A Market Shift

by: George Daugharty


Monetary policy has provided a huge tailwind for equity markets over the past 10 years. Markets have generally been characterized by increased indebtedness, market passivity, upward trajectory and suppressed volatility.

As of the summer of 2018, that market as we know it is shifting.

Five reasons for this conclusion are given.

Investor caution, and perhaps even portfolio insurance, may be warranted.

Whereas before monetary accommodation provided investors with a "put", moving forward we believe that investors who deliberately and selectively position themselves with companies best positioned to capture fiscal spending will prove more successful.

Providing demonstrable and actionable investment advise is a pretty difficult task. Some market seasons can range in predictability from everything-goes-up, funny money, and buy-the-dip mania to choppy technicals and endless whipsaw.

With exceptions, the past decade has more or less been the former of the two. Over the past ten years, buying the dips and closing your eyes has been a winning strategy. Buying stocks with bullish 50- and 200-DMAs has been a winning strategy. Passive investing in general has been a winning strategy, to the point such that professional stock pickers seem more knowledgeable and talented than they really may be.

We are investors, and while it would certainly make our jobs easier if that macro-background kept on keeping on, that wish is merely hopeful thinking. They say that all good things must come to an end, and looking back on the 2018 half-year mark, it seems that maybe just maybe that turning point is now. Indeed, the inspiration for this article was all the Street’s talk of “the Great Pivot”, “the late cycle”, and “finding new playbooks”. In this article, we will 1) provide a review of past market structure, 2) give five reasons as to why a structural market shift is happening now, and 3) provide our main takeaway, the summation of which is the following:

Whereas in the past decade monetary policy has allowed for massive debt issuances, share buybacks leading to strong(er) earnings, suppressed volatility, and the proliferation of passive investments vis-a-vis exchange-traded products, the next 10 years may well be characterized by increased caution, choppy technicals, reduced monetary stimulus, increased fiscal accommodation, and perhaps even a moderate return to value investing.


Part I

It's been a good run in equities (SPY), the second longest in post-war history and not without underlying/fundamental economic improvement. The bottom three charts show S&P 500 appreciation since 2009, the length and extent of this bull market in relation to other U.S. bull markets, and lastly, solid earnings growth.

More than just a decade of more or less upward trajectory, the post-Great Recession period has been characterized by suppressed volatility and the proliferation of passive investing vis-a-vis ETFs. These two phenomena are not unrelated. The first two pictures touch on this dynamic. The first only shows data though the end of 2017, mere weeks before the February 5th short volatility blowup. This chart clearly demonstrates that 2017, in particular, witnessed unprecedentedly low vol.

The second picture shows all financial quarters in the bottom quartile and all financial quarters in the top quartile with regard to SPX volatility since 1993. As you can see, post Great Recession, only four financial quarters rank in the top quartile, yet 11 financial quarters rank in the bottom, four of which were from 2017 alone! Even more eye-catching is that after four 2017 quarters of stunning tranquility, ending in the 3rd, 7th, 5th, and 1st percentile sequentially, Q1 2018 ended in the 76th percentile!

So, in times of tranquility and indiscriminate assent, what does a wise investor do? Index cheaply, remain passive, and don’t get cute. With this remunerative breeding ground of passivity, the financial innovation known as the exchange-traded fund took off. While exchange-traded products have been an excellent simplifying and cost-cutting aid to retail and institutional investors alike, their proliferation has not been without concerns, and their meteoric rise is more emblematic of the macro environment than anything else.

So what does this mean to you, the average investor? Well, understanding the debate between active versus passive is critical to finding a winning strategy and picking tickers accordingly. This whole conversation of active versus passive, and in larger part value versus passive indexing, has been typified by Warren Buffett's famous 2007 ten-year bet, whereby he wagered a million dollars that over the next ten years an affordable index fund would outperform a collection of hedge funds. More than just a mere bet, the reasoning for and the probability of the continued dominance of passive investing is crucial to understanding the market. To shed some light on the bet, passive investing in general, and why Warren Buffett won, I refer you all to an October 2017 Mark Yusko quote taken from The Felder Report.

“One pet peeve of mine is that there is no such thing as passive management. Passive is just slow active. The S&P over the past thirty years replaced 85% of the names in the index. That’s not passive. That’s active, it's just a committee with decides every year who is in and who is out.

