday, April 19, 2018

AIMCo Gains 10.4% in 2017

Benefits Canada reports, AIMCo posts 10.4% return for 2017:
The Alberta Investment Management Corp. posted a 10.4 per cent return, net of all costs, at the end of 2017.

In a news release on Wednesday, the fund said its active selections in each asset class contributed a return premium of 1.3 per cent for its balanced fund clients relative to the passive benchmarks it uses for comparison. The fund’s release emphasized its extended time horizon and noted that, over the past five years, it has achieved a net return premium of 0.9 per cent on behalf of all clients.

“As a long-term investor, we are proud of the sustained value add that we have delivered to our clients since the province made the bold decision to establish AIMCo 10 years ago,” said Kevin Uebelein, chief executive officer of AIMCo, in a press release.

As of Dec. 31, 2017, AIMCo held $103.7 billion in assets under management, which represents $8 billion in growth from $95.7 billion at the end of 2016. Further details of AIMCo’s strategy and performance for 2017 will be available in the fund’s annual report in June.

“Our strong investment performance in 2017 represents a short-term affirmation that our course of action is the right one and is the result of the high degree of trust our clients have placed in us to meet their objectives,” said Dale MacMaster, chief investment officer of AIMCo, in the press release. “More important, these returns have empowered our clients to make critical decisions for their stakeholders, such as reductions to contribution rates, or budget reconsiderations due to newly available funds. As Alberta’s economy strengthens, it is gratifying to be able to deliver our clients $1.1 billion of net value add against our benchmark returns.”
Earlier today, I had a chance to talk with AIMCo's CIO, Dale MacMaster, to go over 2017 results.

Before I get to our discussion, AIMCo put out a press release, AIMCo Achieves Premium 10.4% Return for Clients in 2017:
Alberta Investment Management Corporation (AIMCo) announced today its investment performance for the year ended December 31, 2017. The aggregate return achieved on behalf of its fourteen Alberta pension and endowment balanced fund clients was 10.4% net of all costs. AIMCo actively selects the assets it invests in within each class, and measures its performance relative to a standard passive benchmark for each class. In 2017, AIMCo achieved a net return premium of 1.3% for its balanced fund clients, over and above the composite benchmark.

AIMCo's investment strategies are designed to deliver premium returns over an extended time horizon, not just for a single year or two. Over the last five years AIMCo achieved a net return premium of 0.9%, on behalf of all clients. This places AIMCo in the top quartile of its peer investment managers based on the most recent analysis by CEM Benchmarking, the industry's principal performance measurement firm. CEM's analysis also places AIMCo in the most favourable quartile for cost performance and risk curtailment.

"As a long-term investor we are proud of the sustained value add that we have delivered to our clients since the Province made the bold decision to establish AIMCo ten years ago," states Kevin Uebelein, Chief Executive Officer. "The commitment to our clients, and indeed all Albertans, demonstrated by the talented men and women at AIMCo is something I am most proud of. Every investment AIMCo makes represents Alberta, so we ensure that our decisions are both responsible and sustainable."

Dale MacMaster, Chief Investment Officer, adds, "Our strong investment performance in 2017 represents a short-term affirmation that our course of action is the right one and is the result of the high degree of trust our clients have placed in us to meet their objectives. More important, these returns have empowered our clients to make critical decisions for their stakeholders, such as reductions to contribution rates, or budget reconsiderations due to newly available funds. As Alberta's economy strengthens, it is gratifying to be able to deliver our clients $1.1 billion of net value add against our benchmark returns."

Detailed performance information will be available in AIMCo's Annual Report to be released in June 2018.

About Alberta Investment Management Corporation (AIMCo)

AIMCo is one of Canada's largest and most diversified institutional investment managers with $103.7 billion of assets under management, as at December 31, 2017. The organization's mandate is to maximize risk-adjusted net investment returns in a manner responsive to the needs and expectations of its 32 Alberta-based pension, endowment, government, and specialty fund clients. Balanced fund pension and endowment clients account for $88.2 billion of assets under management, and are most representative of AIMCo's overall performance, as they utilize the full range of the organization's asset and style capabilities. Government and specialty fund clients account for $15.5 billion of assets under management, and largely rely on AIMCo for its expertise in managing fixed income assets and for liquidity management.

Established as a Crown corporation on January 1, 2008, AIMCo is operationally independent – operating on commercial principles and at arm's length from the government of Alberta – yet strategically aligned with the Province as our shareholder. The organization is committed to the highest standards of corporate governance including an independent, highly-qualified and diverse Board of Directors that draws on global experience to provide meaningful guidance and oversight to the organization.
Alright, so AIMCo's detailed Annual Report won't be available until June but I did get speak with Dale MacMaster earlier to go over 2017's performance and more. I'd like to first thank Dale for taking some time out of his busy schedule to speak with me.

