Jordan Roy-Byrn: Hello and welcome back to the Atlas Investor Podcast with Tiho Brkan. Thank you so much for tuning in today for Episode Number 11. Well, Tiho it has been an interesting past couple of days for the market since we last recorded. Bond yields have surged higher and in recent days equities finally experienced a correction that you've been warning about for weeks.
Tiho, it's great to talk to you again. What would you like to share with our listeners today?
Tiho Brkan: Thank you for having me on. I think the podcast that we released in the middle of December titled Four Reasons Why Stocks Are Risky Right Now, the timing wasn't too far off, but it would have been better if I said as much at the beginning of February, Jordan, because it would have nailed it right at the top. But it's difficult sometimes with strong momentum in markets, but I'm glad that I was able to foresee a big VIX spike and a serious selling event, which could be called a mini-crash.
So that's what we should talk about. We should cover the price action, the volatility spike, and the various assets that got hurt and even the catalyst for why this happened. So let's get into it.
Jordan Roy-Byrne: Okay, Tiho, so let's start off with U.S. equities and I know that dating back to a previous podcast, you had mentioned repeatedly that it had been a record amount of time since U.S. stocks had corrected 5%, and you said, therefore the correction is not going to be 5%, it's probably going to be 7-10%, and I think the drawdown was right in that range. Can you tell us about the drawdown and maybe a few other observations about the correction to this point?
Tiho Brkan: Yeah, well, starting in late December after Christmas and coming into the whole of January, in particular, the four weeks in January, we had like a mini-blow off in equities. We just started rising in a vertical fashion, and clearly, that wasn't sustainable. We started to get very far away from the three-month moving average where the S&P has been sitting comfortably and bouncing off every single time since the U.S. election in 2016.
And obviously coming into January, we just broke a record for a number of trading days since at least a 5% drawdown or a 5% pullback from an all-time high, which you just clearly stated. So the VIX was compressing, which was something else we'll cover in a minute. But it's clear that U.S. stocks, as well as other stock markets, which correlate very closely, were over-extended and overdue for a decent correction. So it's not unnatural to see the kind of price section that we've seen, and S&P 500 from a total return basis has lost almost 8% and emerging markets almost 10%, which is something I've been predicting since the middle of December. I just wish I was smart enough to predict it on the first of February, Jordan.
Jordan Roy-Byrn: Well, I guess your crystal ball wasn't working 100%, but I mean, hey, it was pretty good. I mean, you were warning about it. You didn't say it was going to happen to the day, but you were warning about it. That it was very likely to happen soon and, you know, we can't ask for anything more than that. But Tiho you mentioned the VIX. Let's get into that.
It had a massive intraday spike. I think it got up close to 50, but on the chart that our followers on YouTube and our followers on the AtlasInvestor.com can see shows a healthy spike up to nearly 40 on a closing basis and that is more than a two-year high.
Tiho, this spike in the VIX, just give us some observations on that, and if it can tell us anything about whether the correction is over or not or if we can expect more volatility in the near future.
Tiho Brkan: Well, I definitely think we can expect more volatility in the near future. One of the things about this VIX spike was that we were, as I was warning in previous podcasts, making a series of lower highs. And as we're compressing in the VIX, the short volatility trade became extremely overcrowded, and we've seen what's happened with that over the last few days.
I think one of the funds that was heavily short just went bankrupt. So they've gone bust. And that's not surprising because every time you see one of these "events," somebody always makes a critical mistake and goes bust. So, the old saying on Wall Street, Jordan, is when the VIX is high, it's time to buy, but not necessarily straight away. Sometimes it's perfect on the spot and sometimes it's not.
For example, when the VIX spiked in August 2011, it took until October, early October, 4th of October, actually in 2011 and I remember that precisely because I was buying stocks heavily on the day. I was writing about that on my old ShortSideofLong Blog. Basically, there was a divergence by the time that the final bottom occurred.
Looking at August 25, 2015, which all the viewers on YouTube can see right now, that marked the perfect bottom when we had a China devaluation and China's stock market crash story. And then looking at May 2010, the flash crash that we all might remember, in early May VIX spiked and stocks went down, but then over the coming months, they slowly cascaded down and re-tested their low. And on a closing basis, the low was in early July 2010. So it took several months.
