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Category: Market Commentary

What’s the One Thing That Never Changes?

Last week I talked about how the implosion of the short volatility trade was likely not the start of a bear market.

However, it is a nasty reminder that stock prices do, in fact, actually go down from time to time. I think that the record lull in market volatility is over for the foreseeable future. Expect big moves in both directions as speculators react to day-to-day events.

A bear market likely needs a nudge from a major default, a bankruptcy, or a painful increase in interest rates. As far as rates go, market pundits watch every move of the Federal Reserve to try and glean what the members might be thinking about inflation and the impact it will have on the markets.

I think those pundits are looking in the wrong direction.

They should be watching the London Interbank Offered Rate, or LIBOR for short. It’s an important rate because a lot of financial instruments – as is the case with the federal funds rate – are priced off of it.

LIBOR has been rising, so much so that the chart looks a bit like bitcoin. This could be a bad omen. Worse yet, the Fed is well behind the curve.

So what’s the problem?

Well, people with heavily invested portfolios at big banks have used ultra-low interest rates to borrow against their investment holdings to fund other needs. These lines of credit can be used for virtually anything. They may have used the money to pay for day-to-day expenses. Maybe they bought a boat or built a wine cellar. It’s easy money, and it’s cheap – rather, it has been cheap, until recently.

Sound too good to be true? I’ve used one myself.

It was surprisingly easy to access capital.

I have an elderly parent with health issues that I needed to relocate for both better medical care and closer proximity to immediate family. I borrowed against my portfolio and had access to the capital almost immediately. As long as I didn’t use the money to buy stocks, I was free to tap into the line of credit as I needed. Road trip to Austin, Texas, this weekend? Hey, no problem! Want to fire up a private jet to Cabo San Lucas from Dallas? We got you covered.

I used the line of credit for what I would consider a reasonable and fair situation. Rather than get a mortgage on a second home to take care of my parent, I just use the line of credit. It was cheaper and easier, and you’re essentially offering cash for a property which gives the buyer a lot of leverage in the negotiation.

What’s more is that I paid it back in 10 months, and therein lies the rub.

People may be using these lines of credit for all sorts of reasons, with little ability to pay them back if something causes stock prices to fall. Higher interest rates create a cash flow pinch, and falling stock prices create margin calls.

What are you supposed to do in that situation? As a sailing friend of mine once told me, “You can always buy a boat, you just can’t always sell one.” The heavy use of cheap money against stock portfolios will eventually blow up in people’s faces. Markets change, the key drivers of the markets change, but human nature never changes.

In 2015, when I first started researching credit lines, the three-month LIBOR was about 25 basis points. See, the rate fluctuates, and you have to tack on the extra percentage the bank takes as well. A loan that was about 0.85% a couple of years ago is nearly 3% today.

There’s a tipping point which could lead to a massive margin call on stocks when a snafu in the market occurs and these lines are shut down. What that point is, I do not know.

All I know is that we’re getting closer by the day.

Good investing,

This post was originally published on Economy & Markets and can be seen here.

What the Heck Just Happened?

We’re only about five weeks into the year and one of my 2018 predictions is already coming true.

The thing is, it was an easy one – though it’s always nice to be proven right. I predicted that volatility would rise in 2018 after years of middling action. And rise it did. According to Ned Davis Research, the volatility index just spiked four standard deviations above average.

It’s subsided a bit, but volatility is here to stay.

Investors were reminded that, yes, sometimes stocks actually do go down, and they responded by yanking nearly $46 billion from investment funds last week.

But I don’t think this is the start of a bear market.

Don’t get me wrong, I’m still bearish. Market sentiment is still too bullish, and valuations are way too stretched. Something will have to give.

I think the recent market action is related more to folks going short on volatility rather than a market event that could take down stocks to major bear market levels.

Why do I think that?

Well, some hedge funds have made consistent returns day after day for several years betting against market volatility. It’s worked beautifully.

Those types of trades tend to work beautifully until they don’t.

Then, after years and years of gains, it’s all wiped out in a single day before breakfast gets cold. Most of the trades are done with huge amounts of leverage to amplify the otherwise small returns.

Once the trade goes the other way, margin calls come in, the trade gets unwound, and there’s a huge reversal in whatever instrument the hedge funds are trading. Then the hedge funds experience extreme pain, and I know that some banks have experienced the greatest number of margin calls in years.

This happened in 2008 when funds had been making a lot of money by shorting the Japanese yen with higher-yielding currencies. It worked great… until it didn’t.

