Weekly Update: 2.9.18

February 9, 2018 Tobin Smith

"A Bottom but not THE Bottom IN"--No Shit!

Dear Subscriber,

I wish I was at the Capital Grille just up the street from NYSE with my old buddy Art Cashin today--we would be more than 2 whiskeys in by now (I met him when he was the Paine Webber floor broker in the early 80's...he started with them in 1968!). On Tuesday I reported Art's note to you where he said "What we want to see is a woosh down below since 100-day ...The S&P 500 hasn’t closed beneath its 100-day average for 15 months, its longest streak since 1996. THEN we want to see a counter rally off that bottom...and another "sell the rip" plunge and THEN see if that bottom holds. THAT is how bottoms are made."

Well we got it...and it did not hold. I think Art (and certainly I) did not really accurately measure the size and spread of the latest equity market contagion: massive leverage shorting volatility and massive rebalancing required by various volatility instruments and financial products.

But we DID get that trading action on the 200-day which is REAL long term trendline in the sand. It makes sense that we drop below the 200-day for few trading days in the next few weeks because the S&P 500 index was 18% ABOVE its 200 day moving average in that unsustainable January retail driven FOMO melt-up (which is why if you recall those glory days on two weeks ago we raised cash and hedge our portfolio with put options against the 2X leveraged TQQQ which mostly covered ALL our downside from this crash thank you very much!)

Key point: The VELOCITY aka the rate of the rate of change in market price momentum in the last 8 trading days is ALL-TIME historic. Not the $amount...the rate of momentum as measured by the RSI--relative strength indicator: From a pure momentum rate this dive was faster than 1929 crash, 1987 crash, 2000 and 2008 crash.

And what did these high velocity momentum reversals have in common? They all were created by holding big economic "balloons" under the water until the got so big they ripped off the shackles holding them down and they exploded UP above the surface and blew up into the atmosphere of the equities market.

LUCKILY this balloon was only $500 billion (not $120 TRILLION in mortgage derivatives and other wacky financial products owned by 40-60 to one leveraged banks and hedge funds).

BUT LET US NOT MAKE THIS KILLER MISTAKE: WE ARE IN THE FINAL LEG of the Bull Market

#1 Critical NEW macroeconomic and securities valuation and equity risk rising information HAS COME into the market and HAS to be priced into stocks and bonds
#2 MASSIVELY leveraged institutional and retail investors completely leveraged on the wrong side of equity risk repricing AND volatility risk securities and products did get wiped out and ALL the dead bodies have NOT risen to the top yet.

Barclays analyzes that some investors got a $200 billion lesson in what "volatility" really is; let me give you the ONLY lesson you need.
REALLY KEY POINT: I learned this very important concept at a lecture from Robert Engel, Nobel Prize winner in Economics and who invented the math and concept behind the trading volatility measure we now call the VIX: When asked "what is the real super simple definition of "volatility?"

His answer: "Volatility is the natural response in financial asset markets to new macro or micro economic information." The SCALE of that new information and the certainty/proof of that new information is a multiplier to volatility. For example, if one member of the S&P 500 files bankruptcy, they go to zero but the effect on the S&P 500 index is only temporary and relative to that stock's weight in the index.

But if the new information that requires a natural response effects the discounted present value of ALL the $155 per share earnings of the S&P 500 forecast in 2018 and $170 of SP 500 earnings per share in 2019, then ALL the S&P 500 values need to be repriced.

So what this volatility transforming "macro" information? It is the now CERTAIN rise in short and long term interest rates (bear market for long term bonds) and certain monetary policy stimulus reduction by the US and European Central Banks due to rising rates of GDP, wages ,capacity utilization and thus CPI price inflation.

As I will get into in a moment...we face significantly MORE VOLATILITY ahead and VERY SIGNIFICANT "economic information" is going to slowly HAVE TO GET PRICED into stocks and bonds. And when THAT starts we will be LONG GONE from risk assets.