So to answer your question, I definitely think that we've seen some kind of a capitulation in the short to medium term. We've had a risk event. When somebody blows up, it's usually at least a short- to medium-term bottom, but the volatility remains elevated and also we will have a back and forth action. And obviously, right now, we're having a knee-jerk rally after the initial sell-off. It remains to be seen how low we can go, whether we're going to undercut that low or whether we're just off to the races straight away, which I think is a less likely outcome. Most of these big spikes have a retest of the low.
The recent one that we're looking at here on YouTube, for the followers, is the September retest of the oldest lows. So September/October 2015 and we had a double bottom there. So I think if the VIX now retraces a little bit, we could have a second spike, which would be a lower high and stocks would actually make a lower low. I also think the stocks might want to retest their 200-day moving average, but nothing is for certain, and definitely expect higher volatility, Jordan. That means back and forth action and fighting between the bulls and the bears.
(Since this podcast was recorded earlier in the week, it goes to shows the extent of Tiho's experience. Later in the week, US equities did make a lower low, retesting the 200-day MA, while VIX re-spiked and made a lower high - just as predicted).
Jordan Roy-Byrn: Yeah, and a possible reason for that higher volatility could be the higher interest rates that we've been seeing in recent days. I mean, the last episode, I believe number 10, you were talking about the potential inflection point that the Treasury market is arriving at.
Give us an update on that. What happened with bond yields in the last week or so? And give us your thoughts on what kind of range bond yields might trade in. I know you can't get too specific because that's for your clients, but please give us just a sense of where you see the bond market going in the near term.
Tiho Brkan: Yeah, of course. Well, one of the things that we discussed in the previous podcast, one of the great charts that I had on for people following at AtlasInvestor.com, as well as people on our YouTube channel, is that since 1987 we've had a downtrend line in place. And that downtrend line has kept yields perfectly intact to make sure that they're making serious lower highs and eventually lower lows.
Every time yields hit this trendline we've had some negative things happen in markets. Usually, stock markets would peak, they would correct, and sometimes they would even crash. The 1987 crash, the Savings & Loan crisis - they crashed, then when you had the Tech Crash, we had the Eurozone Debt Crisis and the Emerging Market Crash just recently. Finally, we've had an inflection point as you said and yields have broken out, but more importantly, they're approaching a level of 3%, which I think is a horizontal support for the bond prices and a horizontal resistance for the yields in the chart that we're looking at.
So, generally speaking, I'm not surprised to see stocks react the way they have because throughout the period of the last, let's say, 15-20 years, a lot of the economic growth has come from debt and I think eventually as interest rates rise higher, that's going to put pressure on economic growth. We have a bunch of economists, market strategists, and tweets of gurus on Twitter talking about how rising yields are healthy. It's a great sign, they say. You know, it just means the economy is booming and that justifies higher interest rates.
This is fair, but what I would like to say is that growth has generally been supported and I guess inflated due to higher debt levels. For every dollar of GDP that we're achieving, we need several dollars of debt to achieve it. So it's going to be more and more difficult to service that debt as interest rates rise and now that we have broken the downtrend line, and if we break above 3% in the prolonged future, that could be a signal for finally this life cycle coming into a recession. I think we have more than doubled the debt since 2011 on a worldwide basis for governments, for corporations, and for individuals.
You can forget about a healthy de-leveraging. That's a bunch of nonsense. We've more than doubled the debt. So as interest rates rise, it's going to put more and more pressure on the shoulders of the world economy to continue to grow at the current pace.
So, yes, we have certain cyclical events in the economy where we have manufacturing moving at 60 on the PMI like we have right now. And the ISM together with business confidence, which we discussed a handful of episodes ago when I was in Germany, at record highs. And everyone's feeling optimistic for the time being. But this is just the short-term gyrations within the larger economic cycle. Once interest rates rise higher, Jordan, I think it's just going to put more and more pressure on servicing the debt. This is not really productive growth. This is more financed by debt.
So when people tell you that interest rate rises are justified because the economy is booming, just keep it in the back of your mind that you know that they don't know what the hell they're talking about.
Jordan Roy-Byrne: I'm writing that one down. Thank you.
