4/9/20

First & foremost: The U.S. Federal Reserve is now the most obvious hedge fund using virtually unlimited leverage to buy anything and everything if need be. Just think about that statement for a minute. Where does it end? It will end in a banana republic, a trashed currency, and a civil war between the rich and everyone else left behind.

The stock market kissed the 2800 significant resistance level at the close so it will be very interesting to see what happens in stocks next. The Fed is buying high yield debt, municipal debt, it will be forced to buy equities next.

I’ve been investing & trading for 26 years now and consider myself a student of markets. What I saw today out of the Fed was simply amazing and riddled with moral hazard. The Fed showed us today, they are willing to do whatever it takes, I mean whatever it takes, to keep the economy from collapsing. Overall, that’s a very important and big deal but it does change the concept of capitalism from here forward.

How did we get here?

The Fed. These people control short term interest rates while the market controls long term interest rates. When rates are low and being lowered, risk taking is recommended and rewarded to a point. When you have years of free money, risk takers get complacent because their excessive risk taking consistently gets rewarded. Once you do something over and over and continue to get rewarded, you forget what you are doing has risks and could fail miserably. It’s called recency bias. I took risk, I got rewarded, it kept happening over and over therefore I don’t really need to worry about the ramifications to this imprudent behavior because it’s always rewarded. That’s classic late cycle mentality. Normally, once the end of the cycle occurs, growth slows and cash flow slows. The quality businesses that saved money and invested in their people and products tend to get through slowdowns and recessions but those with poor business models, unsustainably high debt and slowing revenue and cash flow get pinched. Some make it, some don’t. Thats the way Capitalism is supposed to work. Darwinism, survival of the fittest.

WIth Covid-19 and the government shutting down the economy, the imbalances are now present everywhere in plain site - corporations, municipal governments, states, under-funded pensions, institutions, nd individuals. Initially, the weak links were sold and shorted vs money flowing into the perceived safety assets like quality stocks, credits, bonds, etc. Travel, airline, energy stocks were down 50-80% from the peak. The Fed and the Senate have launched a few bazooka’s to try and plug the holes in the dam. So far its working albeit with the creation of wicked volatility across all assets classes.

Today, the government told us they are now operating with a Socialism for the Rich mentality. The worst part about that is: they are doing it under the cloak of saving main street. This is about the rich, who have most of the assets in this country being saved by the Fed who has always been the protector of the wealthy and elite. Power always saves power, the little guy though, is on his own.

The amount of money being sent to those that really need it is minuscule compared to the policy accommodations being used to save big companies, their bonds, assets, and the investors who are tied to them. Can you imagine the calls to the administration and the Fed asking for them to figure out how to back-stop the commercial real estate market, private equity, VC’s, etc? If the Fed was really operating under the “protect main street” mentality, why not just send each person making under 150k-200k/year $30k so they can stay afloat while the government mandated closure of the economy is in play? That money gets directly to the people that need it most but they don’t so that because this is a capitalistic society. Yet saving zombie companies who are destined to die anyway which creates an even bigger credit disaster is a no starter? Seems odd.

Here’s the data from todays Fed bazooka:

The Federal Reserve on Thursday took additional actions to provide up to $2.3 trillion in loans to support the economy. This funding will assist households and employers of all sizes and bolster the ability of state and local governments to deliver critical services during the coronavirus pandemic.

"Our country's highest priority must be to address this public health crisis, providing care for the ill and limiting the further spread of the virus," said Federal Reserve Board Chair Jerome H. Powell. "The Fed's role is to provide as much relief and stability as we can during this period of constrained economic activity, and our actions today will help ensure that the eventual recovery is as vigorous as possible."

The Federal Reserve's role is guided by its mandate from Congress to promote maximum employment and stable prices, along with its responsibilities to promote the stability of the financial system. In support of these goals, the Federal Reserve is using its full range of authorities to provide powerful support for the flow of credit in the economy.

