Welcome to the Vitus Capital Blog!
Notes to myself, possibly of interest to others.
-- Bill Northlich

Tuesday, October 9, 2018

Jeff Saut 10.8.18

...according to our models the past two sessions were pretty critical in that they should have vaulted to the upside and that just has not happened. This lack of direction, and subsequent failure to foster an upside breakout, makes us have to consider that on a trading basis, the mid-November energy peak, instead of being an upside inflection point, may just mark the end of a downside reaction low. Accordingly, we are recommending selling some trading positions, yet we are undeterred on our secular bull market theme that has years left to run...

Clearly, interest rates have been rising because of the strong economy and the concurrent decent economic numbers. Take last week’s employment report. The last time the U.S. unemployment rate was 3.7% was in December 1969 as the economy was overheating, inflation was soaring, and a recession was soon to follow. Could that happen again? It is very unlikely in the near term, as the Present Situations Index is definitely not telegraphing it. However, fears of such a sequence materialized last week, causing a slide in stocks. As for support levels, the SPX’s 50-day moving average (DMA) is at 2876 and the 100-DMA is at 2817. We do not expect this zone to be violated on the downside.

One stock that has become of interest to us, because we have numerous portfolio managers mentioning it, is Viking Therapeutics (VKTX/$15.57/Outperform). As our fundamental analyst writes:

Viking Therapeutics, Inc. is a clinical-stage biopharmaceutical company that engages in the development of novel therapies for patients suffering from metabolic and endocrine disorders (read fatty livers). Its clinical program, VK5211, treats patients recovering from non-elective hip fracture surgery. It also specializes in development of VK2809 and VK0214.

The call for this week: Our short-term model registered a “soft” cautionary signal after Tuesday’s closing bell. The McClellan Summation Index is below zero for the first time in six months and has also turned negative with stocks near their all-time highs. Meanwhile, the NASDAQ 100 closed below its 50-DMA for the first time since May (chart 2, page 3). That is likely driven by the FANG stocks on the revelation that China has implanted tiny “spy chips” in many of the FANG stocks’ servers (chart 3, page 3). Support levels for the SPX are the 50-DMA at 2876 and the 100-DMA at 2817. We do not expect this zone to be violated. However, even a pullback to 2817 would not “dent” this secular bull market. This week there is a fairly strong negative energy blast due, but it should subside by week’s end.
Chart 1