Tiho Brkan: Definitely.
Jordan Roy-Byrne: Tiho, before we get into junk bonds, just quickly … last thing on Treasuries. We've talked about the poor technical action there, but you noted that they've become very oversold and correct me if I'm wrong, but it seems like sentiment has become extremely bearish. So, before we get into junk bonds, I should say any final comments on the potential for Treasuries to perhaps stage a relief rally here?
Tiho Brkan: Yeah, I just want to quickly touch upon the performance and the returns of the Treasury market. I've gone back 120 years to look at the current performance. There is only a handful of times where Treasuries have underperformed over the last three years and the three-year rolling compound annual growth rate is negative. That's only happened I think like three or four times in 120 years.
So Treasuries are very oversold. Also, the seven to eight-year duration, which is the IEF ETF, that drawdown of about 8% is one of the longest in history. I think 1981 was the longest and that was during Paul Volcker's tenure as we discussed in the last episode. But once you get to about 8 to 8.5 and towards 9% drawdown, that's about as bad as it got previously.
That doesn't mean it can't get worse. Especially if yields move through the 3% resistance. But bonds are definitely oversold right now, Jordan, and since the North Korean event in September 2017, yields have been just rising sharply and bond prices even on a total return basis with interest received every month - they've been declining very sharply.
So, I think over the last two years, the performance is negative. Over the last three years, the performance is negative, and starting this year, the performance is negative. Bonds are down five out of the last six months. So Treasuries are really underperforming.
Jordan Roy-Byrne: Okay, Tiho. Now let's move on and talk about junk bonds. How did they perform in recent days? I'm looking at one of your charts here and it seems like they didn't get hit that badly, but you tell me what you see.
Tiho Brkan: Well, one of the things is we just talked about Treasuries. So Treasuries are underperforming and junk bonds are doing okay. That automatically tells you the credit spreads are narrowing. It basically means investors are happier holding junk bonds than they are Treasuries. Now, generally speaking, in the investment world, while I don't agree with this, Treasuries are known as risk-free assets. I don't believe anything is risk-free.
Well, I think your mother's unconditional love is risk-free usually, but other than that nothing else is risk-free. Not even your father's love. Especially if you had a disciplinarian father. But speaking of junk bonds, they've been underperforming equities but outperforming Treasuries. So we have this conundrum where the credit spread is actually narrowing, but it's not because of amazing performance on the behalf of junk bonds. It's actually because of the large underperformance of Treasuries.
So junk bonds didn't really get hit hard during the current correction. Usually, credit spreads and the VIX can be correlated somewhat. A higher VIX correlates to higher credit spreads. However, in this case, we're not seeing any of that. So it's very interesting. Junk bonds are just kind of disinterested. They had like a 1 or 2% correction similar to the North Korean event back in September of 2016, but nothing like the China crash that we saw in 2015 and the oil bottom in 2016.
So, at the moment, credit spreads are amazing, Jordan. Investors are kind of happy sitting where they are in junk bonds. They are taking risks and they're not compensated very much to hold junk bonds or even Treasuries at this point. The credit spreads are very, very narrow. So, you know, it will be interesting to see what happens from here.
Jordan Roy-Byrne: Okay, now one more thing on credit spreads. Let's touch on emerging markets credit spreads because you sent me a chart of this and I have to really look at it closely, but it looks like those credit spreads might have increased a tiny bit, but nevertheless in the big picture, they've still barely moved and they're still extremely low, wouldn't you say?
Tiho Brkan: Yeah, I think the data is delayed by maybe one day, but I think generally speaking they didn't move much when the crash happened.
So emerging markets, it's interesting here. First of all, if you remember the initial talk that we had about S&P 500 at the start of this episode, we actually lost a three-month moving average. The emerging market ETF is holding it. So, despite the fact that the emerging market declined more, it actually also rose more.
So on a general perspective basis, relative strength basis, emerging markets are outperforming on the way up and kind of as well on the way down technically. And emerging market credit spreads are also outperforming junk bonds. So, you know, investors have really shifted towards foreign as I've been discussing all throughout last year. They've remained there. The question is, Jordan, whether this trade is a bit overcrowded now because we've had the compression of credit spreads from about 5% over the equivalent or equal maturities of Treasuries, US Treasuries, now to below 2% just recently.