The actions the Federal Reserve is taking today to support employers of all sizes and communities across the country will:

• Bolster the effectiveness of the Small Business Administration's Paycheck Protection Program (PPP) by supplying liquidity to participating financial institutions through term financing backed by PPP loans to small businesses. The PPP provides loans to small businesses so that they can keep their workers on the payroll. The Paycheck Protection Program Liquidity Facility (PPPLF) will extend credit to eligible financial institutions that originate PPP loans, taking the loans as collateral at face value;

• Ensure credit flows to small and mid-sized businesses with the purchase of up to $600 billion in loans through the Main Street Lending Program. The Department of the Treasury, using funding from the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) will provide $75 billion in equity to the facility;

• Increase the flow of credit to households and businesses through capital markets, by expanding the size and scope of the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF) as well as the Term Asset-Backed Securities Loan Facility (TALF). These three programs will now support up to $850 billion in credit backed by $85 billion in credit protection provided by the Treasury; and

• Help state and local governments manage cash flow stresses caused by the coronavirus pandemic by establishing a Municipal Liquidity Facility that will offer up to $500 billion in lending to states and municipalities. The Treasury will provide $35 billion of credit protection to the Federal Reserve for the Municipal Liquidity Facility using funds appropriated by the CARES Act.

The Main Street Lending Program will enhance support for small and mid-sized businesses that were in good financial standing before the crisis by offering 4-year loans to companies employing up to 10,000 workers or with revenues of less than $2.5 billion. Principal and interest payments will be deferred for one year. Eligible banks may originate new Main Street loans or use Main Street loans to increase the size of existing loans to businesses. Banks will retain a 5 percent share, selling the remaining 95 percent to the Main Street facility, which will purchase up to $600 billion of loans. Firms seeking Main Street loans must commit to make reasonable efforts to maintain payroll and retain workers. Borrowers must also follow compensation, stock repurchase, and dividend restrictions that apply to direct loan programs under the CARES Act. Firms that have taken advantage of the PPP may also take out Main Street loans.

The Federal Reserve and the Treasury recognize that businesses vary widely in their financing needs, particularly at this time, and, as the program is being finalized, will continue to seek input from lenders, borrowers, and other stakeholders to make sure the program supports the economy as effectively and efficiently as possible while also safeguarding taxpayer funds. Comments may be sent to the feedback form until April 16.

To support further credit flow to households and businesses, the Federal Reserve will broaden the range of assets that are eligible collateral for TALF. As detailed in an updated term sheet, TALF-eligible collateral will now include the triple-A rated tranches of both outstanding commercial mortgage-backed securities and newly issued collateralized loan obligations. The size of the facility will remain $100 billion, and TALF will continue to support the issuance of asset-backed securities that fund a wide range of lending, including student loans, auto loans, and credit card loans.

The Municipal Liquidity Facility will help state and local governments better manage cash flow pressures in order to continue to serve households and businesses in their communities. The facility will purchase up to $500 billion of short term notes directly from U.S. states (including the District of Columbia), U.S. counties with a population of at least two million residents, and U.S. cities with a population of at least one million residents. Eligible state-level issuers may use the proceeds to support additional counties and cities. In addition to the actions described above, the Federal Reserve will continue to closely monitor conditions in the primary and secondary markets for municipal securities and will evaluate whether additional measures are needed to support the flow of credit and liquidity to state and local governments.

All of the facilities mentioned above are established by the Federal Reserve under the authority of Section 13(3) of the Federal Reserve Act, with approval of the Treasury Secretary.

The Federal Reserve remains committed to using its full range of tools to support the flow of credit to households and businesses to counter the economic impact of the coronavirus pandemic and promote a swift recovery once the disruptions abate.

3/18/20

The selling is accelerating and I didn’t think that was possible but when you’re a part of the largest and quickest sell-off in the history of markets, anything is now possible. At the lows today the market was down 11% but managed to close down only 5%. This game is turning into a game of relative wins when -5% is the new “winning”. Trump and his cast of clowns continue to throw everything at the wall to see what sticks and the bill to actually help real people in their time of need continues to get debated. Here’s a quick summary of what we’ve seen thus far from@HayekAndKeynes on Twitter:

Trillions of stimulus...

$1.5T in Repo

$1.1T Commercial paper relief

$1T in US fiscal stimulus

$750B QE from ECB

$600B QE from the Fed

$600B bank loan guarantee (France/UK)

$500B in loans (Germany)

$300B in Japanese stimulus (proposed)

$100B in fiscal stimulus across Europe

And that doesn’t include whatever they do for the citizens in need here and abroad.

This is a very difficult problem to solve and a very large problem indeed but do something for gods sake. Frankly, I have to agree with crazy Bill Ackman at this point, just shut everything down NOW so we can contain this virus work on the financial system behind the curtain. His rant was a bit incoherent at times but he understands the short term future is very asymmetric. Do something to contain the virus and ease confidence or shit is gonna get worse and fast. The entire system seems increasingly fragile even though at the company level, the best companies will survive and eventually thrive again while taking market share in times like this.