Here are the main points we covered:
  • Total return: As stated above, AIMCo's Balanced Funds returned 10.4% in 2017, 130 basis points over the benchmark. Dale told me they've been very cautious over the last couple of years and were pleasantly surprised to see strong gains across public and private markets this late in the cycle. Over the last four years, the Balanced Funds delivered an annualized return of 9.5% relative to a benchmark return of 8.75%.
  •  Fixed Income: AIMCo's Fixed Income which includes money markets, mid-term and long-term bonds, private debt, real return bonds, and short-term and long-term segregated assets did very well. Dale told me there was 110 basis points value add over 4 years and 80 basis points value add last year which is top decile return in fixed income. AIMCo runs an internal portable alpha strategy in Fixed Income and it also engages in repo activities to add to returns. Dale told me they're not making big duration calls, focusing more on the short end and managing their risk closely there too (see further down, our discussion on macro environment).
  • Public Equities: A solid performance across the board in Canadian, global and emerging market stocks with the latter gaining 30% on an absolute return basis and 2% relative to the benchmark. Across the $44 billion portfolio, value add was 1.8%. There is a portable alpha strategy as part of public equities which invests in 9 external hedge funds across several strategies including multi-strategy, macro, credit, L/S equity, catastrophe and even hedge fund secondaries.
  • Private Equity: Dale shared this with me on AIMCo's PE portfolio: "We like the asset class and over the past 4 years we delivered annualized returns of 13.4% and a value add of 1.9% over benchmark. In 2017, the performance was flat versus a benchmark return of 8.0% so we underperformed there. Obviously, it’s the long-term that matters and the reason we lagged last year was the J-curve effect of some new fund commitments that we made over the last 2 years. This combined with the fact that some direct private equity assets that we hold, were more or less flat on the year after having delivered strong returns and relative value in 2016 and 2015."
  • Real Assets: Here we talked mostly about Real Estate and Infrastructure. Dale told me the Real Estate portfolio returned 9% in 2017 relative to 7% benchmark which is the MSCI/ IPD Canadian All Property Index – Large Institutional Subset. AIMCo's Real Estate portfolio is diversifying more globally but relative to its large peers (except for bcIMC), it has more exposure to Canadian real estate and obviously has more exposure to Alberta real estate which dragged returns over the last few years but boosted them for a long time when the province was booming. Dale told me they focus on A buildings and the high vacancy rates in Calgary and Edmonton are mostly in B and C buildings.  "It benefits us because people are getting out of those rents and signing long-term leases with our A buildings (many are LEED certified) which is great income and added protection for inflation." He added: "Things have stabilized over the last year." (no doubt, the rise in energy prices obviously helps but British Columbia's environmental zealots aren't helping Alberta's economy).
  • Infrastructure: Dale told me AIMCo's Infrastructure portfolio delivered 9.2% in 2017, a 2% value add. He told me they took advantage of frothy markets and high demand to trim certain infrastructure assets which either didn't fit in the portfolio or still have great cash flows, a solid counterparties and provide good inflation protection but they wanted to realize on those gains and invest elsewhere. He said they are now taking much bigger stakes in infrastructure and their focus is on assets like ports where they see a backlog and good growth potential. The focus in Infrastructure is more in growth areas.
  • Macro Risks: Dale told me the biggest risk is that we're at the tail-end of a long bull market in equities, inflation is picking up and the Fed is raising rates. He doesn't see a calamity (neither do I) but he does see central banks trying to normalize rates and that will cause volatility to pick up across all risk assets. He doesn't think rates or inflation will normalize to previous levels but there is an effort to normalize rates and that presents challenges across public and private markets. For example, in Real Estate cap rates will rise and valuations will be impacted which is why they're focusing more on class A buildings, signing long 15-year leases to get income and some inflation protection. I told him I'm worried about the yield curve inverting because I see global PMIs decelerating and the Fed continuing to raise rates which will cause the yield curve to invert and I"m not buying the inflation story at all (see here and here). Dale agreed, telling me "the forward yield curve" has already inverted ad policy errors are on his mind too and he’s paying close attention to credit spreads. He added: "Last year, people were worried about valuations and rising rates whereas this year, we also have potential trade wars and investors questioning market leaders like Facebook. I'm not saying it will be catastrophe but all these things really test a bull market, especially this late in the cycle."
Anyway, I'm glad I spoke with Dale MacMaster, he's super sharp and extremely nice, I really enjoyed our conversation. We also talked briefly about AIMCo's investments into renewable energy, including wind power in Alberta, and Dale told me that unlike the Caisse, AIMCo doesn't have a "dual mandate" to invest in Alberta and operates at arm's length from the government (so does the Caisse but it has a dual mandate to invest in public and private assets in Quebec).

Below, Alberta Premier Rachel Notley says the federal and Alberta governments have commenced discussions to "eliminate" investor risk in the Trans Mountain pipeline project.

I'm frankly disgusted and shocked by the ignorance British Columbia's government is showing, fighting this pipeline which the country needs, and I'm glad a new poll says more than half of British Columbians now support the Trans Mountain pipeline expansion project, with the number of backers rising even as the provincial government digs in its heels on the battle to stop the project from moving forward.

B.C.'s government needs to stop pandering to environmental lunatics and start doing what is right for the province and country. Let's all hope cooler heads prevail but I'm very worried and watching Canadian news at night makes me sick to my stomach (we need to wake up and stop perpetuating myths on how bad pipelines are for the environment, that is total nonsense!).

Wednesday, April 18, 2018

US Pension Fund Collapse?

Aaron Brown wrote a comment for Bloomberg View, U.S. Pension Fund Collapse Isn't a Distant Prospect. It Could Come in 5 Years:
Warnings about looming public pension disasters have regularly cropped up since the 1950s, pointing to problems 25 years or more down the line. To politicians and union leaders, the troubles were someone else's predicament. Then crisis fatigue set in as the big problem remained down the road.

Today, the hard stop is five to 10 years away, within the career plans of current officials. In the next decade, and probably within five years, some large states are going to face insolvency due to pensions, absent major changes.

There are some reassuring facts. Many states are in pretty good shape, and many others still have time and resources to fix things. There is no serious chance of retirees being impoverished. What's in doubt is whether states will pay promised benefits to retirees with large pensions or significant outside income or assets. Also, although most of the problem is created by politicians and union leaders cutting deals to promise future unfunded benefits to keep voters happy, there are also plenty of stories of politicians and union leaders risking their careers to stand up for honest pensions.

It's important to distinguish between actuarial problems (the present value of projected future benefit payments exceeds the funds set aside to pay them plus projected future contributions) and cash problems (not having the money to send out this month's checks). Actuarial problems are always debatable and usually involve the distant future. Cash shortfalls are undeniable and immediate.

New Jersey has $78 billion in its state pension fund, which is supposed to cover future payments with a present value of $280 billion. But that latter number is a projection. You can ignore it if you wish, or hope that soaring investment returns or a pandemic among retired workers will fix it. A more certain figure is that the $78 billion represents less than seven years of required cash payments.

If we extrapolate from the past, rather than use promises in the state budget, current employees plus the state will contribute about $25 billion over those seven years, which could provide another few years before the till is empty. But it will also add around $60 billion of future liabilities to current employees. The system probably breaks down before the pension fund gets to zero, for example if assets were to fall below $30 billion while projected future liabilities exceeded $300 billion. Even the most optimistic people would have to admit the situation is unsustainable. This could happen in three years in a bad stock market, or perhaps 10 with good stock returns. But fund assets are so low relative to payouts that good returns aren't that helpful.

The next phase of public pension reform will likely be touched off by a stock market decline that creates the real possibility of at least one state fund running out of cash within a couple of years. The math says that tax increases and spending cuts cannot do much. For one thing, as we learned from Detroit, at a certain point high taxes and poor services force people and businesses out. The numbers are just too big in some states to come out of the budgets. For another, voters won't stand for it. The voters in these states have refused for decades to pay the full costs of the services they were already enjoying; they're not going to have sudden conversions to paying full costs, plus the accumulated costs from the past. State constitutions will be amended if necessary and big legal battles will be fought. I cannot see any plausible scenario in which full promised benefits are paid.