So you're not really being compensated to take a large amount of risk like you were, let's say, two years ago. The yield difference, like in the spread between credit markets and the government bonds, is just not that enticing to lure me back into the trade.
Jordan Roy-Byrne: All right, Tiho. Let's move on and talk about some of the sectors or a few of the sectors that have been performing poorly amid rising rates. I hope you don't mind me telling our listeners, but I know we're going to talk about the commercial real estate, which has been a terrible performer over the last month or two and I think you've been short this and that's done very well. So tell us about that and which other sectors have been performing poorly recently.
Tiho Brkan: Yeah, well, this is alternative asset space. So we're going to look at the commercial real estate. We can also maybe discuss Utilities here, but I didn't bring this one up for those following on YouTube. And then we can also discuss Gold as well. These are some of the alternative assets away from just normal stocks and bonds.
In particular, real estate suffered a one-two Mike Tyson combo punch here. It has been underperforming already since interest rates bottomed in July 2016. The one-two punch really came initially when interest rates started to rise over the last handful of months. So, interest rate sensitive sectors of the stock market such as REITs started to decline. And then once the rest of the stock market caught up to what's happening in the bond yields - stock investors, in general, just started throwing everything out over the last couple of days, including a baby with the bathwater. Everything just went out.
So they also threw out REITs again. There was a one-two punch. First from interest rates rising. Rates were under pressure and then, generally speaking, the stock market correction. The sharp, swift mini-crash that we've had also pressured rates. So they really suffered. I think they went down as low as almost 16% on an intraday basis from peak to trough. So, you know, I think more of this is necessary for other areas of the stock market to relieve some of the valuation pressure that we discussed in I think episode Four Reasons Why Stocks Are Risky.
So a healthy correction, further healthy correction should actually occur. So that doesn't mean that it's going to, by the way, but because the momentum is so strong, but at least we're seeing it here in rates. And they've now landed on important support, which is where they were during the U.S. elections in November 2016. Just to keep that in mind, Jordan, if the S&P 500 was to go back to the U.S. elections levels, which was late 2016, I think the price on S&P 500 SPY ETF would be something like $200. And recently, it almost reached $300. So just keep that in mind.
On a relative performance basis that shows how much underperformance REITs have actually had. They are trading back where S&P 500 was in November 2016. So, very, very interesting there.
Jordan Roy-Byrne: Okay, Tiho. Now sticking with alternative assets, one asset that's widely followed, gold. In recent days it looked like it's pulling back from trendline resistance. What are your observations there?
Tiho Brkan: Yeah, well, Gold has performed decently well when you look at the so-called safe-haven assets, which were in favor around the middle of 2016. I think Market Watch published an article of me discussing to take a step back from these assets in July 2016. In particular, Treasury bonds, but I also talked about Utilities. In particular, I also discussed real estate and gold.
Now, if you look at REITs. We just discussed them. They have been continuing to underperform. We discussed Treasuries. They've also continued to underperform since July 2016, but obviously one asset class that has held its own and on a relative basis has done better than the other two is gold. Gold is back to that level of July 2016.
Yes, recently, it's falling back, but I'm wondering if this consolidation is a signal that Gold wants to go higher. It kind of still, at this moment in time, is sitting around resistance. You know, volatility is very low and especially on a relative basis. Gold has been making, I guess, a series of highs or lows in recent quarters. Especially since December of 2015.
So it remains to be seen whether Gold can push higher and also Silver. You know, it is the sidekick of Gold. The more volatile, crazy sidekick of gold. I think one brave financial analyst, Tom McClellan, I think; he describes Gold as the dog and silver as the wagging tail. So basically, Silver is more volatile. It does follow Gold. Wherever the dog goes, the tail goes as well, but it just has a bit more action to it. And Silver is also compressed in a triangle and coiling in. So both of these assets, it'll be interesting to see what's going to happen as we progress throughout the year because I think if any further correction in volatility does occur in the stock market, maybe the Fed might take the pedal off the metal a little bit.