We cannot afford to over-run our healthcare system or lose the long term confidence in stocks .

Technically speaking, we are in deep do-doo for now. I have confidence we will look back at this saga as one of the great buying opportunities of our lifetimes but for now, it’s hard to focus on the trophy when we are down 45-0 at the half.

We have been lucky in San Diego with very few cases reported. They are just preparing for the storm at this point. What’s really sad is the lack of testing that’s happening, we have 70 year old people coming to the hospital and either they don’t get tested or it takes 3+ days to get the results.

I’ll reiterate, the media is making things worse, they are having a field day with this turmoil because fear drives eyeballs and eyeballs drive ad revenue. They have a vested interest in keeping us glued to the TV. I don’t even watch anymore, thank you Amazon Prime and Netflix. Allowing this show to play out while public markets are open should be illegal. People don’t have enough stress without watching markets crash daily and seeing their long term assets shrink? The White House has never gotten control of this narrative and does not seem to have a real plan to get to the people that need help. First they are focused on liquidity and the financial system, for that we are all grateful but the mass layoffs have already started and it will likely get much worse before it gets better. There will be these short and fierce rallies along the way but the bear market and down channel continues to pay well.

For people with longer term time horizons and cash to put to work, the next 45-60 days will offer a once in a cycle opportunity to buy the some of America’s most admired companies. I haven’t seen opportunities like this in a very long time but I fear it will get worse before it gets better. This market is completely illiquid and broken for the moment. Into this weakness, I would start building bigger positions small tranche by tranche on these very scary down days. Here’s the carnage thus far YTD and on a 1 year basis. Some very good opportunities are presenting themselves, patience is a virtue.

YTD

1 Year

3/15/2020

Sunday fun-day continues. Panic is everywhere, I refuse to watch the news or media at this point because they are thriving selling ads while creating panic so they can monetize it. Not to mention spreading mis-information and adding to the confusion of this virus and the economic impact from it. At 2pm PST, Trump comes out to the podium and announces the newest Fed bazooka:

The Fed cut interest rates down to basically zero, their lowest level since 2015. The U.S. central bank also launched a massive $700 billion quantitative easing program buying Treasuries and Mortgage Backed Securities. In my opinion, they did it too early if they were trying to get a real positive market benefit. If they wanted that they should have announced it 5 minutes before tomorrows open when futures were limit down. From where I sit, the most important thing is to separate the markets and economic impact from the actual virus and health impact. This thing is spreading like wildfire simply because people in America have not changed behavior in their everyday lives. Going to a local bar with a band playing and shoulder to shoulder with 100 other people? That’s called stupid. With a 2 week incubation period, the virus has already spread exponentially. This is fine with the exception of the elderly and health-impaired. The vast majority of people getting the virus will be fine after a 2 week pain period. Here’s the upside - they will build valuable anti-bodies to fight future outbreaks. Remember, if we try and avoid all viruses, our immune systems do not continue to stay strong. I’m not going to see a band in a crowded bar but I’m absolutely not sitting inside my house for 6 weeks. I’m a healthy 51 year old and I’ve been a believer of testing my immune system for my whole life, we need to build that strength for a time when we are older and need it. This isn’t my opinion, this is the council of some of my very smart doctor friends.

It’s impossible to know if the newest global central bank bazooka’s will have any short term effect on risk assets given the bias towards panic selling but the easy money and QE all over the world will absolutely have a violent ricochet-effect once we get to peak virus out-break in 4-6 weeks. You can bet the Fed and others will keep the easy money casino open for the rest of this year so whenever we stabilize it will create quite a powder keg of animal spirits if one can look through the short term uncertainty. That’s what I will be doing. I love buying high quality assets when others panic out of them. Call me an opportunist. If you are blind-sided by poor or zero guidance when earnings season begins again in April, you aren’t really paying attention and you’re darned sure not connecting obvious dots. Buy when others are fearful, sell when others are greedy. Rinse repeat.

3/14/2020

Mr. Toads Wild Ride continues. Here’s the week in summary:

Monday: Down 7.8%

Tuesday: Up 5.2%

Wednesday: Down 5.0%

Thursday: Down 9.6%

Friday: Up 8.5%

That’s surely enough to give anyone a case of the “get me outs”.

Here’s a quick summary:

• Covid-19 has been declared a pandemic by the World Health Organization.