Click here to enlarge

Source: FactSet
Chart 2

Click here to enlarge

Source: Bespoke Investment Group
Chart 3

Wednesday, October 3, 2018

Jeff Saut 10.2.18

As mentioned on numerous occasions, if nothing else, if investors only understand and appreciate the following, they will always be on the right side of the market and will never be influenced by others’ opinions or news headlines:
  1. Investors must understand the role of the U.S. central bank (the Fed). The U.S. Federal Reserve System was created in 1913 to perform all roles monetary, but one of their key statutory (written in law) mandates is to “To maintain orderly economic growth and price stability.” This agency has more and better information on the economy than anyone in the world. It was not created to promote hyperinflation or to create depressions. The Fed’s key mandate must be clearly understood and appreciated.
  2. The stock market is a leading economic indicator. The economy does not lead the stock market. Hence, once these two points are clearly understood and remembered, the market’s logic becomes apparent. Hence, when the economy slows and heads into a recession, the Fed will ease and will keep easing until the economy responds (remember, that’s their mandate). The stock market, being a leading economic indicator, will have bottomed 6-9 months before the recovery begins, not after. For example, "the market" bottomed in October, 2008 and the recession ended at the end of June, 2009 and a [market] recovery commenced, eight months ahead of the [economic] recovery. Conversely, when the economy overheats; inflation surges; and speculation is rampant, the Fed will tighten by draining liquidity from the system and raise interest rates in an attempt to cool the economy. The stock market, being a leading economic indicator, will head south long before the onset of a slowdown or recession, not after. This chain of logic is so simple that anyone with an IQ slightly above room temperature would understand it. Yet, most on Wall Street with umpteen degrees and decades of experience can’t figure it out.
  1. The economy is in bad shape; jobs are hard to find; and headlines are black. Capacity utilization plunges. Talk of depression is widespread. The talking heads will declare “this time is different. They (the Fed) has lost control.”
  2. Investors are crying the blues as their portfolios are showing huge losses. Worldwide, investors panic and a sense of despair and hopelessness prevails. Brokers are sleeping like babies; theywake up every hour and cry.
  3. The Fed eases by injecting liquidity into the system and lowers the Discount rate three or more times in succession and will keep easing until the economy responds.
  4. The Classic Yield Curve (13-week T-bill Yield vs. 30-year T-bond Yield) starts to steepen (short rates below the long rates).
  5. The interest-sensitive sectors such financials, bonds, preferred shares, utilities bottom and start to head North while the major market averages continue to head south. Mesmerized by the decline in the market indices, investors are unaware that a “rolling” bottom has begun.
  6. As the Fed eases further, the growth and consumer discretionary issues bottom while the major market averages move yet to new lows.
  7. The market becomes grossly undervalued.
  8. Investors are sitting on a mountain of cash and hold little equities. They have no appetite for stocks.
  9. A selling climax occurs as investors panic. Seized by fear, investors “throw the baby out with the bathwater” as they can’t bear the loss anymore and are convinced the world will end. An emotional catharsis occurs and stocks move from weak hands into strong hands.
The bear market ends and a bull market begins.
  1. The economy is booming; workers are hard to find; and headlines are glowing. Capacity utilization is running full tilt.
  2. Investors are euphoric and the stock market becomes topic du jour at cocktail and dinner parties. Waiters, taxi drivers, bartenders, and shoeshine boys are giving clients hot tips; they think they are market mavens. Everyone is a genius and have the keys to Fort Knox.
  3. Euphoria reins. Investors are heavily invested in equities and hold little cash.
  4. Stock brokers, confusing their own genius with a bull market, buy Ferraris and Lamborghinis and dine in uber expensive restaurants.
  5. The economy overheats, inflation surges; and speculation is rampant. Consequently, in their attempt to cool the economy, the Fed tightens meaningfully by draining liquidity from the system and raises interest rates numerous times.
  6. The market becomes grossly overvalued.
  7. After a long period of flattening, the Classic Yield Curve is inverted (short rates higher than long rates). Then, as the economy deteriorates, the yield curve starts to steepen (short rates start to move below the long rates).
  8. Interest–sensitive sectors such as financials, bonds, preferred shares, utilities along with consumer discretionary, start to head south. Meanwhile, dragged up by the late-cycle issues, the major market averages keep moving to new highs. Investors are lulled by the new highs in the market indices, not realizing the broad market is already heading into a bear market. Not surprisingly, the various Advance-Decline Lines start to head south 3-6 months before the major market averages. New Highs start to contract and New Lows expand.
  9. Finally, the major market averages top and join the rank and file by heading in a southeasterly direction.
The call for this week: We are on the West Coast seeing accounts, speaking at conferences, and doing gigs for our financial advisors and their clients. If past is prelude the markets will do something in our absence. Unsurprisingly, last week we received no less than 30 emails about the ten Hindenburg Omens that have been registered over the past two weeks (read: telegraphing a stock market crash). That indictor, however, is being triggered by the selling of interest-rate-sensitive ETFs and closed-end bond funds. Meanwhile, as we wrote last Friday:
“[Next] week we could see more powerful upside energy, but at this point it’s not looking all that powerful either. It’s more likely we’ll see more energy come into the market as we get closer to the [mid] November energy peak.”
Quite frankly, given the low energy mix stocks typically “drift,” which is exactly what happened last week as we suggested. It may be more of the same this week, but should develop into something more powerful to the upside over the next few weeks. As a sidebar, the recent changes in S&P sector weightings are worth mentioning. Of particular note is that Telecommunication has gone from a 1.98% weight to a 9.9% weight (see chart below).
Yesterday, the equity markets caught an unexpected tailwind, although we have repeatedly said Canada was going to “blink” on NAFTA, and we think China will do the same. Evidently, the equity markets expect the same, but yet the equity markets could not hold on to yesterday’s gains into the closing bell. That is consistent with our upside “drift” call. Of our unpublicized letter yesterday, which is being published today, a day late, we stand by this strategy and embrace our upside trading target of 2980 – 3000 despite “calls” of this is JUST a range-bound stock market . . . GOOD GRIEF!

Very quick, very dirty history of the crisis

Misunderstanding Credit and Housing Crises: Blaming the CRA, GSEs  #10YEARSAGO  ritholtz.com/2008/10/misund…

ibilln's avatar
Vitus Capital
Replying to @ritholtz

A GREAT new screed about the crisis!  Causes, motivations, etc. This should be made into a book!  Wait... One big thing - which is hard to discuss - is the factor of the structure of the debt. EG, the first big CDO championed by Blythe Masters at JPM /1

ibilln's avatar
Replying to @ibilln @ritholtz

...started out not matching it's performance profile.  IE, beating your model of piles of disparate financial vehicles into something that fails along a Bell curve is, um, hard. In fact, CDO's in general never worked.  The -substance- of the crises was that shadow banks 2/
ibilln's avatar
Replying to @ibilln @ritholtz

and regular banks were caught in a downdraft in 2007 when they all, knowing what kind of assets they all had, stopped short-term (repo) loans to each other. More bluntly, they knew that they all were a blink away from insolvency  All due to misunderstanding normal distributions/3

