Retrenchment: Can The Markets Continue To Go Up Forever? Maybe - Should You Bet That Way? I Don't Think So



High yield is in a bubble.

Sovereign bonds in Europe are in a bubble.

Are U.S. stocks in a bubble? Maybe. But this can continue for a while longer.

Hedging is very cheap. So why not do it?

Miller's Market Matrix

Clear. Focused. Timely.

March 5th, 2017


It's been quite busy over here in the Matrix. Earnings season was very interesting, as different sectors of the U.S. economy appear to be on wildly divergent paths. Retailers with stores apparently are dead in the water, while Amazon (NASDAQ:AMZN) continues to soar. Healthcare stocks are battlegrounds of believers and doomsayers, while "Trump Trade" stocks like industrials, financials, and defense seem unstoppable - at least for now. This week, I am off to a community bank conference, where I am meeting with well over a dozen management teams of banks from all over the country. I will report back with any interesting insights. These are the folks on the front lines of the economy, those that actually see what small businesses are doing. As a result, they often have good insight into the broader economy and its outlook.

So here we are about six weeks into the new Trump administration, and am I the only one that thinks that things are a little, umm, unsettled at 1600 Pennsylvania Avenue? Just wondering. I'm a news junkie and my Twitter feed is populated with reporters and politicians from both sides of the aisle and overseas. For the first time in years, they all actually seem to agree with each other. The only thing is that they all agree that there is some strange stuff happening in D.C. Whether strange is good or bad depends on your worldview and desired outcome from the retrenchment in the executive branch that is occurring. But strange is the common ground upon which everyone seems to agree. And strange isn't usually a good thing for markets in the long term.

Let's review a bit what's been happening in the world, or at least that which is relevant to financial markets. China is the middle of its annual National People's Congress meetings. It just announced it will be targeting "about" 6.5% growth in GDP this year. But will this level of growth be possible at the same time it is trying to manage a debt bubble the likes of which the world has never seen? If they slow growth and tighten financial conditions to control rampant speculation in financial and property markets, they risk a rolling series of market crashes. If they don't slow growth and do tighten financial conditions, they risk continuing to inflate these bubbles further. Can they walk this narrow path without incident? Maybe. Will they? I doubt it. We're adding a short on China to the portfolio. I think the risk-reward is favorable for a short, but it's not for the faint of heart. Check out these charts:

Elsewhere in Asia, Japan continues to struggle with an aging population and stagnant growth, although there are some signs of inflation and growth. The bigger issue will be how Japan responds to an increasingly aggressive China operating just off its shores and claiming to own the bulk of the South China Sea. Historically, Japan and China have not, how should I put this?... Oh right, liked each other very much. They don't tend to play nice. I think the period of relative peace since the end of WWII may come to an end in the next five years as Japan is becoming less pacifist and China is becoming less isolationist. These two forces could come into conflict, and I'd guess that will happen right around the time Xi decides he doesn't really need the U.S. anymore as a trading partner, or when internal dissent in China makes having an outside enemy a convenient distraction. Don't think this could happen? Then you haven't been studying your history. This almost always happens… especially when leaders start to lose control over their restless populations, which is happening to China in its western provinces. China's claims to basically all of the South China Sea are not sitting well either. See the map below. Stay tuned…

How are things in Europe? Well, Erdogan is calling the Germans Nazis for not allowing some Turkish officials to hold rallies inside Germany, Italy's economy continues to struggle while elections are coming up, France's election has devolved in a comedy of sorts, with the leading first round candidate, Le Pen, looking more and more like the only one that might not get indicted before the election. Fillon is the best they have? Wait…where have we heard that before. Throw in some Brexit hard feelings on both sides of the channel, and an ECB still operating in La La Land, and you have a combustible mix of politics, a bond bubble, and potential Black Swan events. Oh, I almost forgot - the EU decided it might be a good idea to require U.S travelers to get a visa before entering. Apparently, the U.S. hasn't rectified some issues with visa-free travel for all EU countries, so they are going to take their ball and go home. Ok…except someone should tell those geniuses in Brussels that tourism is 16% of the Eurozone GDP, and 67% of that comes from the U.S. So my quick math shows that over 10% of Eurozone GDP is directly derived from U.S. tourism. Maybe they don't know this, but over here in the U.S., we tend to be a lazy and petulant bunch when it comes to dealing with regulations and paperwork. It's already kinda a pain to take the whole family to Europe - you need to deal with different languages, currency, time zones, etc. So now if we're going to have to deal with getting visas, I'd bet a good number say aw, forget it, we'll go somewhere easier. Say it's 1/3 of travelers. That's enough to throw Europe right back into recession. Yes, sometimes politicians really are that dumb.