• Stock markets all over the world have crashed >20% & are basically 1-sided (buy or sell) and illiquid. In my opinion, that’s now become a national security risk. Shut them down for a month. Shut down the markets til the tests are widespread, let the cases spike as we expect and when we see the peak, open the markets in an orderly fashion. There’s a lot of moving parts but this is now becoming a corporate solvency issue. Should we allow bear-raids to destroy businesses simply for profit?

• Social distancing is now a widely uttered phrase. - Truth be told, I’ve been playing my own game of social distancing for decades, I call it being socially awkward.

• The oil markets have crashed with a wonderful and well timed price war to drive American Shale companies out of business. On Friday Trump announced we are buying for the Strategic Petroleum Reserve, very smart in my opinion.

• Small businesses, schools, charities, sporting events are all closing, suspending events, and seasons.

• There will be major, I mean major profit dislocations across the board but we know a nation of consumers have spending in their DNA so we will spend on what we need now and defer spending on what we want later. The pent up demand will build a wild powder keg to be unleashed later this year. The government will need to provide $trillions in bridge loans to help companies and employees bridge the gap in work/salary flows.

• And hear’s the kicker, people can’t even get tested because the most modern health system in the world doesn’t have the test kits yet. That’s truly embarrassing.

• The panic at the grocery stores and Costco accelerated Friday as school closing became a reality. Trader Joes in San Diego was 25 deep and shelves were empty by 5pm.

3/12/2020 - CRASH CONTINUES

The market crash continues as more and more businesses deploy “work and stay at home” mandates. This is getting real for consumers, their businesses and the economy but the upside to this massive momentum towards social-distancing is keeping the virus from spreading like a wild-fire. A virus contained with a white house credible plan, particularly when working with actual experts versus governmental bureaucrats, wildly bullish things can happen. Alas, a guy can dream!

The NBA has suspended the season for the time being. MLB is cancelling spring training plans for now. The NHL suspends the season for the time being. March madness cancelled. Most corporations >1000 employees have mandated a work at home strategy. While I think the sporting events is excessive, I’m sure it helps the chances of things calming sooner vs later. Why not test all the players, coaches and staff and televise the tournament? The entire country would be watching and it would be an ad bonanza. That’s too logical. The lawyers have taken over now, common sense is now off the table.

As I write this, the market is down 2000 points or 8% after a 25% drawdown from the highs just a few weeks ago. The Fed has fired the first liquidity bazooka.

• The Fed announced a bold new initiative in an effort to calm market tumult amid the coronavirus meltdown.

• In all, the new moves pump in up to $1.5 trillion into the financial system in an effort to combat potential freezes brought on by the coronavirus.

This was the second day in a row and the third time this week the Fed has stepped in. Here’s some comments from Tony Dwyer and an economist talking about today’s Fed actions:

What the Fed just announced according to my friend Chris Low – the economist from FHN Financial:

1.    Today, the Fed will offer $500bn in 3-mo repo. This will add badly needed cash to the SOFR market, helping calm a growing hotspot.

2.    Where before they were investing principle roll-off across all maturities and limiting new purchases to T-bills (New purchases = the $60bn/mo program intended to rebuild the balance sheet so that there are adequate reserves for bank liquidity needs), they will now reinvest both principle roll-off AND the $60bn across all maturities. Is it QE? Well, the balance sheet is growing, and it’s not going into bills alone anymore. But the purpose is not to drive yields lower.

3.    The intention of 1 and 2, above, is:

1.    Calm the stock market.

2.    Calm the repo market.

3.    Because the open market desk decides which Treasuries it will buy, the Fed can soak up more off-the-run Treasuries, which are trading wide to on-the-runs as people sell to raise cash. Our Treasury traders note off-the-run bid-ask spreads have widened as the remarkable volatility of recent days has reduced liquidity.

4.    The Fed will no longer be sucking a ton of supply out of the bill market, which will be a relief to others eager to buy.

According to Chris, this is not really QE4, though people will say the FOMC just turned its balance sheet growth program into QE, which is true. But really, it is much needed repo liquidity and a technical tweak that will help less liquid corners of the market clear in a more orderly fashion.

Honestly, I am trying to get my arms around the announcement but it remains clear the pandemic is creating an environment of fear that is difficult to overcome…Human nature has a way of pulling that fear forward in the financial markets and is clearly do it with the current panic.