Thursday, September 6, 2018

Jeff Saut. See "Call for this week" at bottom

The Endless Summer  September 4, 2018
The Endless Summer (1966) is the crown jewel to ten years of Bruce Brown surfing documentaries. Brown follows two young surfers around the world in search of the perfect wave, and ends up finding quite a few in addition to some colorful local characters (Endless Summer). Well, summer has officially ended with the Labor Day celebration. Traditionally, for Americans it marks a change in attitudes and latitudes, from leisure, play and vacation, to work, school, and more serious attitudes. With the entrance of fall comes September and October. While October is considered to be the “cruelest” month for investors, September is actually the worse month statistically for the stock market. That said, October has been the most spectacular with two crashes, the end of the 1990 bear market, the “Crashette” of 1989, and a few nasty setbacks in the 1970s. We reflected on the endless summer on our recent six hour plane ride from San Francisco. Our problem was that we were sitting next to a person who did not bring any reading material. All he wanted to do was talk. In a bar, or other situations, we are always able to get up and move to another location, but on a plane you are trapped. Normally, when confronted by someone who is interested in talking, and asks us what we do, we tell them we are auditors for the IRS and that usually ends the conversation. Failing that, we revert to writing and tell our inquisitor we have a deadline and cannot talk. Thus defensive writing was invented.

During the plane ride we also recalled some comments from our departed friend, Ray Devoe, who was considered to be one of the best writers, and best strategists, on Wall Street. It was back in 1997 that Ray wrote:

Against the Gods by Peter Bernstein is probably the most difficult books I have ever read. Not that the style or content makes it hard to read, but so many points made by Peter got me thinking extensively and then writing out lengthy notes to myself about the points he made. Perhaps “difficult” is not appropriate – if “time consuming,” “provocative,” and “thought inducing” could be rolled into one phrase that might do it. Throughout the book he makes the point that risk cannot be avoided, only shifted. This is not a book that “New Era” investors would enjoy. One quotation that every new investor should keep in mind is, “At the extremes, the stock market is more likely to destroy fortunes than make them. The stock market can be a risky place if one does not manage risk.” This will come as heresy to those who believe that 1) the only risk is being out of the market and/or 2) there is no risk in stocks held over the longer term, only short-term volatility.

The book states unequivocally that individuals are risk averse financially. They will always attempt to avoid risk WHEN THEY ARE AWARE THAT RISKS EXIST. His conclusion is that “Losses will always loom larger than gains,” which has been reinforced by behavioral scientists. The public may have one attitude about pain when paper profits are being eroded, but when actual losses are incurred the pain can become physical. I know this from personal experience. Steve Leuthold’s “Perception for the Professional” cites financial behaviorists Amos Tversky and Daniel Kahneman, who have estimated that the pain of losses is over three times as great as the pleasure from gains.

We revisit Ray Devoe’s sage writings this morning because we continue to stress how important it is to “manage risk.” We emphasized this point following the Dow Theory “sell signal” of September 23, 1999, and again with the Dow Theory “sell signal” of November 21, 2007.

Most recently, we advised that trading types raise some cash in January of this year and then put that trading capital back to work in early February after the ~10% decline. Further, last Tuesday we wrote:

It would not surprise to see the S&P 500 stall around the 2900 level, but eventually it is going to poke through 2900 and travel above 3000, which we have said repeatedly was going to happen in these missives since the February 9th undercut low. And, while the short-term market energy has been used up, there is still plenty of intermediate “internal energy” built up to power things higher.

Yet last week the equity markets did indeed “stall” and our sense is the “energy mix” is likely going to continue to keep the equity markets in stall-mode for the near term. However, since the February 9th low (2532) the S&P 500 (SPX/2901.52) has not stalled, crashed, or even stayed range-bound. Indeed, since that February low the SPX has gained some 15%, but the gains do not stop there. The technology sector has advanced 19.9% YTD, the consumer discretionary space has improved by 18.1%, and healthcare is better by 11.7%. Those have been our favored sectors, but alas our other favored sector, namely the financials, has lagged (+0.9%), which is a real surprise because the financials are just plain “cheap” (Chart 1). To reiterate, the way we suggest investing in said group is through the David Ellison funds (Hennessy Financial Funds) and Anton Schultz (RMB Financial Services Fund). Of course the sectors we have shunned, telecom, consumer staples, and utilities, have materially underperformed (Chart 2).