And also inflation seems to be coming around the corner. In particular, yesterday or over the last couple of days we had a handful of interesting traders, analysts, and strategists who I respect a little more than your average investment banker on Wall Street discussing the matter. In particular, Paul Tudor Jones, a legendary trader who said that he feels that the stock market currently looks like something like 1989 in Japan. For those that don't know the history, there was a major top and he also said that it looks like similar to 1999 in the U.S.
Now, we might agree or disagree on that point, but one of the reasons he said that stocks might correct is because the Fed is behind the curve on inflation. And inflation might come out with vengeance. Now if Paul Tudor Jones is right, and we don't know - this is just his prediction, his own opinion - but if that ends up happening, I think Gold and Silver could have a healthy run-up in 2018. This would also probably mean that the U.S. dollar would have a further weakness. But this is something to discuss in upcoming episodes of podcasts, Jordan.
Jordan Roy-Byrne: Yeah, we'll definitely have to stay tuned to the action in precious metals. Now, speaking of something that's been performing really well, let's talk about emerging markets and you're a little bit concerned about the monthly winning streak there and also the monthly winning streak that the S&P 500. Tiho, people are talking about this as a big correction, but as you told me off mic, I mean, we've only had a couple of days with decline here and if the market just recovers and ends the month positive or only down a couple percent, I mean, that's really nothing on a monthly basis.
Tiho Brkan: Correct. Well, first of all, since the beginning of this podcast, I have warned that when you're an investor, you have to pay attention to both sides. It is what I call two sides of investing. Both sides of the coin. On one side you have valuations and you're a value investor. You like to buy low and sell high or you like to buy when something falls back or declines in a drawdown of some kind and the other is momentum. You have to respect momentum regardless of how expensive stocks are. They can become more expensive.
Regardless of how overstretched the market is, it can become even more overstretched so, that's something to remember. But even momentum has its limits. Nothing can keep running forever. And looking at the emerging markets, in particular here. On a monthly closing basis, we haven't had a 10% correction for 24 months, which is two years basically. And this is very rare. We've only had this occur or something similar like this occur three other times. And the two last occurrences marked major peaks, which weren't exceeded for years after. And I'm not saying that's going to happen again, but it's just something to keep in mind.
Furthermore, regarding S&P 500, officially S&P 500 is still on a monthly winning streak. Yes, February is down. Something like 3-4% and emerging markets are currently down about 6 to 6.5% on a total return basis. Markets are moving every day as we're recording this. It's hard to know the exact number, but generally speaking, S&P is still in an official winning streak of 15 months up in a row, which is a record and it hasn't happened before.
So, basically, from that aspect, if February was to close up again if we were to assume that this correction is over - we haven't really alleviated all or taken out any of the excesses that the previous rally has had. We are just going to keep pushing higher. That's possible by the way, but we're just going to have an even bigger blow off top and then the consequences might be even a sharper correction with an even bigger volatility spike. Just keep that in mind.
So, it really depends how the market participants take this correction in hand. Will they pile in because they haven't had the chance to buy over the last year or will they actually sit back and let the market retest the lows and kind of consolidate for a while? Take out some of the standard build up. It will be healthy to see emerging markets correct by 10% on a closing basis. This streak here would be taken off the radar. You know keep in mind that the S&P 500 price to sales ratio - a great measurement of valuation, in my opinion - is at 2.3. And I think it was moving towards 2.4 before this correction. And that's a record. That's higher than March 2000, which was the previous record.
So, if you have a 5% drawdown, Jordan, and we've had about a 5-6% drawdown in the United States, in Europe, Australasia, and far East and the stuff we just called EAFE MSCI index, and as well as emerging markets index as well. This is a very, very small correction right now, but that doesn't mean that it has to go further. So just keep that in mind because you have to separate yourself into two strategies. Is this going to be a long-term buy and hold as an investor? Or are you buying this as a trader hoping for the next three to six months to continue to rally?
That's what you have to strategize and there are both ways of doing things correctly. You can make money on a short-term basis to medium-term basis and you can also make money buying something like the October 2002 low or the March 2009 low or the October 2011 low. These are major buy and hold opportunities possibly for emerging markets even in January 2016 low could have been a generational entry for stock investors. So just to keep that in mind. There's a difference between a trader's mentality and an investor's mentality.