Now we need the politicians to fire the next monetary bazooka which targets the distress from low income people and hourly employees who live paycheck to paycheck and need short term assistance. Unemployment claims need to be extended, and corporate interest free loans for affected businesses. The small business administration just announced loans for companies and charities affected.

How much of this has been reflected in stock prices? Honestly, it’s impossible to know because there really isn’t a comparison for this disaster. Moving averages are now impossible to rely on because this is just a “sell it all, I can’t take it anymore” emotional response. Yes, the panic indicators have all been reached which historically have meant a short term bottom in here. Honestly though, the news flow will get worse before it gets better so I now expect the indexes to make new lows but am watching for the most attractive, most healthy stocks to bottom before the indexes do. I also expect the worst stocks to bottom before the indexes. Things like airlines, concert promoters, theme park operators, cruise lines, etc. The travel stocks stabilizing should be a very good indicator. We are in full capitulation mode but without some fiscal stabilization AND virus stabilization, things will stay wildly volatile each day in markets.

I’m supremely focused on adding to the most relevant brands serving consumers because they will not stop spending for long, it’s in our DNA. Here’s Tony Dwyer’s panic metrics and their current readings. In a word: PANIC.

3/10/2020 Notes

Well, today was not a fun day in equity markets. Today was one of those days where every possible uncertainty was weighing on the minds of investors, here and abroad. I’ve seen some serious drawdowns over my career but the current move’s swiftness has truly been historic. Am I the only person that thinks it’s ironic we had this historic drawdown day on the 11th anniversary of the March 9, 2009 bottom around 670 on SPY?

I’ll get right to the question everyone has on their mind: Is the cycle over and the recession here?

Answer: I don’t think so but I cannot be stubborn.

History says the markets often go through periods of turmoil and big corrections happen and are to be expected. The real test of a bull market correction and the beginning of a bear market and recessionary drawdown tend to come from breaks of the long term uptrend. The real madness tends to begin once the break occurs on a monthly basis. Why monthly? Because anything can happen on a daily or weekly basis but when we see a slower time frame start to breakdown, we have to accept there could be even more pain coming and stepping aside to some degree may be prudent. We are trading around the long term uptrend line so how we close this month will help me decide what kind of market we could be in for the rest of this year and next. Please understand though, this virus will run its course sometime over the next 3-6 months and commerce will snap-back the way it always does so we could see continued selling for a few more months followed by a realization this is a shallow recession and one that likely snaps back quicker than most.

Yes, sentiment was extreme to the bullish side, there’s no disputing it and I have written and talked about it a number of times in blogs, Bloomberg interviews, etc. Here’s some trader/investor psychology:

• Market sentiment is über-bullish and we don’t think we can lose money.

• The market pulls back and dip buyers add more exposure and get rewarded.

• The “buy the dips” mentality keeps getting reinforced with strong returns.

• That breeds complacency & excess risk taking aka using margin, buying speculative call options, etc. An extreme amount of complacency is a very dangerous thing when it goes on for a period of time.

• Proof of complacency: The number of option call buyers was at extreme levels a month ago. Let’s just assume, those people lost 100% of their money. I’m guessing they are no longer complacent.

• The market falls, dip buyers grab some stocks but they keep falling, now people are trapped. That creates overhead resistance. There is a massive amount of holders at much higher levels just hoping they get closer to break even which keeps the upside capped for a while. For now we just need some stabilization to help calm fears.

• Not being rewarded for multiple tries now puts investors back on their heels, that’s a healthier situation. People are absolutely on their heels right now.

• Now we have investors and traders in “short rallies” mode and “don’t buy dips yet” mode. We are very close to being as extreme bearish as we were extreme bullish just a little over a month ago.

Why did markets crash today? UNCERTAINTY

• 10 Year Treasury under .50% - that’s scary

• Should we even leave our houses at this point? The media is scaring people to death.

• Stock markets hit the -7% halt circuit breakers this morning. That will make for scary headlines for investors when they watch the highly news and talk to their friends.

• Crude oil collapsed ~30% and is off 47% from the highs to about $30 a barrel. American Shale producers are mostly profitable above $50/barrel. Russia has clearly decided they are willing to flood the market with oil to drive prices down in the hopes of putting American companies out of business. Saudi Arabia is no help to us as they lower prices to become the low price player around the world.

• Crude oil crashing is also a sign of recession as economic activity slows.