Also of note is that the SPX just had its best summer (May – August) since the March 2009 lows with a gain of 9.25% and we have been bullish. Moreover history shows that when the SPX is up 5%+ through August, the scary month of September has shown a positive return (Chart 2). Interestingly, with the SPX breaking out to new all-time highs, the stock market’s valuations are actually contracting. Given the excellent technical and fundamental conditions (Chart 3) it is tough not to be bullish! As we tend to do during earnings season, we screen for companies that beat on earnings and revenue estimates and raise forward guidance. They also must carry a positive rating from our fundamental analysts and screen well using our proprietary models. Two such names are: Analog Devices (ADI/$98.85/Outperform) and Splunk (SPLK/$128.15/Outperform). Another article we perused during our six hour flight noted, “Some 16.5 million passengers are expected to fly on U.S. airlines in the week-long Labor Day travel period, which started last Wednesday and runs through today.” That quip piqued our interest and caused us to look at the charts of the Raymond James’ airline research universe of stocks. The name that jumped out at us was Alaska Air (ALK/$67.49/Strong Buy), which is breaking out to the upside in the charts and has just turned green on our proprietary model (Chart 4).

The call for this week: Given the softer short-term internal “energy mix” it would be surprising if the SPX can initially vault above the 2930 – 2935 level immediately. Longer term, however, the energy mix is wildly bullish. Last week ALL of the Advance-Decline Lines we monitor registered new all-time highs; and, as the astute Lowry Research organization writes:

The balance of Supply and Demand remains positive, with the percentage spread between Buying Power and Selling Pressure reaching 31.1% this week, one of the most positive readings of the year and far above the 20.9% positive spread that accompanied the Jan. 26th high in the S&P 500. Thus, in terms of the key measures of Supply and Demand, this bull market remains healthy and with little of the evidence that typically precedes the formation of a major market top.

Friday, March 9, 2018

Noah Smith scifi books

Friday, January 26, 2018

Jeff Saut Call of the Week

Jeff Saut...  DoubleLine Capital’s Jeffrey Gundlach is recommending for 2018, namely emerging markets and commodities, themes we have been featuring for quite some time. Manifestly, commodities relative to stock are as cheap as they have been in a long time (see chart 1 below).

The call for this week: Friday’s option expiration usually leads to a lower Monday open for stocks on position squaring. That is what is happening this morning with the preopening futures down marginally. Our conversations with international accounts suggest they are more worried about the government shutdown than our domestic institutional accounts. Ergo, if stocks decline during the morning, look for a rally after the European close. The real question is, “Will U.S. investors continue to ignore the shutdown like they did in 2013?” 2800, 2767 (gap), 2750 (gap), 2736, 2723 (gap), 2714 (gap) on the S&P 500 Index are support levels.

Tuesday, January 23, 2018

Immigration - Noah Smith

A thread by Noah Smith

Immigration is the big issue in 2018. I've been writing about it for a while.

So here's a thread of articles, facts, and graphs that you can use in the immigration debate. First: Why immigration at all? Why do we need to bring newcomers into our country?

Economic reasons:

1. They pay for the retirements of the native-born.

2. They are highly entrepreneurial.

3. They help keep America the center of the world economy. (bloomberg.com/view/articles/…) Immigrants also help save declining towns, counties, and states. Immigration is the best hope for the Midwest and Northeast. (bloomberg.com/view/articles/…) Finally, Americans just LIKE immigrants.

The "nation of immigrants" thing isn't just elite propaganda. It's reflected in all the polls. (bloomberg.com/view/articles/…)
Now, let's address the arguments AGAINST immigration. The first argument against immigration is economic.

"Immigrants take jobs away from the native-born!"

"Immigrants lower native-born wages!"

Are these true?

Probably not. (bloomberg.com/view/articles/…) (bloomberg.com/view/articles/…)You may have heard that George Borjas of Harvard says immigration hurts native workers.

He does. But he's in the distinct minority. And the research methods he uses are often suspect.

The vast weight of evidence is against Borjas. (bloomberg.com/view/articles/…)The second argument against immigration is legal.

"We just want to enforce the law! We like LEGAL immigration, just not ILLEGAL!"

Well, guess what: The number of illegal immigrants living in America has actually FALLEN, not risen, over the last decade.
Furthermore, Americans favor a path to citizenship over deportation.

Enforcing the law is good, but most Americans agree it's not worth turning our society into a police state just to kick out people who live here.
The third argument against immigration is fiscal.

"Immigrants are a drain on government resources!"

As it turns out, all but the least educated immigrants are a net POSITIVE for government budgets. (bloomberg.com/view/articles/…)
The fourth argument against immigration is cultural.

"Immigrants don't assimilate!"

Well, yes they do. (bloomberg.com/view/articles/…) Today's immigrants learn English just as fast (or faster than) previous waves.

