Well here we are...13 days before the most bizarre and frightful election on my lifetime (I was old enough to vote when Barry Goldwater was the GOP candidate!). I have spent WAY to much freetime on analysing every part of the POTUS election and won't waste your time on what I believe the facts are (if you want to follow my political analysis just friend me on Facebook.com Tobin Smith or send me a message on Messenger.)

But our macroeconomic work and recent market movements have now led me to conclude we are near or at a tranformational inflection point in the relationships between bond rates, inflation and cyclical stocks...more on that in a second.

Over the weekend I will go through ALL the charts of our positions and recommend a Trump Surprise put option on the S&P 500 as well and get that our on Sunday late. So let's get to the most important issues facing us into this election.

Political Risk: Trump or "Trexit" is Toxic for Multinational S&P 500 Stocks

Well the markets told us today what they think of the economic risks to the world economy if DJT and his merry band of trade warriors win the Presidency..mayhem. The market ALSO gave us a real time read on what they think will WORK in Trumponomics and what will not.

Worries about a surprise election outcome resurfaced anew in financial markets on Friday afternoon after the Federal Bureau of Investigation uncovered new evidence in its investigation of Democratic presidential candidate Hillary Clinton‘s email server.The FBI announced they are taking new steps related to its previously closed investigation.

Great. :)

The news sent ripples through stocks, currencies and commodities in afternoon trading and gave us a BIG tell on what a Trump win would look like in the capital markets. The S&P 500 slumped to the day’s lows and the CBOE Volatility Index, the market’s “fear gauge,” shot to its highest level in six weeks which means the cost of put options (betting against the market) soared  Several traders told me this was the kind of knee-jerk stock selling this is triggered by algorithmic robotic trading platforms that analyze headlines for specific words and phrases and then buy and sell stocks accordingly in a BIG way as they kick-in OTHER robotic trading platforms based on momentum reversal. 

What happened? Well since most recent polls obviously heavily favor Mrs. Clinton (you Trump fans...don't shoot the messenger) traders in turn had positioned for a muted response to the outcome on Election Day. When the news of the FBI move hit ALL major U.S. stock indexes flipped from positive to negative...and gave the read on a Trumpian market.

The Trumpian investing game plan? Well the dollar climbed against the peso, a currency pairing that has come to be seen as a market proxy for Republican nominee Donald Trump‘s chances of winning the presidency. The CBOE Volatility Index shot higher.Gold, which investors often buy during times of market turbulence, jumped on the news.U.S. oil futures slumped with the idea trade wars slow global economy. 

Biotechnology stocks, which have been seen as one group vulnerable to a Democratic White House victory because of Mrs. Clinton’s rhetoric about high drug prices, rose a bit.  My favorite physical infrastructure stocks were in the green (and BTW I think they win no matter what happens--we will be getting long some or all of these tickers: DY Dyncom, JEC Jacobs Engineering, MLM Martin Marietta Materials, VMC Vulcan Materials). Favorite is Vulcan Materials for pure infrastructure projects (roads and bridges).

The HUGE Transformation in Bond, Stocks and Base Commodities says Inflation is Coming

Believe it or not, higher levels of inflation are here and expectations for more are getting priced into assets.

How do I know? Well the" inflation trade" is back on Wall Street. With signs of rising prices around the globe, investors who for long craved inflation finally seem close to getting some, and they are preparing so WE are too. 

In fact, with the rotating bear and bull markets by sectors over the last 18 months (i.e., our semiconductor stocks have ridden emand a HUGE bull market while biotech stocks have gone the exact opposite) the inflation trade has slowly come around to a new bull market  U.S. mutual funds and exchange-traded funds targeting inflation-protected Treasurys, known as TIPS, drew $6.2 billion in new cash this year through Wednesday, headed for the biggest calendar-year inflow since 2011, according to fund tracker Lipper. The sector attracted $384.5 million new cash for the latest week, the most on a weekly basis since April. It has logged net inflows nine of the last 10 weeks.

TIPS increase their payout to holders if inflation measures exceed certain thresholds. And market-based inflation expectations, reflecting yields on TIPS subtracted from the yields on nominal government bonds, hit their highest level in more than a year Thursday. In the U.S., the 10-year break-even rate—the yield premium investors demand to hold the 10-year Treasury note relative to the 10-year TIPS, hit 1.73%, indicating investors are banking on annual inflation in that range for a decade.

The TIPS chart has gone nowhere for 4 years...but if it breaks out that will be OUR "tip" on a new inflation expectation market.

Why is this transformative capital markets event happening?

#1 RISING COMMODITY PRICES ARE BOOSTING GLOBAL BOND YIELDS ... I find it amusing listening to my TV talking head pals trying to explain why global bond yields have started to rise (pushing bond prices sharply lower). They don't seem to have noticed that commodity prices have risen more than 20% since February which is one definition of a bull market. A bull market in base commodities is inflationary and that means higher bond yields (higher inflation eats away at the value of a bond at the end of its duration).  Seeing some real inflation (after 8 years of disinflation or deflation in many countries) in turn has to be encouraging central bankers to scale bank quantitative easing and, in the case of the U.S., yo finally start raising short-term rates.