I hope that the problems of the least responsible states will shock the rest of the country into more rational reforms. Actuarial problems 25 years in the future can be solved with only moderate pain today. Cash flow problems three years in the future require chainsaws, not pens. But history does not inspire confidence that warnings will be heeded.
You can read Brown's Bloomberg comment here along with his 14 footnotes which I removed above.

I share Mr. Brown's skepticism that profligate states are going to reform their public pensions any time soon. They won't. Either they'll pull an asinine Kentucky response, cutting defined-benefit plans to replace them with "cheaper" but much lousier defined-contribution plans, or they will pull an Illinois, emitting pension obligation bonds in perpetuity and become another American pension shithole.

How bad are things in Illinois? Last June, Illinois Policy cited the state's $250 billion pension debt as the main reason why Moody's Investor Service downgraded Illinois’ credit rating to Baa3, just one notch above a noninvestment-grade, or “junk,” rating.

More recently, the Herald & Review commented, Illinois has a $130 billion pension shortfall. Why aren't Gov. Bruce Rauner and J.B. Pritzker talking about it?

The simple reason is nobody wants to really slay this pension dragon. To do so requires serious compromise from the state, public-sector unions, and maybe even Illinois' taxpayers.

A big part of the problem which I alluded to in my comment on the US pension squeeze last month is the system is so corrupt on all sides that nobody wants to "fix" anything, just maintain the status quo as long as possible even though liabilities are soaring and cash flow problems will arise at one point.

It's not a matter of if but when. At one point, these chronically underfunded US public pensions will run into serious cash flow problems and either they will need to sell assets (at the wrong time) to cover pension payments or their state will need to emit pension obligation bonds and increase the contribution rate, cut benefits and increase property taxes to make up for the shortfall.

But all these measures are just prolonging the agony, placing a Band-Aid over a metastasized tumor. Unless these states adopt Canadian-style governance and more importantly, some form of a shared-risk model, these pension debts are only going to grow and constrain public finances.

In his comment above, Brown states "the next phase of public pension reform will likely be touched off by a stock market decline," but stock markets only figure into the asset side of the equation. As I keep telling my readers, pensions are all about managing assets and liabilities, and my biggest fear is when the pension storm cometh, interest rates will drop to a new secular low and liabilities will soar to unprecedented levels. And this will be the final nail in the coffin for chronically underfunded US public pensions.

But the situation isn't as dire as Brown and many others think. US public pensions may never adopt Canadian-style pension governance, separating public pensions from state governments, but they can start implementing sensible pension reforms, like implementing conditional inflation protection, a key element to Ontario Teachers' Pension Plan's success, making it young again.

Again, to do so requires compromise on all sides, including public-sector unions, but the alternative remains Kentucky or Illinois and that's a road to pension hell.

Lastly, MoneyStrong's Danielle DiMartino Booth put out a comment on Public Pensions & the Trolley Problem — The Impossibly Immoral Choices the Future Holds:

Take the time to read Danielle's comment, she understands the problem and that there are no easy solutions to the ongoing US public pension saga.

Will US public pension funds collapse? Of course not but the time for action is now and the solutions require some compromise from all sides because if these pensions do collapse, it not only spells doom for hardworking workers and pensioners who were promised a pension for life, it will significantly impact the US economy in a very negative way over the long run.

Below, Goldman Sachs's CEO Lloyd Blankfein told CNBC on Wednesday that "central banks all around the world are buying risky assets." This confirms my belief that another Black Swan event like 2008 is highly unlikely and that the Fed and other central banks are not even contemplating quantitative tightening in any serious way.

My only question is how long before central banks all over the world start buying pension obligation bonds? If you think it can never happen, I remind you that global bonds remain in the Twilight Zone and if things get really bad, central banks will continue buying risky assets to reflate the economy.

Update: After reading this comment, Lew Andrews of the Yankee Institute for Public Policy sent me this email response:
In response to your post, I wanted to make you aware of a study that Dr. Marty Lueken and I did for Connecticut’s Yankee Institute. It shows how a modest school choice policy generates enough annual savings ($385 million) to bail out our state’s underfunded teacher pensions. A group of us here in CT are pushing for a grand compromise with the public unions: allow school choice in return for a securely financed retirement.
You can find the study he is referring to here.  I note the following on page 4:
The state’s fiscal problems are especially aggravated by public pension plans which, in 2016, the American Legislative Exchange Council determined to be the most underfunded in America. The teacher ’s retirement system alone is only 59 percent funded, with pension debt exceeding $10.8 billion, or $19,000 for each student in the state.
Clearly, something needs to  be done in Connecticut and other states where underfunded public pensions are sapping public finances. Is a modest school choice policy the answer? Maybe not but it's an option worth considering. Still, I'd like to see structural changes at the pension level, including the adoption of conditional inflation protection.

Tuesday, April 17, 2018

Prepare For Another Black Swan?

Yakob Peterseil and Cecile Gutscher of Bloomberg report, Winning ‘Black Swan’ Investor in 2008 Says Market’s More Fragile:
For funds that thrive on crisis, the volatility jolt that wiped out over $4 trillion of global stock value in February was merely a tremor. A full-blown financial earthquake looms.

They’re known as tail funds, for whom the traditional objective of producing annual returns is replaced by the contrarian task of preparing for events that are more than three standard deviations from the norm, or those that have a 0.3 percent chance of coming to pass.

Those mandated to hedge such maelstroms -- like Richard “Jerry” Haworth, whose 36 South Capital Advisors LLP profited handsomely from the 2008 crisis -- say conditions are now ripe for the next big one.

“The financial system is a lot more fragile than it was in 2007,” said Haworth in an interview in his Mayfair office in London. “Leverage is up on every single metric, in just about every category, and debt has increased. The more you indebt someone, the more fragile they become, especially with variable interest rates.”

Tail-fund investors are predisposed to warning against the next blow-up. Haworth admits that he’s called “10 of the last two recessions.” To steel themselves against financial armaggedon, the funds typically scoop up long-dated out-of-the-money options on multiple asset classes -- and wait.