But that also coincided with other crises as major financial institutions cratered for reasons unrelated to that trade. The short yen trade simply added fuel to the fire.

The other clue is when I look at the price action of stocks like Johnson & Johnson (NYSE: JNJ), which are defensive in nature. When they go from near 52-week highs to near 52-week lows in a matter of days, there’s something going on besides just fundamental issues. These stocks are in the major indexes, and it’s the futures contracts on those indexes that are linked to the volatility trades.

Unlike 2008, there’s no default or major bankruptcy. Interest rates are low, although they are trending higher.

I think we’ll see the real, nasty, and painful bear market once there’s a major corporate event such as the failure of someone too big to fail, a geopolitical event, or, most likely, that the interest rates used to price loans that people use to borrow against their stock portfolios simply get too expensive. Then everyone will rush for the exits at once.

While this may not be the start of a bear market, let this be a reminder that stocks actually do go down – sometimes and higher volatility can be expected in the months ahead.

Good investing,

John Del Vecchio

This post was originally published on Economy & Markets and can be seen here.

Where is the Bottom in this Nasty Decline?

Just how powerful is recency bias?

Well, the markets finally broke their record streak of days without a 5% or even a 3% pullback. Stocks rallied 40% since the presidential election, and last year the S&P 500 was up every month.

We’ve had a years’ worth of unflinchingly high indexes, which meant we had a year to convince ourselves this was the new normal. And so it’s unsurprising everyone is freaked out with a 3% decline, a fairly common occurrence in normal markets.

It really was easy to get lulled into complacency, and complacency is exactly what we have. Market sentiment indicators are at peak levels, and they have a long way to go to reflect the type of fear that marks market bottoms.

Let’s look at a few of these indictors and see where we’re at today.

First there’s the U.S. Advisors’ Sentiment Report, which has been around for decades. Last week, the level of bulls hit 66%. This represents the 16th consecutive reading where bulls clock in at over 60%, which is considered a danger zone.

That’s a constant level of over-bullishness while the market marched higher.

To put this in perspective, while the level of bulls dropped slightly from a high of 66.7% over the past couple of weeks, that high-water mark represents the highest level since April 1986! Investors are chasing the market higher and plowing their cash into equities as evidenced by record fund flows at the start of 2018.

Bears, on the other hand, are clearly still in hibernation. They sit at only 12.6%, which is also a record since April, 1986. With so many bulls and few bears, everyone is leaning in one direction. It’s the shift back to a more neutral stance that tends to hammer the markets over periods of time.

Next is the Ned Davis Crowd Sentiment Poll. Ned Davis Research is an institutional research firm with clients all over the globe. Its poll is a compilation of sentiment indicators. At 75.6, it’s well into the danger zone. And, while it backed off slightly last week, the prior high had been 75.7. That was 14 years ago!!

Lastly, we have the actions of individual investors.

Collectively, individuals are horrible at allocating capital during market extremes. The recent allocation to equities hit 71.2%. The all-time high is around 77%, right before the dot-com bubble burst and took the stock market with it.

Conversely, individual investors’ cash positions are just 13.3% now. That compares to an all-time low of around 11% in the late 1990s. Thus, for the most part, investors are fully loaded into the stock market and do not have a cash hoard from which to buy more equities if the market decline continues.

Whether this recent scare is “just” a scare or the start of something more, the stock market will eventually experience another bear market.

Given the extreme level of bullishness across advisors and individuals, the declines will probably be greater than normal. Once market sentiment shits too far into the bearish camp as equities get washed out, it could set up the buying opportunity of the decade.

Good investing,

John Del Vecchio
Editor, Hidden Profits

This post was originally published on Economy & Markets and can be seen here.

Can Ugly Stocks Soar Your Returns?

Whew! What a run!

It’s been breathtaking to see stocks rocket higher in 2018 with almost no selling pressure. It’s the hottest start in decades, investors are scrambling to catch up, and stock and bond exchange-traded funds have seen average daily inflows of $3.3 billion in the first eight days of trading in 2018.

That’s a mind-blowing amount of buying.

Individual investors aren’t the only buyers. Corporations have stepped up their buyback programs – in December, corporate buybacks hit a six-month high at nearly $100 billion. Big buybacks have been a key driver of this bull market since 2009, and at this point it’s a requirement to propel the markets higher.