The latest market outlook for raising Fed Funds rates in December: 72% odds of raise to 50-75 basis point range. That is above the magic "70%" number that many feel is the level that the Fed is looking for to allow them to raise without causing much market havoc.

But the REAL issue for market havoc is the "Dot Plot" i.e,. the forecast by Fed Governors for FUTURE rate hikes.Here is the latest which is a LOT milder than last December over the next 12 months.

Last December when the Fed raised rates it ALSO had an official forecast of 13 MORE 1/4 point hikes for the next 3 years..and THAT  is what freaked out investors and tanked stocks in Jan/Feb 2016. THIS "dot plot" chart shows only 1-2 more rates hikes in 2017...THAT is not scary to equity investors...some inflation means more pricing power and higher profits for commodity firms that offset higher dollar value that comes with rate hikes. 

Chart 1 shows the PowerShares Commodity ETF (DBC) clearing its 200-day high in late April/early May. Its 50-day average rose above its 200-day in late May, which is another definItion of a bull market. The green bars show the 10-year Treasury Yield ($TNX) bottoming in early July. That bottom was of course postponed by the June 23 Brexit vote in the UK. The TNX has since cleared its 200-day average (as have the 10-Year British and German bond yields) on higher inflation numbers.

BASE METALS FUND IS ALSO IN A BULL MARKET...We carefully track base metals vs. precious metals. It's a sector that gets less attention than energy and precious metals but its a lot more important to the business cycle. Chart 2 shows the PowerShares Base Metals ETF (DBB) trading at the highest in a year. The DBB includes aluminum, copper, and zinc and has outpaced energy during 2016. Recent buying of base metals in China is giving an added boost to the group and stocks related to them. Chart 3 shows the S&P Metals & Mining ETF (XME) also in a 2016 uptrend.

The rising XME/SPX ratio (top of chart) also shows the group to be an outperformer. Big gains in iron ore and steel in Asia are also supporting global mining stocks. To the extent that rising base metals point to more inflation and economic strength, that also supports higher global bond yields.

RISING INTEREST RATES FAVOR STOCKS ... As we have said ad infinitum...there are two way to view rising interest rates. One way is that it's bad for stocks if the Fed is raising rates with no inflation but a slowing down of the economy.  The recent rise, however, doesn't appear large enough to sidetrack the global bull market in equities because what underpins stocks is "TINA" syndrome: There Is No Alternative."

Why? Because rising no-risk interest rates also mean lower bond prices which actually benefits the stock market. Some of the money coming out of bonds has to find its way back into stocks...its can't be in no-yield or negative yield cash. Because trillions of shares have been repurchased by the SP 500 companies, there are now 24% LESS shares to purchase than the last time the Fed started a rate cycle.

IN fact the move of cash from bonds to stock is already starting to happen. Chart 4 plots a relative strength ratio of the S&P 500 divided by the 20+Year Treasury Bond iShares (TLT). The falling ratio shows stocks underperforming the long bond since the middle of 2015. That was primarily due to a couple of bouts of stock selling last summer (China Yuan blow-up)  and the start of this year (Fed Taper Tantrum 2).

Key point: Falling bond yields means higher bond prices. Stocks, however, have been doing better since the February bottom. The stock/bond ratio has already broken its falling trendline from mid-2015 and appears to be turning higher. Falling bond prices are part of the reason why. A stronger economy also favors stocks over bonds. Today's better than expected 3rd quarter GDP reading of 2.9% is better for stocks than it is for bonds. Sector-wise, rising yields should continue to hurt rate-sensitive dividend paying stocks (telecoms, REITs, Utilties) while helping economically-sensitive groups, especially those that benefit from rising commodity prices.

S&P 500 TRIES TO REBOUND... Stocks are trying to end the week on a strong note. Chart 5 shows the S&P 500 trading higher while remaining above chart support along its September low. A close above its 50-day average would be a positive sign.

Ten sectors are trading higher with healthcare the only loser. The three strongest sectors are industrials, materials, and technology. Seasonal patterns are also turning more friendly. A lesser known part of the "sell in May" maxim is also to "buy on Halloween". Chart 6 shows the 20+Year Treasury Bond iShares (TLT) ending the week below its 200-day average. That may cause some rethinking of asset allocation strategies over the weekend -- in favor of economically-sensitive stocks.

Our FIRST MOVE After Election: BUY the 2x Leveraged SHORT 20 Year Bond ETF the TBT

Man I have been waiting on this baby for 8 YEARS...we made SO MUCH money in it (over 300% including options) in the LAST Fed raise cycle. Look at this chart...oh man...its JUST about to break out (more proof of increasing inflation expectations.).

Now look at the chart back 10 years

Here is the mirror image...the TLT which goes UP when bond yields crash

I think it is prudent to wait for the election on this because IF Trump pulls of a miracle there will be a stampede into U.S. Treasuries in a massive "riks off" trade. But assuming Hillary's latest bout of inflamatory emails is benign...we stand ready.