Assets in tail-risk funds have grown to $4.9 billion from $3.2 billion in 2011, according to Eurekahedge Pte Ltd. In 2011, the year of the Greek crisis, tail-risk funds boasted the top-performing strategy, but as markets rallied in the six following years they suffered the steepest losses of any hedge-fund style tracked by Eurekahedge. This year, they’re up 0.54 percent, according to the data provider.

Leverage Alarm

It’s getting easier to make the case that the probability of outsize losses is rising thanks to an increasingly complex market landscape late in the U.S. business cycle.

Risky securities and investing strategies that have flourished during the decade of easy-money policies -- from autocallable structured products to risk-parity funds -- could accelerate a downturn, Haworth says. The boom in passive investing may intensify the looming deleveraging wave as exchange-traded funds rush to sell the same securities in unison, he added.

Haworth, who co-founded 36 South in 2001, declined to say how much he manages in his tail-risk funds, which hedge extreme scenarios in both bull and bear markets. After returning 204 percent during the global financial crisis in 2008, his Black Swan Fund closed the next year and returned money to investors.

Tail funds make up “barely 0.2 percent of total global hedge fund AUM, pointing to the difficulty of marketing such strategies to investors despite the crisis alpha they are capable of delivering,” said Mohammad Hassan, head of hedge fund analysis and indexation at Eurekahedge. “The inherent bleed in this strategy is a tough sell.”

New Regime

There are few prophets of doom on Wall Street even with elevated valuations across stocks and credit amid the recent global selloff. But the tone is getting more bearish.

Guggenheim Partners and Pacific Investment Management Co. are among those sounding the alarm on corporate debt, saying higher interest rates could pressure the swollen ranks of over-leveraged firms and weigh on growth, with the risks of a recession rising.

Consumers are loading up on credit, too. A measure of U.S. household debt levels has been edging higher relative to income recently after plunging in the years following the crisis, according to Wells Fargo & Co. Delinquent subprime loans are nearing crisis levels at auto-finance companies.

February’s equity selloff doesn’t register as a tail risk, or black swan, event outside of the relatively small group of investors who wager on securities tied to the VIX. But it may presage a new regime of choppy trading across asset classes, increasing the prospect of hard-to-predict events, according to strategists.

“The summer should be hot for U.S. equity and oil volatilities,” Societe Generale SA strategist Olivier Korber wrote in a recent note.

Still, with price swings across bonds and currencies at subdued levels, volatility remains cheap for tail funds. Even equity volatility -- which has almost doubled compared with last year -- isn’t particularly elevated, but merely back to more-normal levels, according to Haworth.

There are plenty of things that comfort bulls. Corporate America, for example, is embarking on another round of earnings announcements expected to beat estimates.

“Among the reassuring criteria are the good health of banks, a favourable macroeconomic situation, economies with lower sensitivity to inflation than before, and central banks still credible, predictable, good communicators,” Philippe Ithurbide, global head of research at Amundi Asset Management, wrote in a recent note. He predicts “not a crisis scenario, but rather more nervousness” for the rest of the year.

For the investor at 36 South Capital Advisors, signs of good health are illusory.

“Fundamentals today are strong, but they’re strong because there’s effectively free money,” Haworth said. “If interest rates normalize, a lot of that goes away.”
A contact of mine on LinkedIn posted this article to which I replied:
I remember 2008 very vividly, it was unlike anything I’ve ever seen before. It doesn’t feel like 2008 now. There’s too much money out there chasing dips, central banks ready to pull the trigger at a moment’s notice. Yes, there are structural problems, but funds warning of Armageddon have been bleeding money for the most part. Will their time come? Maybe or maybe we get a long sideways market. It’s all up in the air now but one thing is for sure, global economy is definitely slowing and it’s best to stay defensive allocating to US long bonds (TLT) and defensive sectors like healthcare (XLV), utilities (XLU) and telecoms (IYZ). Or try your luck trading energy shares.
The problem with Mr. Haworth is he doesn't really know what he's talking about but trumps up the same crap a lot of permabears routinely spew, namely, "risk-parity will exacerbate the downturn" (umm, no it won't!) and "rates will be normalized" and all hell will break loose (umm, no they wont!).

Haworth should have taken his money after he closed up his "Black Swan Fund" in 2008 and followed my favorite hedge fund manager of all time, Andrew Lahde, who had the good sense to ride off into the sunset after he wrote an honest and terse farewell letter to everyone, stating "Goodbye and F*ck You!".

Forget about 2008, it's never going to happen again in our lifetime. It doesn't mean we're not going to have cycles and stock market meltdowns, but financial armaggedon is something that sells newspapers and tail risk funds love thumping their chest telling investors, "hey, look at us, the Big One is right around the corner and we're positioned to profit off it."

Oh please, you're better off investing in a smart short seller like Jim Chanos if you're that bearish or just buy out of the money puts on the S&P 500 now that vol is still relatively cheap and roll them over every three months.

But I don't just have a beef with Mr. Haworth. GMO's Jeremy Grantham came out earlier today to say he forecasts a rough seven years for equities and bonds.

I take GMO's asset class forecasts with a shaker of salt. I'm not saying he's wrong as I also think we're in for a long tough slug ahead, but there's no doubt in my mind there's great money to be made in US long bonds (TLT) over the next year or two as rates decline to a new secular low.

It's all about macro, stupid. Don't ignore the yield curve, position yourself defensively with a right mix of US long bonds (TLT) and low vol stocks (SPLV), and yes, it might be time to start taking a closer look at hedge funds after a nine year bull market backstopped by global central banks.

But pick your hedge funds right and that's no easy task. Forget the high-priced beta chasers, find real alpha generators which will be able to deliver alpha in up, down and sideways markets.

The 'Boom Boom' markets won't last forever, and when it's lights out, it will be painful for a lot of young quant momo chasers. They're going to get their heads handed to them.

Let me end, however, by stating that not all tail risk funds are structured the same or charge you an arm and a leg to hedge downside risks.

This week, Bryan Wisk, CIO of Asymmetric Return Capital, sent me a nice comment he authored, Volatility in the Age of Quantitative Tightening:
Why should institutions think about hedging?