But the question remains, are investors piling in too late? To say that market valuations are stretched would be an understatement. Take, for example, the median pricetosales ratio on the S&P 500. It’s at the highest level. Ever.

Back in 2009, when we were coming through the financial crisis and the market was bottoming, you could have picked up the S&P 500 for 0.8 sales. That’s a reasonable level to buy a dollar of sales for less than a buck. It also represented the cheapest level in about 17 years.

Today, you’re paying 2.63 times revenue. That’s rich. And it’s not because sales growth in the S&P 500 is rocketing to the moon. There hasn’t been a double-digit growth rate in a decade. In 2015 and 2016, revenue growth was negative. Yet the market has been in an unrelenting uptrend.

As you would expect with a market that rises nearly every day, investor sentiment has become extremely bullish. One of my favorite polls is the Ned Davis Research (NDR) Crowd Sentiment Poll because it’s a collection of various market sentiment gauges and provides a good sense of market sentiment among different investor groups.

Currently that NDR poll is at 78.9, which is not only a clear sign of extreme optimism” but also the highest level ever. As an investor, you want to act contrary to the group view on the market, so extreme optimism is a scenario where you want to act defensively with respect to your investments. Right?

Of course, none of this has mattered.

The market has also hit records of low volatility and lengths of time with no meaningful pullbacks. We’re in uncharted territory. These warning signs won’t matter until they do. While the markets change and the factors driving the markets change, human nature never changes.

Right now we’re lulled into a sense of complacency. When that changes, it’s going to get nasty.

But there is a stock out there that’s already gotten a beating and hasn’t enjoyed the huge upward trajectory that’s taken hold of pretty much everything else. In fact, my research once identified this company as one as the worst stock among the 500 largest publicly traded companies in the United States.

Thing is, when you’re at the bottom, there’s only one place to go, and that’s why I’ve selected this stock as this month’s Hidden Profits recommendation. Sometimes ugly stocks make for great investments. After getting hammered, things appear to have bottomed, and improving fundamentals will lead to big margin and cash flow benefits and the stock can trade much higher from here.

This company now has so much room to run, and so much cash flow in its future, that it’s set up to reward investors for the long haul. Wall Street is still bearish on this stock, so we have the chance to get in well before anyone else does. It’s clearing out inventory, investing in important new technologies, and it’s well on its way to doubling or even tripling operating margins.

This is a play for the back half of 2018 and beyond. Read the whole story here.

Good investing,

John Del Vecchio
Editor, Hidden Profits

This post was originally published on Economy & Markets and can be seen here.

Will 2018 Scare the Markets?

Happy New Year!

I’m starting the year off right with my six predictions for 2018. Surprise! They’re bearish. They’re my dirty half dozen, and you should think of them as risks.

If one or two of them come true, it’s probably a Nostradamus-like success. I don’t make predictions based on 100% certainty (and anyone claiming such certainty also likely has a bridge to sell you). Rather, I focus on subjects that are on my mind right now and project how they could play out in 2018.

Now, to the list!

Bitcoin Prices Will Fluctuate Between $2,000 and $60,000

Bitcoin was all the rage in 2017, especially amid its parabolic rise in the fourth quarter. It’s reached a phase of public fascination that usually indicates unrelenting price increases aren’t sustainable.

Many talking heads in the financial media have said that the introduction of Bitcoin futures legitimizes the cryptocurrency as an asset class. To that, I say phooey! (I’m trying to swear less in 2018…)

First, Wall Street will create any product that it thinks it can make money on. They’d create futures on Green Bay Packers games if there was a market for it.

Second, Bitcoin futures started out with a thud. The notional value of the contracts is miniscule relative to the market valuation of all the Bitcoin in circulation.

Third, Bitcoin futures are settled in U.S. dollars. That’s ironic, considering Bitcoin is a “currency.” If bitcoin futures were settled in Bitcoin, we could have a truly wild market!

In my mind, Bitcoin is nothing more than a vehicle for speculation. It’s not money. Just because two pizzas were bought with Bitcoin doesn’t make it a medium of exchange. Furthermore, people seem to be confusing blockchain technology (which has interesting prospects) with Bitcoin.

If the speculative fervor continues to stay white hot, I expect Bitcoin can rally much higher. If governments step in, there’s a security breach, or competition increases, the pullbacks in price will be death defying.

Volatility Will Increase Dramatically in 2018

The markets have been in a period of unprecedented low volatility. The record number of trading days without a 3% downdraft will come to an end in 2018.