What's more, today's immigrants intermarry at very high rates - a sure sign that they're integrating into America. (washingtonpost.com/news/wonk/wp/2…)
What's more, immigrants' political attitudes are similar to Americans' attitudes.

Immigrants are not importing foreign values that are going to displace traditional American values. (object.cato.org/sites/cato.org…) The fifth argument against immigration is racist.

"Immigrants come from shithole countries, so they'll make America a shithole too!"

Guess what: Immigrants from poor countries in Africa and elsewhere do really well in America. (bloomberg.com/view/articles/…) There are also some arguments I haven't written about. For example, the idea that immigrants bring crime into the U.S. (False! It's the opposite: )
To sum up: There are many good reasons to keep letting immigrants into the U.S., and to let in even more than we currently do.

There are few good reasons to tighten restrictions.

Happy debating!

Friday, March 24, 2017

AHCA passage: Chaos and death, but not the end of the world

It looks like the AHCA will pass.  Fooey.

Well, it won't be the utter tragedy that we libs think it will be, but it will be bad.

Some quick things:

  • We will go back to healthcare circa 2008:  
    • Employer-paid for workers, wherein, mostly, one gets coverage for pre-existing conditions, some amount of pre/postnatal care, etc
    • Lousy, expensive insurance for individuals not covered by employer (self-employed, between jobs, laid-off, etc)
    • For the poor, emergency rooms
  • Medicaid will be canceled for all practical purposes..Some/many hospitals will probably go out of business, as they are not set up to handle the poor in volume
  • Some if not many Insurance companies will go out of business due to inability to estimate future customer flow.
  • It will be chaos for a year+ until it settles down
  • Many will simply die due to unavailability of health care.
  • Some states which can afford it, like California, will set up exchanges and mimic and maybe improve Obamacare.  This will be good for California, but nationally will add to the chaos.

The optimist in me says that if California splits with the national “standard”, it will point the way to a bright new future, with things done right.  But the reality is that, as usual, the middle of the country will be left behind, adding to the disunity already visible.

PS - if you are an economist, try modeling the California split.

Thursday, March 23, 2017


At some level, I'd like the current "AHCA" effort to succeed.  Yes, massive pain all across the land.  However, that would be the end of the GOP!


Maybe not.  The Koch's have mastered the art of gerrymandering.  It seems, enough money, anything can be gerrymandered.

The plan seems to be, after the "AHCA",  herd all the (surviving) "citizens" into a gerrymandered crypt, seal it off, and get on with the burning, pillaging, and grabbing them by the pussy that we come here to do.

Unless one or more of our fearful leaders steps up.  ...Really?

Unless there is a revolution.

Never thought I'd say that - ever.

Tuesday, March 21, 2017

Comey Notes

We think that someone - finally - has arrived to save us!  James Comey!

Not so fast.  Why do we think he's the good guy now?

When he threw the election by "reopening" the Clinton email investigation, he either did it on purpose or by mistake.

If by mistake, he's both incompetent and stupid.  So no saving by him.

If on purpose, he certainly has not - now - for some reason - gotten religion, seen the errors of his ways, and is energised and dedicated to helping us bring down the Orange One.  Ie, if he's not stupid, and if he's still there, he's just as evil as any of 'em.

IMO, he's playing us, seeming to contradict the Orange One, lulling us to sleep.  Meanwhile he sees his mission as placating the masses, letting the furor die down, giving the Orange One time to wreak greater havoc and depredation upon them masses, who deserve what they get, being neither FBI agents or rich muthas.

Yep, we are being played.  Paraphrasing Krugman, however bad you think it will get, it will get much worse.

Tuesday, February 23, 2016

Reasonable post by El-Erain. Note: "Tactical Component" ~= Momentum...