We are witnessing the largest real-time, Pavlovian experiment in global capital markets that’s ever been conducted. Since 2009, we haven’t seen an equity market drawdown greater than 25%. The problem is, there is almost universal consensus that Quantitative Easing (QE) has been directly responsible for this. Therefore, classical conditioning leads investors to believe that as long as this continues, there is a permanent floor under risk assets. Now that the Fed has begun to reduce the pace its asset purchases, or Quantitative Tightening (QT), this floor will be tested.

But what is going to change this mentality?

QE technically started in the middle of 2008 and equities reached their lows in March 2009. QE did not support equity valuations outside of the stabilization of interbank lending and the effect it had on pushing institutions into riskier assets (also known as the portfolio transmission mechanism). The stock market recovery was driven by a recovery in corporate profits. And that recovery in earnings was in turn driven by the largest global fiscal stimulus in history and a doubling of the credit base in emerging markets over the recovery period.

Now this is beginning to reverse as credit growth in emerging markets has been decelerating and the deflationary effects of austerity programs in the developed world are starting to have their impact. At the end of the day, credit growth must translate into sustained rising incomes and velocity to create long term growth. Right now we have neither. In past cycles we could lean on credit growth to make up for the loss in purchasing power of the middle class. But looking at private debt, we are at the highest levels in recorded history. Until this debt is written down, inequality will continue to rise against muted growth, no matter how many one-time monetary or fiscal injections policy makers try to jumpstart the global economy.

So what is the risk that pension funds should be preparing for?

Japanification, which is to say continued rise in public deficit spending to offset long term muted growth because of too much private debt. To seeing why this is most likely, you have to understand both demographics and the dynamics of private credit. But investors have a hard time accepting this because the asset management business is conditioned to assume central bankers and politicians will always bailout asset prices. But looking at the Japanese experience, decades of QE can’t change the underlying demographics. If anything, QE and taxpayer funded bailouts of systemically important financial institutions (SIFIs) halt the free market cycle of creative destruction. If the old doesn’t make way for the new, then the new technologies can emerge that reemploy the middle class.

But what about timing?

Right now is a perfect time to think about options for de-risking due to a near across the board compression in risk premia since 2009. Again this relates to faith in the Fed to backstop both equity and credit risk. Once this unwinds it will of course already be too late. The problem is that for institutions that don’t already have a dedicated derivatives team in house, the choices are really limited. The listed VIX ETF products have a high burn rate and the data is mixed on the level of protection they would actually deliver in bear market scenarios that don’t involve an extreme event like October 2008.

What are institutions doing to diversify?

Well, as we have written about extensively, since 2008 we have seen institutional investors increase their allocation to alternative investments like hedge funds and private equity because of the general perception of higher returns and lower correlation with stocks and bonds. The problem is that data over the last 10 years shows that alternatives have had an ever increasing level of correlation to the broader market. The scariest part is that during the recent periods of high volatility, the correlation increases dramatically, which is exactly when you need the diversification benefit to kick in.

What has caused the higher correlation of alts with traditional investments?

There isn’t one clear explanation for this phenomenon but just taking a look at hedge funds, in the late 90s when most of the studies began the industry was still less than $200 Billion in AUM total. Now it has grown to over $3 Trillion with the top 100 managers commanding over two-thirds of those assets. Given that size and level of concentration, hedge funds will naturally become a higher beta product. So ironically, in an effort by investors to reduce risk by sticking to brand names in the space, there has been an indirect increase in risk and a corresponding decrease in the revenue potential of the industry as a whole.

What could change this trend?

If alternative investments do not deliver significant protection to the downside during the next prolonged period of high volatility, institutions will begin to abandon the asset class due to high fees. Institutions like pension funds are already putting pressure on fees due the impairment of public balance sheets globally, putting extra pressure on active managers to outperform.

You see this showing up in both concentration and net exposures which are at all-time highs. A lot to do with having to play catch up with the S&P 500 every year since 2009. This is a feedback loop that gets worse with every move up as managers replace shorts with index and ETFs, and add to high momentum longs in an effort to catch up. This creates a risk that if the next crisis is not a systemic one, the assets that alternative asset managers are long could actually go down more than the broader market, because of their illiquidity and concentrated ownership.

Why aren’t hedge funds a hedge?

Hedge funds have underperformed in recent years because this cycle has not rewarded deep fundamental analysis in the same way that it did prior to 2008. Since then, the market has been driven largely by the emergency measures that were taken at that time which for most of this cycle drove correlations to historical highs. Again, the price of artificial stimulus is investors want to own all assets alike. Betting on the relative value of different assets matters less and less in an environment where all assets go up indiscriminately. And again, this is because we are trying to cure a bad debt problem by adding more debt. Inevitably, with a perceived central bank backstop in place, this added liquidity finds its way back into financial assets in a perpetual growth loop.

Politicians like to talk about deleveraging, but at over $100 Trillion globally, bank debt is actually 40% higher than it was in 2007. This goes back to the fact that the US housing market was largely backstopped by the taxpayer. Since then, low-to-middle income borrowing has been driven by 100% LTV loans from the FHA, subprime auto loans and loans to students for higher education. These are now becoming delinquent at an alarming rate.

This is the problem with the bailouts of the post-Crisis period, we were told that we needed a short term fix to restart animal spirits and that once that happened we would be able to address the real issues. Well, we got the animal spirits part right but did not address the real issues that remain. Looking at monthly return data there is little granularity as to how those returns were made, but you can compare relative performance across strategy buckets. As a result, hedge funds, like everyone else, have been forced to chase yields or go out of business.

Aren’t pension and sovereign wealth funds incentivized to hedge?

Yes. Large institutions are depending on alternative investments to help them mitigate volatility in their portfolio when the trend reverses. But that trend has forced the very positioning that is more concentrated on the sectors that are working. This is especially the case on the long side of the book where it could really hurt in a down market when one type of asset sells off more than the broader index, actually producing negative alpha over some periods.

Given net positing at a fraction of a long only portfolio, this would correct with a deep market sell-off. But what about the many other markets where we don’t have a catastrophic Lehman type event? One positive thing that can be said about the bailouts is that there is a $20 Trillion global QE backstop that wasn’t there in 2007–2008, so the likelihood of a 2008 event is much lower than it was then.

The truth is that the bailouts and fiscal stimulus of the 08–09 period were fantastic for financial asset prices, but those are just marks. When house prices, or stocks or corporate bonds are trading on light volume, it can have little or no bearing on actual fundamental value. Market manipulators from the beginning of time have understood the ease of moving prices on light volume, why do we treat it any differently when the Fed does it?