But it’ll likely get much worse. Disappointing economic growth, higher interest rates, the threat of war, and increased nationalism threaten the confidence of the markets.

When the levee breaks, and the next bear market occurs, it will be worse than the last two bear markets. When the Internet Bubble popped, it was mostly technology stocks that took a beating.

Several years later, in the collapse of the housing crisis, stocks across the board got hit hard, but many rebounded well before the indexes hit their lows.

This time, everything is priced dearly.

The median price-to-sales ratio on the S&P 500 is so far outside the normal bounds that it’s unlike anything in history. These metrics scream “revert, revert!” And this mean reversion will be very painful. Unfortunately, there’ll be almost nowhere to hide to avoid that pain.

War with North Korea Is a Higher Probability Than What’s Priced by the Market

Kim Jong-un struck a conciliatory tone to start the year and seemed to offer an olive branch to the South Koreans to start dialogue. Maybe that’s in the spirit of the upcoming Olympics. That glimmer of hope will be short-lived.

The fact of the matter is that North Korea’s nuclear ambitions have not changed, and the regime is nearly singularly focused on being a credible nuclear threat. There’s plenty that could go wrong in 2018, including a failed missile test like the one the North had last year where the missile exploded in one of its own cities.

Next time, it could be a failed test where the missile comes down in another country.

The rhetoric also remains high with recent barbs about who has a bigger nuclear button. This is the world we live in, folks.

Senator Lindsey Graham of South Carolina has pegged our odds of a war with North Korea at 30%. They should be much higher, in my opinion. If the U.S. is determined for the North to not possess a credible nuclear threat, then this verbal conflict has to come to a head some other way. Time is running out, so 2018 looks to be the most probable year for this to happen.

Not a Single Job Created from Tax Cuts

Very few companies pay the statutory tax rate. Big corporations staff up to the gills with tax accountants and lawyers to figure out how not to pay taxes. A significant portion of the earnings in the S&P 500 is generated overseas, and often those profits stay overseas.

So, the tax cuts are a lot more noise than truly beneficial to the economy. I do think they’ll be beneficial to earnings somewhat, just not as much as advertised.

We’ve seen this movie before, where companies get preferential breaks to bring cash back to the U.S. And, what do they do with it? They buy back their own stock, which will happen again this time, and the next time as well.

Companies use their cash hoard to buy back stock and financially engineer their results. Not hire people. It’s been going on constantly this century and there’s no reason it will change now.

Interest Rates Go up, and the Dollar Rallies

Interest rates will continue to rise, and I don’t just mean the Federal Reserve raising rates.

In my mind, the LIBOR rate is of ultra-importance. Investors with big accounts at major banks can typically pledge their stocks and bonds to tap into a line of credit and use those borrowings to fund their lifestyle. For years, when rates were near zero (and the market was going up), this was a great trade. However, buyer beware!

LIBOR rates in U.S. Dollars are breaking out to multi-year highs and are well higher than the Federal Funds Rate. That could be very bad news for the markets. Investors have used their lines of credit for non-investing purposes. If the market were to correct and they receive a margin call, they’ll be forced to sell even more stock because the line of credit they used is either spent or in something illiquid like a boat.

You can always buy a boat, but you can’t always sell one.

This combination of rising rates and spent capital will only add to the downside pain in the market.

The dollar has taken a bit of a drubbing recently. But, with higher interest rates and greater volatility, it’ll rally sharply at some point in 2018 as a safe have asset class.

Economic Growth Disappoints

The only way we get to a 4% growth rate – like the administration keeps suggesting is possible – is with the stroke of a pen. In other words, the government just fills in the blank and like magic determines that the economy grew 4%.

There’s no way that happens on a sustainable basis. Again, tax cuts might help a little, but if you compare the annualized growth rate in working-age population in the U.S. to the annualized growth rate of productivity between the U.S. and other major developed and emerging economies, the U.S. is in a lackluster position.

As a result, high hopes for 4% economic growth will be met with disappointment.

Uncertainty is the Only Certainty

Lest we forget, last year saw record high after record high in nearly every corner of the market. Conventional wisdoms were turned on their heads or disappeared completely. Between crytopcurrency manias, Twitter brinksmanship, and an even-more-insane political climate in Washington, it’s even harder to say what’s going to happen in 2018.

Good investing,

John Del Vecchio
Editor, Hidden Profits

This post was originally published on Economy & Markets and can be seen here.

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