Look: This all started because we never have HAD all major Central Banks create $15 trillion of new money via bond purchases that made bonds guaranteed losing investments and stocks (and other asset classes) the only investment game in town (i.e., Quantitative Easing aka buying huge amounts of bonds to bring interest rates to ZERO and keep other asset class values from crashing post-2008 Great Recession).

Therefore we never had to analyze what would happen if the US Fed (and soon the ECB) started to sell off their $15 trillion portfolio of bonds...the process has started but at a glacial pace. The markets really thought that this process would be so slow as to not add risk to the equity markets.

No longer... I can now see the day of financial reckoning is drawing closer than I thought previously.

I have been looking for inflation and the Fed reaction oo kill this bull market mid 2019. NOW I think we are at significant risk of that time frame compressing. Not tomorrow or next week. But I know with complete macroecomic certainty:

#1 The present value of risk assets' now have to be repriced lower to reflect the now certainty of higher interest rates for no-risk short and longer term US bonds as well as corporate bonds up and down the risk curve
#2 This means a return to normal rates of daily and weekly price volatility because of the certainty of higher NPV discounting...volatility risk is being repriced HIGHER because volatility WILL BE HIGHER with interest rates rising. The only game now is to guess how fast they rise.
#3 There is still uncertainty as to just how much impact the corporate tax cut (aka FISCAL macroeconomic stimulus) will actually bring to corporations to offset a higher cash flow discount rate. BUT we have NEVER added $1.5 trillion of fiscal stimulus to our economy while it is getting to maximum employment and capacity. This is time in an economy when we normally would be paying OFF debt we borrowed to juice the economy in a recession...but we instead are now adding $2 trillion of fiscal stimulus per YEAR to the U.S. economy for the foreseeable future. (see below). The 3.2% unemployment rate and lack of capacity in ALL key areas of the consumer economy is brewing and THAT IS SHOCKINGLY INFLATIONARY but right now...these inputs are coming in gradually.
#4 We don't know other major countries will will cut their corporate taxes to respond...but we know they will. Fiscal moves made by the United States HAVE to be countered by our trading partners.

AND of course we have the most basic rule of ANY asset class pricing/valuation:The higher the volatility, the riskier the security is relative to no-risk Treasuries. THUS... the riskier a security is relative to no-risk bonds, the more price sensitive that security becomes and more that higher risk premium discount is priced in stocks. In other words, stocks have been priced for little risk of loss. We are at the 7-8th inning of this expansion cycle and then BOOM stocks were repriced (with this 20% move in January) as if we are still in the 3-4th inning of earnings and revenue growth.

WE are NOT in the 3-4th inning of this expansion. For some stocks...the ones we own...we ARE in 2-3-5 secular growth sectors that WILL produce 20% top and bottom line growth. BUT for the entire market to be priced like secular growth companies? That is like every kid in America getting a trophy...sorry...all sectors and companies do NOT DESERVE the low volatility 18-20 p/e trophy. And your ugly kid...sorry...he/she IS ugly.

Really Key Point: Denial and HOPE are NOT an investment strategy...they are emotions. Like I said last week--the gush of retail FOMO money that drove our portfolio up 20% in January was TOO MUCH...they in essence pushed forward two years of market returns and valuation in ONE MONTH. THAT I said was "unsustainable"... and would have to be corrected out of the market otherwise the air was too thin for stocks...a correction HAD to occur.

We raised money and added the TQQQ put options (I realize many of you bought other put options as well-kudos!) I however did not think the necessary correction would rear its ugly head in the next 5 trading days.

The NEW NORMAL IS HERE and it is RISKIER and MORE VOLATILE--and WE HAVE TO GET PREPARED to BAIL on Risk Assets

We have talked about for years about WHY stock market volatility has been so low: Where's the risk when the world's central banks made risk-free bonds guaranteed to LOSE money (ie negative rate bonds in UK/Euro/Switzerland and Japan)? With bond returns negative or break even after inflation the "risk premium" for stocks--the risk and volatility adjusted return institutional investors want for taking the higher risk of risk assets, has been dormant.