This is why the ideological bedrocks of modern finance are such dangerous ideas. Policy makers can hide behind concepts like equilibrium growth, market efficiency and a random walk model of asset prices. But over and over again these theories have been disproven by empirical fact. Like people, economies and financial markets do not evolve as a series of independent coin flips. Both are the result of collective human behavior and opinion.

Why is moral hazard bad?

The definition of moral hazard is a lack of incentive to guard against risk where one is protected from its consequences. When central banks and governments decided to bailout the bad business practices along with the good, they created a precedent for financial risk management ultimately falling on the taxpayer. Since then, risk premiums have compressed as if this will always be the case and for every tradable asset.

As dangerous as this belief is, in 2008 a system-wide collapse of the global financial and economic system was possible, and at that limit the taxpayer stepped in to stabilize it. This is why a central banking model was created. Having dodged that bullet, it should’ve been understood that letting bad debts get to the point of catastrophic failure before we act is a bad idea. Our theories on how the economy and markets functions should have been revised. Instead we doubled down on the failure and just labeled it a really “great recession”, as if it were a Black Swan that no one could be expected to see coming.

But people did see it coming, and they did say something and most importantly, they tried to do something about it. Unfortunately, those voices were drowned out by the high incentives to create more debt. Worse yet, certain market participants used that knowledge to create products they knew would blow up when the crisis happened, sold them to institutions who needed the yield and then bet against them. This behavior was only ceremoniously punished, and as a result, the net effect is encouraging that behavior to continue in the future. Bailouts or no, general faith in those institutions has been lost. Furthermore, this loss of trust has led to rising populism based in a general distrust of the democratic institutions that have held since the end of WW2. Ironically, it will be that loss of trust that prevents policy makers from stepping in this time around.
Where does this leave investors today?

Investors should come to the realization that a share of stock or a corporate bond is not cash, it is a risk bearing asset. With QT, the idea of risk premium will return the conversation around valuation.

Risk now means underperforming benchmarks by missing free ‘central bank sponsored’ capital appreciation, not capital preservation. And why shouldn’t it? If you believe that central bankers will always be there to make sure that you don’t take a real capital loss, then all financial assets become putable into a US Treasury bond struck at par. This of course is ultimately ridiculous because if it were to persist indefinitely, no business manager would re-invest in growing their business. Instead, they’d be incentivized to lever up and sweep all profits back into capital markets as stock buybacks or dividend them out. This is not far off from the real choice corporate managers have today where their compensation is tied to the stock price. This is why we are seeing buybacks at peak levels historically irrespective of fundamental valuation.

How will this end now that the Fed is tightening?

As nice as this free ride has been for certain well-positioned players in global markets, it is a delusion and delusions end the same way: quickly and brutally. After 1999 and 2007 it would be hard to argue that this is new knowledge, yet behavior doesn’t change. Why? Because like Pavlov’s dog, asset managers think that the food will still be there every time the bell rings.

The conditioning of the last 10 years in the asset management business has rewarded more and more passive strategies, with fewer and fewer people tasked with understanding the big picture. The bailouts put the food there one last time. Good fundamental securities analysis and high specialization matters less and less against a backdrop of ever rising correlations. Instead of trying to understand why this is, the incentive is to bury one’s head even further in the sand with respect to the big picture, and try not to get caught off mandate making market calls.

As long as the short term trends are detectable and persistent, this works fine. But when large systems shifts occur to the whole environment, it fails miserably. This is what happened in 2008, but instead of rewarding the few who were able to shift gears and see a very obvious bubble, the bailouts further entrenched the herd chasing behavior with the idea that if you get burned missing the forest: don’t worry, everyone else will too.

It’s hard to argue that this was a minor side effect when compared to preventing systemic collapse. What we should take issue with is revisionist history; bailed out institutions pretending they would have still been even if the government had not stepped in. Now everyone wants to rewrite history and say, “hey that was just a great recession and yes, we sustained losses but in the end we were able to stay in business.”

No. You weren’t. Everyone had to chip in to keep you around. Most of the industry was DOA. Those that were able to stick around and meet redemptions without putting their gates up were punished. How can we begin to learn what it was that allowed those players to stay in the game when everyone gets a pass? The very foundation of free market theory is that it’s evolutionary; over time, long-term productive ideas survive and bad ideas die. Instead it is like we are all playing a game of monopoly where those who are sitting closest to the banker get to keep playing no matter what, just because the banker used to be on their team, or will be when they retire.

All of these flaws will come back to bite us when we begin to realize that the last ten years has not been a real recovery, and that we forgot to start fixing the real problems. The recovery story is a myth. The demographics in the West are deflationary. That is not a debate, it’s a fact. As the Baby Boomers cash out it in order to live, what they sell will go down relative to what they receive. But the problem is there isn’t enough cash to pay them out, at least not at where those liabilities are marked. This is debt deflation.

What most fail to understand is not that this gap exists, it is that, no matter what, the gap will be subtracted from future generations’ ability to consume. The same Baby Boomers whose spending drove the back half of the 20th century will turn into Baby Busters as their dependency requires an ever expanding share of everyone else’s income. Furthermore, funding this gap means selling out of financial assets to meet short term cash obligations at a time when those who would typically buy those assets are forced divert a larger share to taking care of the sellers.

The funding gap at pension funds is not about mismanagement or union politics. These may be issues at the margin, but the real story is the collective gap between what Baby Boomers earned as workers and what they will receive as dependents. This comes down to simple numbers and by 2030 the economic dependency ratio in the US and EU will have reached 150%. This means there will be 3 dependents for every 2 active workers. So even if it were possible to privatize social security and liquidate pension funds at current market values right now, so what? We haven’t fixed the gap, we’ve just shifted it from a pooled responsibility to an individual one. Either way the gap still exists and still comes out of future consumption; it is just a matter of how this loss is distributed. This is why social safety nets like pension funds were created in the first place. Just because we decide not to share the burden doesn’t mean there is no burden.

What will trigger the next market crisis?

At some point soon we will enter a new phase of deleveraging where bad debts will be separated from those that can be paid off. No one can predict exactly when this will be, but you can look at the drivers of growth over the last 10 years, look at when those are decelerating, and make appropriate preparations for accelerating risk. Right now this is exactly what is happening. Looking backwards, there were two primary drivers of this cycle: emerging market credit growth on steroids and an unprecedented global fiscal stimulus. But these factors are now slowing with Emerging Markets in the final Ponzi phase of the Minsky cycle and Developed Markets replacing fiscal stimulus (ex-US tax cuts) with austerity measures in order to deal with entitlement problem.