• Energy stocks absolutely destroyed. The XOP ETF, oil and exploration basket is now down -89% from the highs. The market is now pricing in a massive wave of bankruptcies. I have to believe, some of the most high quality energy companies with the strongest balance sheets are feeling this pain but licking their chops for buying assets at pennies on the dollar. There will be an enormous opportunity in energy stocks and energy bonds at some point .

• I have confidence we will see some significant commodity-focused hedge funds and macro funds blowing up, one of the causes for this persistent selling. There’s clear full liquidations happening at this point.

• Corona Virus-19 continues to get worse, more cases are being discovered each day. We will continue to see more cases as the number of tests accelerate. Italy has now announced a full-country quarantine to try and get a handle of the spreading.

• Earnings recession - very few companies will come of our this slowdown unscathed but at this point we need to ascertain how much is already built into prices. Thus far, there’s only been small guide downs and if things accelerate to the downside, there will be further guide downs. The current market is clearly deciding these reduced earnings will continue and likely get even deeper in the red. If consumers live up to their reputation and do not stop spending as the market suggests, there will be a breathtaking rally once the recognition happens. We start to see earnings in mid April.

• Interest rates - most rates are now close to zero. There’s clear panic in the air and a scramble for no yield bonds strictly for the total return potential and perceived safety. Just remember, when people just talk about bonds and making money versus offering yield, we will be ever closer to the bottom in rates.

• Credit crisis - because of low rates created by the Fed, corporation have lathered up in debt and instituted massive and consistent stock buybacks. That’s great until the economy slows, cash flows slow and the company has to pay debt from weakening cash flows. So far, all credit spreads have widened(bad) and the most heavily indebted stocks are under the most pressure. This is a time to own the most high quality balance sheets you can. When the market over-reacts, they will shoot first and ask questions later on stocks that have poor quality balance sheets. Even the LQD ETF, investment grade bond ETF was down -2.4% today. So there’s clear risk that investment grade companies get downgraded and many companies see their debt rating lowered in general. Remember, when fear and crisis happens, the credit markets freeze up and access to capital becomes difficult. If you need to come to the debt markets and they are not open for business, your stock and bonds fall precipitously and shorts get aggressive.

My Problem Here:

I’m a huge believer in buying the defensive stocks in times of slowdown. It’s worked well for the last month even if these companies are still down less than the growth stocks. Here’s my problem: Many of these companies are highly sensitive to rates, called bond proxies so how does one get excited about a bond proxy with rates almost at ZERO?

Here’s my other problem: Most defensives, while being the beneficiary of money flows, are very expensive and have very poor growth profiles. Yes, expensive can get more expensive, particularly when buyers expect a major economic slowdown coming but buying a no growth, expensive stock with an average to poor quality balance sheet just because it has a decent dividend at a period of time when rates have gone straight down is a tough call to make. At some point, fears will abate and growth will trough and when that happens interest rates will rip right back to the drop off level around 1.5% and I doubt bond proxies will perform very well.

What am I focused on and buying/holding now?

With very few exceptions, it’s the quality factor that’s driving the portfolio. I’m focused on the innovators of key industries and consumer themes. I’m focused on quality balance sheets, revenue growth opportunities, strong cash flow generators, and solid capital allocators. Slowdowns hurt most companies but the best companies take advantage of slowdowns to take market share, make strategic acquisitions, and add to their competitive moats. It doesn’t mean the stocks won’t go down when the dominant trend is lower but it does mean they have sustainability and will likely come out of the slowdown even stronger. That’s my focus for now.

March 6, 2020

History does not repeat but it does rhyme.

I want to get this thought to you right up front: Rates are capitulating, this is historic.

In 1981, the year U.S. interest rates finally peaked in September, the 30YR bond yield peaked at roughly 15.25%. From June 1980 to September 1981, the yield rose about 60% from 9.25% to 15.25% roughly. That’s what upside capitulation looks like.

From today’s close at a historically low 1.2% yield going back to November 2, 2018, the former peak before the current drop-off, yields fell around 64%. That’s about the same time period as the rate peak in 1981 and about the same drop vs the rip in yields in 1981. Anything can happen in today’s marketplace but the symmetry is quite amazing. Everything I see, read and hear screams there’s a capitulation in yields afoot. Time will tell. Here’s the image of rates in 1980-1981

I know there is a lot of fear out there and it’s bleeding into the credit markets, particularly through the energy sector given Russia’s decision not to cut oil production to keep energy prices stable because they would like to put American shale producers out of business but just remember, money flows where opportunities live and with rates now so low, high quality equities with nice yields and strong balance sheets offer much more potential return if you widen the lense a bit and look through today’s VOL. Here’s a great tweet from a very smart guy, Larry McDonald regarding the full capitulation in yields looking back 12 years.