Last week, global equity investors got a much-needed reprieve from volatile, loss-inflicting markets. But rather than signaling the start of a calmer market phase, this may well prove a prelude to renewedvolatility in the weeks ahead.
After ending the last trading session of the previous week with a gain, global stocks got off to a good start last Monday. U.S. markets went on to post their best weekly performance since November, as two days of solid market rallies were followed by relatively calm consolidation. Markets in Japan and some parts of Europe did even better, registering gains of 5 percent to 7 percent.
There were four reasons for this respite from an otherwise horrid start to the year:
Attempts by central bankers, especially outside the U.S., to reassure markets; stepped-up negotiations among oil producers aimed at stabilizing prices; the rush by European banks to avoid joining the set of unhinged market segments by coming up with measures including repurchases of their securities; and some, albeit limited, positive U.S. economic news.
Yet none of these factors serve to significantly counter, let alone, overcome three much bigger and more consequential realities.
First, corporate earnings will be further challenged by continued signs of spreading global economic weakness and a persistent inability by governments to deliver the required policy responses. Last week, the Organization for Economic Cooperation and Development joined other international economic watchdogs in offering lower growth forecasts. It also noted additional risks.
Second, the continued ability of central banks to repress financial volatility is increasingly in doubt. The institutions that are willing to pursue such policies, particularly in China and Japan, are facing questions about their effectiveness. And more able central banks, such as the Federal Reserve, may not be as willing to do so, particularly given economic indicators suggesting that financial volatility has not contaminated economic activity and that wage and price inflation are starting to pick up.
Third, although a few days of market gains can force traders to cover their shorts, in this case, it does not seem to have triggered the return of the stabilizing role of long-term capital. Instead, it would appear from data about the flow of funds that markets still need to reprice considerably lower to find the anchoring inflow of significant patient capital.
Until these three factors change, occasional periods of market calm -- and, thankfully, there will be some -- are likely to prove frustratingly short. But this does not mean that investors should just reconcile themselves to passively riding roller-coaster markets that will likely create anxiety and may even force some, during large air pockets, to liquidate at the wrong time.  Instead, investors would be well advised to consider adding a tactical component to their longer-term strategic and structural positioning.
Given the likelihood of a return of significant market volatility, periods of downward pressure will continue to be associated with price overshoots and undue contagion. For investors willing to stomach lots of mark-to-market risk, these gyrations will offer an opportunity to gain exposures at attractive prices to names possessing solid economic and financial fundamentals. And during the periods of upward retracement, these same investors will have the opportunity to accumulate cash, while continuing to upgrade the quality of their holdings.
Anchored by the notion of “buy and hold,” many long-term investors will naturally resist adding a tactical component to their investment approach. But failing to do so could also cause them to risk losing sight of a larger reality that volatile markets are now signaling increasingly consistently.
The world is experiencing policy and economic realignments that undermine two notions that have served “buy and hold” investors well in the last few years: that global growth, while low, remains relatively stable; and that systemically important central banks continue to be both willing and able to repress financial volatility and boost financial asset prices.
This paradigm is coming to an end. Moreover, what may follow is far from predestined, depending in large part on whether politicians are able to bring about the much needed hand-off from excessive reliance on central banks to a broader policy response. In the meantime, we all better get ready for the return of greater financial market volatility.

Friday, February 5, 2016

Grantham: Economy Will Beat Consensus View

Fund manager Jeremy Grantham thinks cheap oil will give bigger boost to global output than many think.

February 4, 2016

Here is summary of this piece.

• The positive effects of low resource prices are underestimated. The U.S. and global economies are likely to do significantly better this year than recent opinions predict. The U.S. has plenty of spare capacity to grow above its longer-term limits. The biggest risk would be China’s GDP becoming much more disappointing.

• The U.S. and global markets do not look like they are in bubble territory. They can always suffer a regular bear market (and are almost in one now). But I still believe we will have to wait longer for the BIG ONE and that global equity markets will regroup once more.

• Currently ultra-low resource prices are not sustainable, particularly those of grains and oil. Oil producers need $65/barrel and rising to finance new oil exploration. Resource prices will inevitably rise and as they do they will reduce once again the growth rates of the global economy.

A quick look at 2015 and 2016


Looking back to last year we could simplify it by saying that the big positive was, as usual, support from the Federal Reserve and its allies, as they continued to maintain lower than market rates. You know my view: These lower rates have surprisingly little effect on the economy but a big effect on pushing up asset prices. Historically – well for 25 years anyway – the lack of reasonable values has often not impeded the Fed’s ability to push equity prices higher. Indeed, by any traditional measure we have spent over 80% of the last 25 years overpriced. The big negative in 2015, of course, was China slowing down, especially in areas requiring raw materials. This helped to broadly lower global GDP growth. Loosely speaking, the closer investments were to China – say, miners, countries supplying raw materials, and emerging markets with heavy Chinese trade – then the relatively worse they did. And the closer to the Fed, as the U.S. is, the less badly they did.

More From Jeremy Grantham

Jeremy Grantham: Watch Out for Wall St. Optimists

Jeremy Grantham: The 10 Topics That Really Matter

Jeremy Grantham: U.S. Stocks Still Have Legs

The global bear market bias of 2015 was also helped along everywhere by the plunging oil price, which caused layoffs, reductions in capital spending, and, probably more importantly for equities, increased global uncertainties both at the company financial level and the country political level.

Right behind that as a negative, particularly in the U.S., was a decline in profit margins. Finally! But the drop was from levels so far above the old trend that even after recent declines they remain handsome.