It Is NOT dormant now. Now what happened is we got a tsunami of $200 billion+ of forced selling of volatility derived quities "The turmoil in global equities has spurred a wave of deleveraging among volatility-targeting funds that’s set to unleash $225 billion of equity sales in the coming days, according to Barclays Plc"

NOW you understand the shit show: Like I said early this week this selling was cashiered forced selling and index rebalancing...all forced.

The Hidden Time Bomb that REMOVED A BID from ALL Index Stocks: But actually (upon digging deeper) more than $500 billion+ of assets are tied to funds that target a given level of volatility -- two-thirds of which are traded by automatic computer algorithms loaded to divest stocks IF they moved past certain VIX levels. Well...After Monday’s puke out of stocks because of explosion of the VIX to 50 (from 10 48 hours earlier) and then Thursday's eruption of turbulence, the "risk parity" algorithms kicked in and suddenly there was no marginal/market order buyer on the bid.

THEN...frightened retail investors who just weeks ago bought the TOP of the melt-up panicked and placed market sell orders for their Index funds. Those index funds HAVE TO BY LAW re-balanced their portfolio starting at 3.45- which in a no market bid market and sell-stops being hit was why we had the late afternoon DIVES down 400-600 points. That was about $50 BILLION of market sell orders too (based on data of index and mutual fund outflows).

The GOOD news is the highly leveraged "Sell the Vol" trade and traders blew up and they are mostly gone. We dodged that bullet.

Today the massively and historically oversold market found a bid from REAL human investors bargain hunting AND the momentum bots saw the 200-day hold and assumed the end of day rebalancing WOULD HAPPEN so a real bid finally came into the market at 3.15 and then BOOM the rebalance orders hit and BANG the melt-up of market orders aka market bids from the marginal buyers.

Key Point: Risk premium fundamentals may have started the sell-off LAST Friday with the hot 2.9% hourly yoy wage increase (which raised 10-year yields to 2.85%/crushed bonds) but it was the new exotic kid on the block that caused this crash (just in 1929 when 90% margin calls for retail investors got called...like in 1987 when the bullshit "portfolio insurance" scheme that had funds SHORT futures which created MORE selling which created a negative feedback loop of falling prices and 22% drop on Oct 19 or September 2008 when 120 -to-1 leveraged Lehman Brothers collapsed with $2 trillion of bad paper, notes and mortgage backed securities infected and locked up the entire highly leveraged world of finance and $120 trillion of derivative counterparty exposure) .

The bastard financial Frankenstein new kid on block this time: Volatility-targeting investment strategies and 2x-3x Daily long and short VIX funds and 2x-3x daily long/short SP 500 and Nasdaq 100 indexes (our favorite TRADE the TQQQ) have become extremely popular spurred by the "easy money" to be made "selling volatility" against the market calm of QE Everywhere and of course the equity bull run created by making bonds and cash riskier than owning stocks.

I love this note:: “As market sell offs and expected volatility increase, these funds decrease their leverage to equities,” strategists led by Maneesh Deshpande wrote in a Tuesday note. Although the specific inputs aren’t known and differ between managers, the leverage taken by quantitative funds in the run-up to the global selloff "was likely quite high given the low levels of volatility."

Ya think?

The Beginning of the Beginning of the End of The Great Equity Quiessence is Here

This is not over. There is plenty more worry to come. We get the CPI number Wednesday and even if it is not hot, the next one will be I guarantee it. I will put out a small PUT OPTION play Monday or Tuesday for those who want a hedge. The market will be jumpy...the nerves are still raw trust me.

#1 Last week's wage numbers understate the boost to spending power that many consumers have gotten or are just seeing. One-time bonuses, like the ones that companies announced following the tax plan’s passage late last year, don’t get included in average hourly earnings. And many of the companies that said they would raise wages hadn’t done so by mid-January when the Labor Department was collecting employment data. Walmart ’s wage increases, for example, start this month.

The tax cut will help boost wages in two ways. Starting this week, workers begin to see lower withholding in their paychecks, meaning more cash in their bank accounts. At least some of that is going to be spent, boosting demand and prompting companies to hire more workers to keep up. The second impact will be businesses, who got the biggest chunk of the tax cut, using some of their windfall to pay higher wages to get the workers needed to meet the higher demand.