Countries are becoming more divided:

Elections are coming in France and Italy - think the status quo will win?

Yet…European High Yield Bonds act like Everything is Awesome!

The stock market in the U.S. appears to be on autopilot. Everyone is now fully onboard with the indexing phenomenon. Even Warren Buffett, in a bold demonstration of do what I say, not what I do, says that most investors should just buy index funds (despite the fact that he made his seed money running a hedge fund and still picks stocks for Berkshire (NYSE:BRK.B) (NYSE:BRK.A). Are there no mirrors in the Buffett household?) When everyone says that there is only one way to do something, I immediately start looking at ways to do something else. Are we at Peak Passive? I don't know, but we're getting close. Nearly $8 billion went into the S&P 500 ETF (NYSEARCA:SPY) on Wednesday alone. Over $7.9 billion has gone into the Financial ETF (NYSEARCA:XLF) since the election. According to the Wall Street Journal, over $124 billion has gone into ETFs just since the start of 2017 in the U.S. alone. And this is all happening at the same time the major market indices are hitting all-time highs nine years into a stock market rally. Am I saying stocks are going to crash tomorrow? Of course not. I don't know when it will happen. But think about this for a minute: which is more likely, that stocks go up another 10% from here without a 10% pullback (which would actually put you down 1% - that's how the math works), or that we get at least a correction, if not a real bear-market first. The market hasn't fallen by 10% for over a year, and it has only fallen by 10% or more 4 times since 2009. Historically, this happened at least once a year. Investors have gotten very used to markets only going up. At the same time, realized and implied vol is nearing all-time lows. Hedging has almost never been cheaper, yet fewer and fewer people are doing it. Being contrarian just to be difficult isn't a good strategy, but just like a year ago, I was pounding the table to get out of "safe" income stocks and to buy "dead money" banks, right now I think we are getting close to a top in the overall market. Consensus is clearly on the side of "higher forever," and being cautious has not been a good strategy in recent years, but with hedging costs low and everyone piling in at the top, I'm going to take the other side of the trade.

I'm a visual guy, so I'm putting in some charts here to illustrate the above situations. Extrapolating these trend lines forever is not recommended. We have a saying at my hedge fund: mean reversion is a pain. Invest accordingly.

Peak Passive? SPY took in over $8 billion in one day. That's not normal.

Bank Stocks have gone from uninvestable to beloved in a year. Think this keeps going up?

A year-ago everyone loved "safe" defensive stocks. Today they love cyclicals. Overdone?

Macro Funds are leaning very long. I don't mean to be mean but…their timing can be off.

Does this mean we are about to crash? No. Markets like this can keep going up.

However, almost all financial valuations are overvalued. Look at US High Yield Spreads:

However, hedging costs are very low. So why not hedge your equity exposure now?

The market is fully-valued and is priced for Trump to get what he wants. We're holding cash in case he, and the market, are disappointed. Our portfolio recommendations returned a net 1.10% with a 10% net long stock and 15% net short macro position over the past 2 months.


Miller's Market Matrix Newsletter is a free monthly financial market e-letter written by investment manager Jeffrey Miller. Mr. Miller has been quoted in financial publications including the Wall Street Journal and New York Times, and he has appeared on Fox Business News, PBS and CNBC.

Miller's Market Musings, Miller's Market Matrix and are not making an offering for any investment. It represents only the opinions of Jeffrey Miller and those that he interviews. Any views expressed are provided for informational and entertainment purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest and is not in any way a testimony for Miller's other firms. Jeffrey Miller is a Partner at Eight Bridges Capital Management and a Member of Eight Bridges Partners, LLC. Eight Bridges Capital Management, LLC is an exempt reporting advisor with the SEC. Eight Bridges Capital Management solely manages the Eight Bridges Partners, LP investment fund and does not provide any advice to individual investors in any capacity. This message is intended only for informational purposes, and does not constitute an offer for or advice about any alternative investment product. Past performance is not indicative of future performance.

Any views expressed herein are provided for informational purposes only and should not be construed in any way as an offer, an endorsement, or inducement to invest with any manager, fund, or program mentioned here or elsewhere. Any opinions about any individual stocks, commodities, or other securities expressed in this article or any linked articles or websites are solely for informational purposes only and are not an offer or inducement to buy or sell any securities. The author and/or funds he manages may hold positions in the securities mentioned and his positions may change at any time without an obligation to update this disclosure.

All material presented herein is believed to be reliable but we cannot attest to its accuracy. Opinions expressed in these reports may change without prior notice. Jeffrey Miller and/or funds he manages may or may not have investments in any securities cited above as well as economic interest.

Disclosure: I am/we are long SPY PUTS, FXI PUTS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Short many ETFs, stocks. Long as well. Balanced portfolio with hedges.