Now we have High Yield Credit breaking out. So we have a macro event here for now: VOL across interest rates, equities, credit, commodities all blowing out, it makes for a wild ride short term but offers wildly attractive opportunities for managers willing to pick through the rubble. Next up: Investment grade credit will catch this cough so there’s definitely a part of peoples fixed income “safe allocation” that wont feel very safe. I’ve posted 2 charts below: First is Pimco Income (lets use this for a proxy for the “risky” part of credit along with the HY ETF’s HYG/JNK and LQD, the investment grade credit ETF. Which one is right? Then I have posted the High Yield Index chart from Bloomberg, you can see credit is widening aka there’s concern out there, particularly in energy credit.

I’ve been writing about markets for decades and now it’s time to have my random musings archived forever in one place. None of this is advice but simply my observations on what’s happening in the world and markets. Everyone who invests or trades should keep one of these journals so they can refer back to times of euphoria and panic and every emotion in between. I hope you enjoy these musings and gain benefit from my observations.

3/6/2020

First the bull case:

Interest rates are lower, that’s stimulative generally. Refi’s are on fire, that’s stimulative for those who reduce their mortgage payments. Gas is cheaper, that’s stimulative. With the consumer re-trenching, many companies will reduce prices to stimulate traffic and demand, that has a positive effect on future sales and inventory replenishment. If the virus proves to be less catastrophic as the market believes and it’s effect on business is also less dramatic, the market, rates and consumer spending will rip back in the second half of 2020. No one is focused on that now but do not forget it is a strong possibility.

With the VIX around $48 again, there’s clear panic in the air and every single minute of media air time is devoted to the virus and more outbreaks. Normally I would say this causes panic and is not helpful but in this case, I like the constant focus on the virus because it’s now changing peoples behavior. With a virus outbreak, complacency can be disastrous. Corporations are cancelling conferences, implementing travel bans for non-essential meetings, concerts are being cancelled, schools closed etc. Yes, this has an impact on consumer spending, we know that drives GDP so everyone should expect a hit to growth but the upside to this is the potential for the contagion to be less than the market expects. People do not stop spending for very long, nothing is more predictable than a consumers propensity to spend. We know commerce will re-accelerate at some point, the trick is to identify the companies that have lost revenue that’s just deferred versus what will never come back. That’s certainly been my focus.

We know from history, the market hates uncertainty (we have plenty), acts swiftly to re-price risk assets for a potential likely outcome (happening now) and more often than not, over-reacts to the downside before the realization that things got too extreme (still to come). For now, there is a committed-buyers strike, risk continues to be taken down and defensives are mostly just offering relative performance versus absolute performance (most defensive stocks are hella expensive with no growth prospects). The real returns are coming from bonds and treasuries and gold to some degree, which are the beneficiary of global flows. Just consider the amount of money from around the world flooding into the world’s largest and most liquid sovereign bond market, the USA. The scramble to buy all the Treasuries one can accumulate is breathtaking at this point. Make no mistake, long bonds are a great place to be in a panic, this has rarely been a bad trade but with rates as close to zero as they have ever been in history, the risk of holding these bonds becomes an asymmetric risk for complacent holders. This is a panic out of risk and into perceived safety. When the panic subsides and it always does, the money flowing out of safety assets will be just as fierce. Where will it go? It will go into stocks. So the bond market is 3x larger than the stock market in size and there’s a massive panic into the big market and hurting the smaller market disproportionately. When rational behavior arrives, this same wall of money will overwhelm the equity markets and the rip higher in risky assets will be equally as breathtaking. This is not an opinion, it is just logic and truth. If you need proof, just look back in history at what happens to Treasuries, VOL and stocks when the panic subsides.

THE WHEN is always the hard part but the outcome is highly certain.

Over the last month, we have seen historic daily wings in the market, +1100 on the Dow and -1200, sometimes the 1000 point swings happen in the same day. This tells you how illiquid the market is and how 1-sided the order flow is. When panic occurs, buyers go dark and sellers of all kinds can have their way with markets. Algo’s trade on very short term momentum signals so when there’s fierce momentum in 1 direction, the momentum tends to feed on itself and becomes self-reinforcing.

What we know:

• The number of Americans testing positive for the virus will go up as more tests are available.