Looking at the U.S. equity market I think we might agree on how powerful the Fed is in the market equation. It approximately offset these three very large negatives: China, oil, and declining margins, which together caused disappointing global growth. But in addition, it had to neutralize the justifiable nervousness caused by increased terrorism, immigrant problems, Russia’s sharp elbows, and an apparently disheveled Europe. Not bad!


Looking to 2016, we can agree that uncertainties are above average. But I think the global economy and the U.S. in particular will do better than the bears believe it will because they appear to underestimate the slow-burning but huge positive of much-reduced resource prices in the U.S. and the availability of capacity both in labor and machinery. So even though I believe our trend line growth capability is only 1.5%, our spare capacity and lower input prices make 2.5% quite attainable for this year. And growth at this level would make a major market break unlikely. As discussed elsewhere, this situation feels at worst like an ordinary bear market lasting a few months and not like a major collapse. That, I think, will come later after the final ingredients of a major bubble fall into place.

As always, though, prudent investors should ignore historical niceties like these and invest according to GMO’s rather depressing 7-year forecast. The U.S. equity market, although not in bubble territory, is very overpriced (+50% to 60%) and the outlook for fixed income is dismal. At current asset prices no pension fund requirements can be met. Thus, we should welcome a major market break that will leave us with more reasonable investment growth potential for the longer term, but I suspect that we will have to wait patiently for such a major decline. The ability of the market to hurt eager bears some more is probably not exhausted. I still believe that, with the help of the Fed and its allies, the U.S. market will rally once again to become a fully-fledged bubble before it breaks. That is, after all, the logical outcome of a Fed policy that stimulates and overestimates some more until, finally, some strut in the complicated economic structure snaps. Good luck in 2016.

U.S. equity bubble update

On the evaluation front, the market is not quite expensive enough to deserve the bubble title. We at GMO have defined a bubble as a 2-standard-deviation event (2-sigma). We believe that all great investment bubbles reached that level and market events that fell short of 2-sigma did not feel like the real thing. (In our view, 2008 was preceded by an unprecedented U.S. housing bubble – a 3-sigma event.)

Today a 2-sigma U.S. equity market would be at or around 2300 on the S&P, requiring a rally of over 20%; even from the previous record daily high it would have required an 8% rally. The impressive bubble peaks of 1929 and 2008 also featured broad international overpricing of equities, measured at over 1-sigma, and this, too, was completely lacking this time. Emerging market equities were just ordinarily overpriced last year and full of investor concerns totally unlike normal bubble conditions. Europe and other developed markets were more overpriced but nowhere near bubble levels, and were also characterized by extreme nervousness.

On the more touchy-feely level of psychological and technical measures, the U.S. market came closer to bubble status but, still, I think, no cigar. I had pointed out two years ago that nearly all major bubbles are immediately preceded by a period when the safer blue chips outperform the riskier, higher-beta stocks on the upside. At other times this would be considered very unusual. Two years ago there was not a hint of that, but last year was a classically narrow market – i.e., led by a handful of the very largest and, on average, higher-quality companies. So the bears can claim this one, although I think with an asterisk because the market was not really going up last year and outperformance of bigger stocks in a flat market is not particularly remarkable. Also mitigating the bear argument is that this market effect was not caused by defensive buying of blue chips but, I would say, offensive buying into the spectacularly superior earnings of this small group. So, not convincing. I had also written that I did not see much chance that this market would end before records would be set for corporate deals done, encouraged by the extremely low rates and reluctance to invest in new plants and equipment. This test, I must admit, was passed with flying colors, for all deal records were broken in the second half of last year. Much more convincing.

A third less elegant but historically effective test further improves the odds of a bear market this year: the infamous January rule. Applied GMO-style, it goes that the first five trading days predict the balance of the year, especially if the average number is negative. (As does the whole month with about the same – and quite significant – statistical weight.) When the two signals oppose each other, on the other hand, we have had very normal years. Needless to say, the first five days and January were both record-ugly this year. Since 1925, a down five-day and down January have more than doubled the probability of a down market for the remaining 11 months.

So I must admit to feeling nervous for this year’s equity outlook in the U.S. But I am not entirely convinced. Sure, we can have a regular bear market. That is always the case. But the BIG ONE? I doubt it. And here is my admittedly reduced case.

The most important missing ingredient is a fully-fledged blow-off. This should come complete with crazy speculative anecdotes for your grandchildren, massive enthusiasm from individual investors, an overwrought, overcapacity economy, and, at minimum, a 2-sigma S&P 500 at 2300. Lacking all of this, I still believe it is “likely” that we will reach Election Day more or less intact. I will, though, admit to my definition of “likely” being beaten down by the negative factors listed earlier to something just over 50%. The wild card, as usual these days, is China. The market is discounting lower growth. (I believe 4% a year for the next 10 years would be a reasonable target.) But a deep entry into negative GDP numbers might ruin my relatively positive case for global growth.