Transformational Regulatory Changes Make Us Money Too...But usually HURT Others Too

I was all ready to pull the trigger on refiners like I have in the past in oil price busts...but have not. Why? It's a great lesson to us all on the power of positive and negative transformational change. As you know, Rule #1 of NBT Transformity Investing is transformational change is the great creator AND destructor of wealth the world has ever seen.

So check this out. During this oil bust, one sub-sector of energy should have been raking it in – the refiners – and yet their stocks have remained relatively flat for 2016. Low oil prices, combined with an increase in gasoline demand as we have seen here this summer in the U.S. should have translated into big moves for Valero (VLO), Tesoro (TSO) and CVR Energy (CVR), but instead we've seen the refiners lag throughout most of the year. 

What happended? Two things: A domestic glut that was slow in clearing and the cost of Ethanol credits. One of them – the glut - has been getting better, while the other is getting worse. And this continues to hold me back from getting excited about refining stocks going into 2017.

Let's look at this big hurdle to independent refiners right now, the Ethanol credit (Or RIN) game.  President Bush signed the Ethanol and Biodiesel program into law, designed to make the US more energy self-sufficient. It outlined a minimum use of biofuels as a blend to gasoline, with a scheduling program that would ratchet up the percentage of Ethanol in motor fuels as time passed.  We could talk about the misguided purpose of the law, because blending ethanol into gasoline does little to move this country towards energy independence, nor does it help at all, on balance, in emissions.  

Instead, let's just talk about the program, which mandates an increase in the amount of ethanol (or other biofuels) that needed to be blended into gas every year. This is an immediate problem, because the program does not take into account how much gasoline is actually being refined. And as blending mandates continued to mechanically increase while gasoline production in the U.S. didn't grow much, refiners are looking at the forced blending of a mandated amount of biofuel that has outrun the supply of refined gasoline being produced.

How much has it outrun it? EPA mandates are currently at 10.5% of gasoline, above the auto makers recommended MAXIMUM of 10% of ethanol in order to keep engines running properly. In essence, the EPA is currently mandating you to use fuel that is bad for your car.  

Of course, the refiners don't actually need to use all that ethanol, and they don't. They can, instead of actually blending ethanol into their gas, buy ethanol credits (RINs) that count towards the EPA program. The idea is that some refiners exceed their ethanol mandate and can sell the rest of their excess as credits for someone else who prefers not to blend up to the EPA directive. RINs have become a market in themselves, and as independent refiners don't make ethanol, they're far more likely to want to buy RINs to fulfill their EPA requirements, as opposed to finding and blending ethanol.  It's more cost efficient, as well. 

But credits are getting dear and the prices on RINs have soared: Since spiking in 2013 from under 25 cents a gallon to nearly $1.50 a gallon, prices relaxed a bit in 2014 and 2015. But again in 2016, as EPA mandates continued to increase, the RIN market began spiking again towards a dollar a gallon.(Where is the RIN ETF man?).

The major beneficiaries of this market spike have been the major integrated oil companies.  Because credits are generated where gasoline in blended, oil companies with a strong retail presence with gas stations are always ahead of everyone else in accumulating RINs. When Valero and Tesoro go into the open market to buy RINs, they are often coming from Shell, BP and Chevron. Independent speculators have also been getting in on the action, trading RINs like Super Bowl tickets and helping to spike prices. For the majors, these extra windfalls on RINs aren't spectacular in moving their bottom line, but for refiners they pose a major hurt: Valero estimates a cost of up to $850 million this year for RIN's, PBF Energy claims their costs will be near to $300 million.  

And the problem really is that these numbers are only going to get worse as the EPA's schedule on ethanol blending continues to automatically ramp up. Without a change in the program, RINs must inevitably get ever more expensive and continue to drain the profitability of refiners.  

Washington has shown a certain understanding of the ridiculousness of the Ethanol program as it currently stands; the Obama administration relaxed the standards once, although we see the mandates again outrunning gasoline production today. Conversely, Washington has shown little appetite for scrapping the Ethanol and Biofuels program completely – with the optics of an abandonment of environmental sensitivity. But something more permanent needs to be done – if this pace of ethanol blending is allowed to continue to increase, weaker refiners are literally going to be put out of business

And until something is changed, even large independent refiners continue to represent a difficult investment, even as they have benefited from low oil prices.

Final Word: The Election Represents a Clear and Present Danger to The Stock Market.

Whatever your politics, if you are like me and want to continue to double my portfoilio every 2.5 years with equities (and some well timed option plays) you gotta understand that the walking talking human hand grenade Donald J Trump is HAARIBLE for many sectors of the stock market. I will go over our options in an EARLY November pre-election newsletter...but if you want to vote purely on your portfolio...then the much less risk vote is unfortunate Secretary Clinton.

Again...don't shoot the messenger...just stating a fact that was proven today in the real markets

Have a great weekend and Happy Halloween!

- Toby

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