• Earnings for most companies will be negatively impacted for 1-3 quarters, starting in April.

• Corporate guide downs will continue and many companies will use the opportunity to ditch 2020 guidance all together. A very smart thing, just kitchen sink it and re-set the bar to places that will be tip-toed over at some point. Now is the chance corporate America.

• Hurricanes do not last for long periods of time. The current state of fear is not sustainable but it can certainly accelerate from here for a while. Most importantly, we should all expect the high vol environment to be here for a few more months at least. It’s great for traders and dreadful for investors. This too shall pass.

• Global central bankers and politicians will throw more stimulus at the problem whether it helps or not. They are a hammer looking for a nail, it never changes. The next round of attempts by government are likely around tax relief and economic relief for the industries most affected and the citizens most affected. The worlds brains are quickly working on the virus as we speak.

• For most people, getting the virus will not be catastrophic. The statistics clearly show the people most susceptible to severe complications or death are older adults and those already with compromised immune systems. Take precautions, stay away from crowded places for a while and all is likely to be well.

• Bonds, Treasuries in particular will get to a point where the intelligent, opportunistic holder will finally decide they have squeezed enough juice from the fruit and they will move on. What scares me now: Advisors manage balanced portfolio’s and the bond allocation has been a wonderful allocation, in the not too distant future, that allocation, if not rebalanced will offer significant angst on its own and just after the equity angst people have just experienced. That’s quite a 1-2 punch. Be nimble everyone. The time to sell your most favorite asset is when you covet it the most. Just like in 1981 when rates peaked in a vertical assault, they will trough in a straight down move that looks alot like what we see now. When the fear and economic data downturn terminates, rates will rocket back in the mother of all mean reversion trades. For now, that’s the key to an equity stabilization and more sustainable rally versus the 1-day wonder-rallies we have seen thus far.

• Stock prices and interest rates could bottom together and it will be BEFORE the economic data hit a trough. So if you’re using the data to judge when to buy risk assets, you will likely miss the bottom by a month or two. Nothing wrong with that but just remember what TLT (20 year Treasury ETF) did when it peaked around 12/31/2008. The 20 year treasury lost holders 26% from year end 2008 to mid June 2009. 6 months and -26%. That kind of move is coming again. So rates peaked 3 months before the equity market trough in the financial crisis. Lets see how it plays out this time. Below I have a picture of the TLT in 2008/2009.

Everyone seems to want to know “where will the market bottom”. Reading between the lines, what they are asking is “when will my pain end”. I would love to say I have a crystal ball but I do not. No one knows at what level equities will find a bottom, for now I believe it’s likely lower. Here’s a wild card: If you are a dedicated bear and short-seller, congrats first. The Fed put you on notice, central banks all over the world will continue to throw whatever ammunition they dream up to try and calm markets. Are they doing the right thing? Honestly I do not care. We all know a fed rate cut will not help the virus spread less but it will begin to calm peoples nerves about a credit event and the seizing up of markets and the banking system. What will have more luck changing sentiment imo is fiscal fuel. Tax cuts, back-stopping of important industries suffering from the economic slowdown, etc. If I were a short, this would be my strategy:

• Short big rallies so long as there was no upgrading of the virus, Fed back-stopping, or economic data that was as bad as it will get, let’s use a sub-40 reading on the ISM as a gauge.

• Cover shorts on massive -1000 point drops or at least don’t be blindly short for days on ed knowing at any time you can get a new liquidity bazooka announcement that rips your face off without warning. It doesn’t matter of the bazooka works on the economy, for a short period of time, your short will feel dreadful, why take that risk after making so much money?

• Tactically day-trade long on big -1000 days but don’t hold overnight unless there’s clear evidence of massive downside capitulation.

• Wait for that full wash-out in equities where everyone has soiled their jeans and flip short to long and go on vacation for the rest of the week, don’t even look, you will just sell too early.

Rinse repeat

Washout status: NOT THERE YET

Below is the chart of the S&P 500 and the number of stocks trading above the 20DMA. Full wash-outs happen when we get under 1% of stocks trading over their short term moving averages. We got the .79 reading last Friday so we expected a big bounce. We tactically bought XLK and traded it in a day for 5% gain. There will be more trades like that. Remember, the most robust rallies happen almost exclusively in bear market cycles. The more of these wild swings we see, the more evidence we are in a bear market for the time being.

Choose your spots, wash-outs are usually good ones that offer high probability gains in very short periods of time.