To rub in how ordinary our present market negatives are compared to the impending doom bubble of 2007 when a crash seemed inevitable – like “watching a slow motion train wreck”2 – let’s compare today with 2007.

Back then the banks looked very vulnerable. Indeed, I predicted in July 2007, “at least one major bank… will fail.” This time oil debt may hurt, but our moderately strengthened banks will surely withstand this much smaller hit easily. In 2007, resource prices, historically a terrible drag on economies, were at cosmic highs – oil alone was over $150/barrel. Today they are at cosmic and unsustainable lows. So a major, major negative is this time a major positive. The U.S. housing market back then was at a 3-sigma high (never before approached) and represented a potential and realized $6 trillion writedown of perceived wealth. This time the U.S. housing market is merely moderately overpriced. Last time the economy was cranking out 1.25 million extra houses and the whole economy was running flat out. This time we are building at least 300,000 houses below normal levels and there is spare capacity in the broader economy. See our Quarterly Letters during 2007. Clearly, this current situation has no material similarity to that which impressed us as so irresistibly negative in 2007. In short, the economic outlook for the immediate future is less bad than recent commentaries would have you believe. Especially in the U.S.

Yet more on oil

So, this is the situation: The world’s most important resource, oil, which we need for practically everything but especially to drive our cars, is getting really cheap. And this is helping to drag other commodities down with it. Everything is getting cheap. It is like a tax cut for individuals that is being financed by the profits of oil companies and Saudi Arabia. Now, what’s not to like about that? Yet this is a big part of what is spreading terror in the markets. Why?

I have described before the situation that although in the long run there is an apparent balance between winners and losers, the problem is that oil companies and their suppliers take their hits up front as they reduce their exploration and development efforts projecting deep into the future. Oil-dominated countries do the same, in addition to cutting their national budgets and their foreign buying. Under this shock, economic expectations can take a hit.

The shock, I suppose, is how completely Saudi Arabia and OPEC were willing to give up any and all attempts to control price. Through 90% of oil history, if oil producers wanted to outproduce demand they could have. And it would always have buried oil prices. But mostly they restrained their competitive market share instincts in the interest of a more stable price. And very sensibly so. To summarize my previous case, I consider that Saudi Arabia, if it has been driven by commercial as opposed to political reasons, has made perhaps the biggest economic error in the history of oil. If their main motive is political, on the other hand, it better be an extremely important one for they themselves are quite likely to pay a very high political as well as financial price. An oil price change of this magnitude and speed is very destabilizing to economies, politics, and social cohesion. It makes for dangerous times and the market does not like it. The psychological response is understandable.

But excluding some major political upheaval, what are the likely economic consequences from here? The largest hits from the major oil company responses are behind us, although at $30/barrel (and maybe less) there will be some further retrenchment. And now comes the matching response from us, the consumers. Everything we buy has cheaper input costs. The major item of gasoline purchases is a steady jolt of encouragement. Heating bills are also much lower. Could there be a better financial input than this to the group that has been hurting for 30 years – the median wage earner? Not easily. Some of us argued that the impact of high resource prices in 2008 had an underappreciated major negative impact on the economy, and there certainly is a strong statistical relationship between previous upward jots in oil prices and ensuing recessions. (Actually, the number is 100%. Every major previous increase in the price of oil was followed by an economic setback. And why would this not be the case?) We argued that mainstream economists were so obsessed with bank and credit problems that they had no time to worry about resource prices. Typically they almost never do. Market opinion now, though, impressed with the early negatives that it should have expected and because the offsetting stimulus effect is delayed and weakened initially by some understandable increases in savings, is doing the opposite. It is underrating what will very likely become an important economic tailwind for the next several quarters. Reflecting current opinion (January 25), Luke Kawa, a writer for Bloomberg reviewing the oil situation claims, “One of the biggest surprises in economics has been how the world responded to a period of lower energy prices.” Well, the economic world is easily surprised.

A lot of people who worry about resources had felt that several years of much higher resource prices (from 2006 to 2014) were acting to weaken our global economy, slowly but surely, and I was one of them. I feel that this period now is a reprieve, if only temporary, from that pressure. It gives an opportunity for the global economy to regroup and start to grow a bit faster again, at least for a while.

The U.S. economy in particular, with its available labor, tucked away in the current ultra-low labor participation rate, and a moderately low industrial capacity ratio (76.5% – 3.5 points below its 1972- 2014 average), appears to be well-positioned to benefit. And, we are still an important wheel in the global machinery.

Grantham is founder of GMO, a Boston-based asset management firm.

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