What isn’t obvious is just how big the impact of a tripling in Emerging Market credit base has been on the valuation of financial assets, and how big the blowback will be to Developed Markets when this finally reverses as it is beginning to now. Add to this the outright deflation in Europe, and investors are looking ever more desperately at central banks for the QE bell to ring. It’s not hard to see why prudent managers are already coming out publicly about the rising levels of global risk.

How can institutions detect this rising risk?

Most investors measure risk by looking at some fixed window over the last several years of data, and bucket their portfolio based on a mean and a standard deviation that they extract from that window. This is then projected forward and is accepted as an accurate picture of future risk. Of course there have been many advances in this method but even sophisticated statistical tools use similar assumptions to extract information about risk from historical regressions.

Unfortunately, this type of analysis suffers as a primary risk management tool at turning points like the one we are approaching. Long-term investing is a very difficult endeavor because the economy is a complex and highly non-linear system. It is not always best described by fitting data to a bell curve. Again, this idea should have been finally tossed out in 2008. Instead we just added the financial crisis as an extreme “Black Swan” event to the distribution and slapped a few people on the wrist for making liar’s loans. This is totally facetious and intellectually dishonest. Imagine physics progressing by just relaxing assumptions to make the data fit.

The good news is that reality eventually overcomes bad scientific theories with empirical facts. The bad news is that there is nothing that stops us from choosing to ignore those facts. We see it today with climate change and if we can do it with something as fundamental as the weather, how does something as abstract as the science of the economy and financial markets even stand a chance?

The problem is that the more we ignore reality, the greater the eventual cost when we decide to finally address it. It is this human cost, not the monetary one, that is the fundamental flaw with the whole 10 year experiment of extend and pretend. Social instability is spreading at a rapid pace and it’s plain to see that keeping the status quo afloat at the expense of the up-and-coming generation has never ever ended well throughout human history. Even in the US, we’re levering up the next generation into a labor market with falling wages and student loan debt they can’t walk away from. Worse, they’re competing with two generations ahead of them who are forced to stay in the workplace much longer than they anticipated working low-skill jobs. Today, 1 in 3 college grads are making less 25k first year out of college, lower than it’s ever been.

In Europe the youth unemployment rate is close to 20%. Anyone who expects some easy rebound in the middle class in US and EU is kidding themselves. We will have to address these issues as a society one way or another, and unfortunately the only solution policymakers and economists put forth is more government spending or more quantitative easing. Both are fantastic for the status quo and financial assets in the short run, but neither does anything to fix the structural problems. In fact it makes them worse by delaying the day of reckoning.

Is there still time to act?

Yes. Now is the time for investors to take a serious look at how their portfolio will perform in a world where financial assets trade independently of government support. We must not bury our heads in the sand, managing monthly returns against a benchmark of other people doing exactly the same thing, and hope that there will be time to reverse course. In an era of QT, if policy makers lose the political will for bailouts where will investors get their liquidity when forced to sell? Unless you believe investors will work together not to sell all at once, the only way to solve this prisoner’s dilemma is by being first to the exit.
For further insights and to learn more about his fund, please contact Bryan Wisk by email at

I've known Bryan for a few years. He found me through my blog and loves my coverage on pensions and debt deflation, the ultimate endgame I keep warning of.

Bryan used to work at a well-known hedge fund, Visium Asset Management, he’s very sharp and knows all about the pros and cons of hedge funds and their insanely high fee structure. He has always told me there is a better way to get better alignment of interests.

 His comment should make a lot of Pavlonian dogs reading this blog stop and ponder: "Hmm, maybe our risk models are not capturing everything properly across public and private markets. Maybe our stress tests aren't as robust as we think."

My biggest beef with Bryan's comment? I don't see an era of quantitative tightening (QT). I think that's total rubbish and I alluded to it a month ago in my comment on where to invest now:
These moves are crazy and no doubt fed by algorithmic trading and big institutions frying small retail investors every chance they get but my point is this, if you really drill down, the market isn't showing me panic, far from it, speculative activity is alive and well!

On this last point, Karl Gauvin of OpenMind Capital told me he looks at the Fed's balance sheet numbers every week (think he said Thursday) from the St-Louis Fed and he sees nothing has changed significantly, only declined as a percentage of GDP (click on image):

As I stated in my recent comment on the Fed's balance of risks, all this talk about the Fed shrinking its balance sheet and its impact on the economy is much ado about nothing.

In fact, if my prediction that the US economy will slow significantly in the second half of the year comes true, I wouldn't be surprised if the Fed pauses its balance sheet reduction or signals a pause.

Karl also notes the following:
The perverse effect of years of quantitative easing is illustrated in the two tables below (click on image). In a nutshell: stocks in the third quartile in terms of Financial Condition Score and first quartile in terms of sales growth (Low Quality Growth Stocks) have outperformed the S&P 500 by 15% in 2017 versus an historical annualized excess returns of -2.25%."

Therefore, if your US Equity manager outpeformed the S&P 500 Index by a lot last years, it may be a red flag!!!!

Institutional and high net worth investors looking for an emerging alpha fund whose managers have years of experience and are very focused on risk-adjusted returns and proper alignment of interests should take a closer look at OpenMind Capital. They're extremely sharp and very good at understanding vol regimes and how to add excess returns in difficult markets.
Lastly, all of you institutional investors who subsribe to Cornerstone Macro's research, take the time to watch Francois Trahan's latest five minute clip discussing interest rates and why they matter more for financial markets (for the rest of you, get ready for more volatility and rock 'n roll in the second half of the year).

Anyway, I've covered a lot, hope you all enjoyed this comment and once again, please remember this blog isn't a charity. I think it's really important to remind all of you that there's a tremendous amount of reading, writing and researching that goes into these comments, so please donate or subscribe to this blog via PayPal on the top right-hand side, under my picture. I'm not good at running after people so I thank those of you who remember to support my efforts, it's greatly appreciated.

Below, Guggenheim's CIO Scott Minerd with his dire forecast for financial markets. Before you go selling everything to slice your wrists and wait for the end of the world as we know it, relax, it's going to be rough, it might last a very long time, but the world isn't falling off a cliff. At least not yet.