All this is happening in a tight job market where wage growth is finally starting to kick in.
Key Point: JUST on wage growth itself and import inflation (falling dollar in a rising rate environment?) the Fed may decide that even four rate increases aren’t nearly enough.

BUT the Fed does NOT DRIVE the $60 trillion BOND market...the BOND MARKET drives the 2-5-10-30-50 year sovereign bonds and corporate bonds. And judging by the prices of the interest rate swaps/insurance I follow (I won't bore you) ...the smart money is starting to pay more to "insure" their bond prices. You don't do that if you expect a benign interest rate world.

#2 America has just put another $1.4 trillion of borrowing (the tax cut) on top of $650 billion to pay for unfunded entitlement spending and now just signed a 2 year Federal Budget that adds ANOTHER $300 BILLION a year for the next

The budget deal changes almost everything you should expect from and because of Washington.

Combined with the big tax cut enacted last December, this new agreement is such a departure from the past in terms of economic policy and American political culture and puts in place such permanent changes in taxing and spending that the deal is likely to be used by historians to mark the point when the federal government lost its FUCKING MIND and we as a country began the new normal.

This new normal includes the following.

1. A New Era of Higher Interest Rates. With financial markets now wildly gyrating at least in part because of an expectation of higher interest rates from the tax bill-caused larger budget deficits, it's safe to assume that traders will look on the even higher permanent deficits from the budget deal as more fuel on an already raging U.S. economic fire. Monetary policy will be expected to offset the fiscal stimulus with higher rates. It's hard to imagine that stock market growth will be as great as it has been over the past decade if less risky bonds provide a decent risk return.

2. Permanent Trillion Dollar Deficits. The fact that the federal deficit will now be at least $1 trillion a year is already common wisdom in Washington . But what hasn't yet made it into the political conversation is that these will be permanent trillion dollar deficits rather than temporary spikes that result from economic downturns. These deficits will be the result of legislative increases in spending and reductions in taxing that for political reasons will be impossible to change. We have 10,000 Americans turning 65 EVERY DAY and 4000 turning 70 EVERY DAY and only 10,000 Millenials turning 21. We have a government REDUCING 1.2 MILLION of the hardest working people in the world...immigrants from shithole countries willing to sacrifice everything for their kids.

We only have 2.2 workers to pay the payroll taxes per beneficiary. Our birth rates and immigration rates do NOT SUPPORT $1 trillion deficits for decades to come. AND the bond market won't put up with this insanity either because a one $trillion deficit is bullshit lie that the markets will sniff out very quickly.

3. The New Normal is a $2 Trillion Deficit. On top of the tax cut, the new budget deal means the federal budget deficit in 2019 and beyond will be closer to $1.4 trillion than $1 trillion, and that assumes the U.S. economy continues to grow strongly, that there's no new overseas military problem, that natural disasters are limited and that interest rates don't spike. There will also be new demands on Washington for non-emergencies -- everything from retirement to infrastructure to health care. Whenever they happen, a $2 trillion deficit shouldn't shock anyone.

3. Interest On The Debt Will Be The Fastest Growing Part Of The Federal Budget...By Far. Forget Medicare, Social Security and the Pentagon: $1 trillion-plus deficits means massive increases in the national debt and that debt will have to be borrowed at higher interest rates (see #1). Add the need for the Treasury to roll-over existing debt at higher and higher rates and you get an immediate increase in the amount the U.S. will need to spend on interest each year.

4. Forget About Ever Balancing The Budget. In fact, also forget about even projecting a balanced budget 10 years from now as Congress and the White House like to do. A $1 trillion deficit in a total budget of about $4.5 trillion means that spending would have to be cut by more than 22 percent to get to balance. But with interest on the debt and military spending at about $1.3 trillion and not going to be reduced, the amount available to cut drops to $3.2 trillion and the percentage reduction increases to more than 30 percent. Economic growth, which is already projected to be high, isn't going to make up the difference.