Jordan Roy-Byrne: Okay, Tiho you mentioned strategizing and so that piqued my interest. If you don't mind can you discuss how you positioned in recent weeks and recent months as we were doing these podcasts in anticipation of the market correcting?
Tiho Brkan: Well, I had a very good 2017. I also had a very good 2016, actually, and I've been very bullish. But coming into November 2017 with this streak continuing without a breather and volatility making lower lows and coiling, I became more defensive.
I think the RSI, the relative strength index, which is a basic common simple technical indicator hit a record going back 100 years. You know, we had a screaming market and basically since Trump's election went, we haven't had a down month. So coming into the handful of months before the new year, I started to protect myself, in particular in December. I started to raise a lot of cash from fixed income in credit markets as well and in particular in equities. And the cash was denominated first and foremost Swiss franc and also some in Japanese yen, too.
So I put a lot of my money and my clients' money into Swiss francs. And over the last, let's say, six to seven weeks Swiss francs have done terrific, and the Japanese yen has also done pretty well. So we were actually up. We didn't experience any volatility. We didn't make as much as everybody else who was long equities in January, but we also didn't lose as much as everybody else in the first couple of weeks of January. So we now have a larger flow of cash in hand, and we're looking at some opportunities, but as I said, it's very interesting strategy-wise what is good to buy long-term and what is good for a trade and how much cash should remain on hand in case something goes wrong.
Because keep in mind this is one of the only VIX spikes that I've seen, Jordan, above the 200-day moving average and only a handful of a percent away from the all-time high and it has not resulted in any new value when we look at the classic valuation metrics. I look at price to sales as discussed before, shareholder yield is not really rising that much, forward PEs haven't really declined that much. The net earnings revisions, where we had analysts recently ratchet up all of their earnings revisions expecting the most glorious outcome for the first couple of quarters of 2018. Those were most likely have to come down.
The best time to buy stocks is when earnings revisions are horrible when everybody is expecting things to go really bad. Just like the Eurozone banks. I think during Brexit that was the major low. I mean, every analyst was expecting a horrific outcome and guess what? That sector and those companies rallied much, much more than the simple index in Europe. Or S&P 500 for that matter.
So sentiment still remains elevated and so forth. So there are opportunities after this. We have to respect the momentum. Market momentum has been incredibly strong. And it can go on for longer. So this could just be a blip in a stronger move, and we are going to be looking at allocating some of this cash, Jordan. Obviously, clients are very happy with the way we strategized coming into this correction and for those people listening to podcasts if they would like to know more they should come to AtlasInvestor.com. Contact me and we can have a free consultation where we can discuss different strategies and portfolio creation as I work with a lot of high net worth individuals.
It's very good to be able to make gains, as long as the market is running, but then from the stand when the market is overheated be able to sidestep a correction, even if you don't catch the perfect top and the perfect bottom. It's still very nice. Then be able to come back into the market when you think it's a little bit safer and a lot of the exuberance has been cleaned up.
Jordan Roy-Byrne: Well, Tiho, great work today. I really enjoyed this update. I'm sure our listeners will as well. Please tell us where you're going and what you plan on covering in the next few episodes.
Tiho Brkan: Well, I'm on the road again. It seems like I'm always on the road every few months, actually. Or every few weeks. I'm traveling to Singapore. We're going to be meeting with a friend of mine, Mr. Jim Rogers. I will have a bit of a discussion with him and I'm also going to see a handful of friends. There's going to be a celebration for the lunar new year, the Chinese New Year and then after that, I'll go to Indonesia to Bali and I'm going to look at some things there of interest for work, as well as a little bit of relaxing because in Bali you can mix two together.
On top of that, Jordan, we will keep connected with the markets and we will track the current developments, as well as the volatility of the markets. So even if we're discussing Singapore, Indonesia, their economies and so forth, every podcast will have a few other markets and interesting things to keep in mind as I remain on the road over the coming weeks.
Jordan Roy-Byrne: Sounds good, Tiho. Well, I'm here in the rainy and cold United States. I'll just have to live vicariously through you while you're in Bali.
Tiho Brkan: Well, you know, I'll send you a postcard. Better yet, an E-postcard. I'll just take a photograph of the sunset on the beach. Hopefully, we don't get any rain. If we do get some rain, I'll just Photoshop it out.