Monday, April 16, 2018

Time to Invest in Energy Stocks?

Keris Lahiff  of CNBC reports, Energy stocks are about to catch up to the crude rally in a big way, says market watcher:
Energy stocks are still negative for 2018 even as crude oil has gained 11 percent. One market technician expects the sector to play catch-up as we head deeper into the year.

"The divergence between what we're seeing with crude oil and the XLE, this is a divergence that is clearly going to close," Craig Johnson, chief market technician at Piper Jaffray, said Thursday on CNBC's "Trading Nation."

The XLE energy ETF (XLE) has fallen more than 1 percent this year, failing to join in on crude oil's rally. It tumbled nearly 11 percent in February, its worst month since December 2015, while crude oil fell just 5 percent.

Energy has made a comeback since those lows. It posted gains in March and is on track to become the best performer on the S&P 500 in April. The S&P 500 energy sector has added 6 percent this month.

Even with those gains, Johnson says fear remains following years of underperformance.

"Most places are underweight the energy play. They've been burned by it, they haven't wanted to come back to it yet," he said.

But Johnson and his team are bullish on the sector and expect more upside this year.

"We're overweight the sector at this point in time," said Johnson. "If we're going to get any sort of pullback, a shakeout (a deeper pullback and shakeout, I should say) in the broader market I think energy is probably a space that some of that money is going to rotate into, given how weak the performance has been so far this year."

To Chad Morganlander, portfolio manager at Washington Crossing Advisors, the energy sector doesn't look quite as good. A possible weakening in Chinese demand and growing domestic supply could unbalance oil and hit energy names, he said.

"China growth has actually been one of the critical contributors to demand for oil," he said. "Any type of reset there within policy for credit growth is going to have this wash-back effect on demand for oil."

"Secondarily, you do have the United States which is actually going to become in our estimates over the next five years the largest producer of oil and they're not directed by OPEC," he added.

U.S. crude oil exports moved north of 2 million barrels per day at the end of March, its highest level on record. Analysts expect that supply to grow this year with the U.S. possibly overtaking Saudi Arabia and Russia as the world's largest producer.

"We're neutral on the sector to underweight," said Morganlander. "We would be much more cautious on this sector overall going forward."

The XLE ETF surged more than 1 percent on Friday afternoon, while West Texas Intermediate crude oil prices gained 0.6 percent to trade at roughly $67.50 a barrel.
It's Monday, have energy on my mind so I wanted to write a brief comment on it. A lot of analysts are talking about the disconnect between oil prices and oil stocks, most predicting it will converge higher.

Gluskin Sheff chief economist and strategist David Rosenberg says that while Canada faces huge economic obstacles – including trade uncertainty, heavy debt and an “uncompetitive tax regime” – the Toronto Stock Exchange is now host to some of the most attractively priced stocks in the world, offering 'mouth-watering' discounts.

I like Rosie, think he's a very smart guy but Canadian stocks just don't tickle my fancy. I remain structurally short Canada and think we're in for a long, dark period ahead.

Still, some smart people I talk with on this blog, like HOOPP's Jim Keohane, have told me they like Canadian energy shares over the long run and find them very reasonably priced at these levels.

Interestingly, the Canadian currency (FXC) and Canadian energy shares (XEG.TO) popped recently which supports the case that maybe Canadian shares are cheap here (click on images):

Similarly, US energy shares (XLE), oil exploration shares (XOP) and oil service stocks (OIH) have also all popped recently, mostly owing to geopolitical tensions in Syria (click on images):

If you look at these charts, you have to wonder whether there is more upside in energy shares.

Earlier today, I called my favorite stock trader, Fred Lecoq, to talk stocks. Fred used to manage Canadian equities at PSP at the time I was there and is now retired managing his own money.

"So Fred, last week Bob Pisani of CNBC was saying how some energy stocks like Hess Corporation  (HES) and Valero Energy (VLO) have been leading the energy sector. I know Paul Singer's Elliott owns a huge chunk of Hess and energy shares have done very well lately. What do you think?"

Fred replied: "Tell Bob Pisani to have a closer look at Anadarko Petroleum corporation (APC) which has made a very nice move this year and is now at its 200-week moving average" (click on image):

I told him the daily chart on Anadarko looks a bit overbought and the weekly looks nice but I would short it if it pops over its 200-week. I also told him that I hate energy shares this late in the cycle and think these are just countertrend rallies in a downtrend channel.

Fred told me: "That's good that you hate energy. Everybody hates energy now which typically bodes well for this sector."

Still unconvinced, I then told him energy has popped because of geopolitical tensions and the very weak US dollar (UUP), both of which have helped energy shares. "Going forward, I see a second half global slowdown, a rally in US long bonds (TLT) and a rally in the US dollar, so from a fundamental view, it's just hard for me to warm up to energy stocks."

Fred agreed but said "that's what makes a market" and added, "a lot of people are betting against energy shares and yet they keep inching higher." He also shared with me a nice presentation from Raymond James's Energy Group which is pretty bullish on oil and energy stocks.

Still, I'm highly skeptical, see the latest rally in energy stocks rallying as nothing more than short covering and a countertrend rally due to geopolitical tensions and a weak US dollar. No doubt, there are excellent countertrend rallies in energy shares but I wouldn't overstay my welcome in this sector.

Below, a quick snapshot of energy stocks that rallied on Monday from my Energy watchlist (click on image):

One other name on this list I didn't mention above which Bob Pisani did mention is ConocoPhillips (COP) whose shares are up nicely this year in a very bullish chart (click on image):

This is a past favorite of Warren Buffett and while I don't know if Berkshire is buying now, I did a quick scan to see which funds increased their stake in Q4 and saw Steve Cohen's Point72 upped its stake considerably (click on image):

Whatever you do, don't chase shares here, wait for a nice pullback which admittedly may or may not happen (it can just keep creeping higher).

As far as energy shares (XLE),  I remain cautious despite a weekly chart that looks fine and is actually mildly bullish (click on image):

Others are a lot more bullish on energy shares. Below, one market technician expects the sector to play catch-up as we head deeper into the year.

"The divergence between what we're seeing with crude oil and the XLE, this is a divergence that is clearly going to close," Craig Johnson, chief market technician at Piper Jaffray, said Thursday on CNBC's "Trading Nation."