Bottomline: A balanced budget isn't going to be possible and any pretense that it is will be dropped by anyone who is NOT a partisan hack and especially the bond market. Remember the Bond Vigilantes? They are warming up the horses.

5. This Is The End Of The House Freedom Caucus' (And Others) Fiscal Hawks in DC. The House Freedom Caucus, which made spending cuts its reason for living, is toast. Today we add The Tea Party, the Committee for a Responsible Federal Budget, the Concord Coalition and all the other deficit scolds. They are totally irrelevant. The deficit Senators are quitting and Rand Paul is Don Quixote without the balls...he cries and moans and yet votes the party line.

6. On Monday we get a $1.5 trillion infrastructure bill...and bill that does NOT HAVE A FUNDING mechanism other than creating new borrowing capacity for lending entities with government guarantees.

WE HAVE A PRESIDENT who built and lost a fortune on borrowed money and is NO conservative despite the act he performs on 24/7 Trump TV.
We have Democrats so thirsty to put a dagger in Trump's heart they will promise EVERYTHING to EVERYONE to get the House and Senate back.

The economic realists are leaving DC, barking at the moon and the STOCK and BOND markets will soon have to price equities and bonds for the American financial catastrophe we just put ourselves on course for AND a Federal Reserve that has NO BULLETS left to add monetary stimulus to the American Economy who will soon be a $20 TRILLION GDP with a stock market at a value 150% of our GDP and Federal and Household debt at 225% of our GDP by 2022.

Our Strategy: IS TO MAKE MONEY on this insanity with the best sectors and stocks in the world. If I knew the week or month that the financial shit hits the fan I would tell you and we would go to cash and get short. WE WILL be using strong up markets to reduce stocks exposure on the next ride up for stocks...and IF we don't hold key support levels or pass them and then fail we will trade puts and SELL CALL OPTIONS on our positions to reduce cost and risk.

But financial and fiscal denial is profound in America (like all countries) because 75% of our country is (according to Edelman Agency polling) is un/under educated and really only 20% of American households have real money attached to the stock and bond market. The country and the markets can remain in denial for months or years as long as Main Street economy stays at high rates of approval on the economy and sentiment.

BUT IF THE STOCK market IS a hostage now to the bond market yield...and IF higher wage growth and CPI is a clarion call for the FED to react strongly to nip inflation in the bud...and IF the global bond and currency vigilantes take the U.S. dollar lower (inflationary) and won't bid on the $2 TRILLION of new debt per YEAR we have to sell (not to mention the $20 trillion we have to roll over in the next 10 years at 2X the effective 2.2% rate we pay now) we are NOT going to take the risk of this new game of bond and stock valuation chicken.

Sorry to send this news...but it's important. NO REASON to panic, there will be upside in many of our positions and some AMAZING trades to be made.

We NEED to see how many "dislocations" a Wall Street remaining dead bodies, forced selling and the FOMO late to the party retail investors who poured $50 billion into ETFs and who have lost their nerve (aka "weak hands).

More to come...sorry to scare the crap out of some of you...but what just happened in the Congress and White House and what is coming is NOT going to be ignored by the Fed. Mr. Trump does not understand yet that he could fire the new Fed Director if he raises rates but all the others who would replace him would do the very same thing. They will be reading the data that you and I are and the rest of the markets will be. We HAVE time but I AM going to err on the side of caution as the inflationary data comes in.

The stock market return since 1989 is 7%. At nearly 300% total return since 2013 we have nearly 42 YEARS of stock market wealth gained in just 5.2 years. I am NOT GOING TO RISK THAT WEALTH for another 30% IF what I see happening to our macroeconomy continues to go down the path I just described.

I just hit my 40th year in and around the capital markets. Many lessons learned...biggest one is capital may be owned by right wing or left wing folks but the capital markets are agnostic. Bull markets rise on a wall of worry that is too worried about cyclical growth because they don't understand fiscal and monetary policy and macroeconomics. But the smart money in the capital markets will see what I see and smell what I see WAY ahead of the crowd. I promise that you and your family wealth will BE WAY AHEAD of the crowd.

Peace out.

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