The other thing about these index strategies is that they are capitalization weighted; which means they are basically momentum strategies. They buy more of things when things go up. And when does momentum work? Momentum works when central banks are expanding their monetary policy and they tend to underperform when central banks are tightening their monetary policy. Well we have had a seven-year period, in fact a record period of expansionary monetary policy, so I think that it's no surprise that Warren Buffett won the bet”

So back to the reasoning for writing this article. It is my opinion that a market shift has taken place this very summer, which will be vital to our strategy and how we pick winners moving forward. There are five reasons for this belief, central bank tightening being the first and foremost.


Part II – Five Reasons

1.) Central Bank tightening and the ending of The Great Experiment. This includes both interest rate normalization - the most important number in the world - and the selling, or rather the allowed maturing, of securities held by CBs globally. The first chart shows the recent appreciation of the funds rate. After many years of ZIRP, quite literally 5,000-year record-low interest rates, Jerome Powell is powering through rate hikes, with two more penciled in for the year.

The second dynamic here, and much less talked about, is the actual slowing down of inflows from central banks on a global basis. The next two charts explain this well enough.

The conversation as to the extent to which CBs will move towards tightening and all the repercussions thereof is too lengthy and complicated for this post, but for the sake of brevity and simplicity, I think a quote from a recent May 2018 interview with the knowledgeable Jim Rickards should do the trick. I would encourage all readers to listen to the whole conversation here.

Taken from episode 190, We Study Billionaires - The Investors Podcast:

“I think things have changed very recently, obviously the stock market’s major indices peaked on January 26th... The European Central Bank, the Bank of Japan and the Bank of England, and certainly, the People's Bank of China, they are all doing Quantitative Easing in one form or another, but they are slowing the tempo a lot, the ECB in particular... They are at the very early stages of the tapper stage, they are just talking about tapering. They haven’t gone very far in that direction, but all these taken together are a form of monetary tightening, and you do have to overweight the Fed. The U.S. dollar is 60% of global reserves, 80% of payments, and close to 100% of all the oil in the world is priced in dollars. When you start tightening on the dollar, you start slowing down on the whole world - that’s a big deal...

The Fed is destroying money... When you send the Fed money, it disappears. It’s the opposite of how they create money. When they create money they buy securities, and they pay for it by crediting the bank's account with money made out of thin air. Well, the opposite is true when the securities mature - the money just disappears. They aren’t just slowing down the tempo of purchases, they are reducing M0 zero. They are destroying money, and it's important to emphasize this is unprecedented, this has never happened before. We never had Quantitative Easing, and therefore, we have never had Quantitative Tightening... I’ve seen estimates, and I think the good ones, particularly Benn Steil of the Counsel on Foreign Relations, says that the tempo of QT that we will achieve by the end of this year is equivalent to four interest rate hikes. Now look at the chatter, what are people talking about? Are they going to hike three times or four times? Three times or four times? How about seven or eight? That’s what we are looking at this year.

2.) Referenced in the quote above, and technically concerning, is the fact that the market didn't recover for nearly seven months after its top was reached in the last week of January. The market correction, however small, earlier this year was the first in nearly two years.

3.) The unending threat of tariff and protectionism rhetoric from policymakers. Again, this trend is already well covered and baked into the global equities. Even still, and contrary to commentators' original assertions that the Trump administration was simply trying to make a hand wave at campaign promises, the rhetoric has yet to die, and every month the threats are becoming larger and quite the reality.

4.) Facebook (NASDAQ:FB) and its tech counterparts’ recent one-day 20% declines. To understand the significance of FAANG with regard to the broader equity trajectory, take a quick glance at the image below to see how much FAANG mattered in 2017.

The high-flying momentum stocks such as the "FAANG" group have been an important "leg" in the stool of market ascension. Take out the leg, and well... This factor is all the more disturbing considering that this wasn't some one-off event. Major market movers are calling the recent FAANG weakness as only the beginning of more weakness. In fact, on Tuesday, July 30th, Michael Hartnett of Bank of America recommended shorting the FAANG group but pairing that with a long emerging markets (EEM) positioning. If Mr. Yusko in the aforementioned quote above is correct and index strategies simply buy more of what goes up positioning themselves with upward momentum, FB and the like could prove to be as much an anchor as anything else should the overall market head into correction.

5.) And finally, the insiders and the brains of the market are checking out of dodge, while the bronze is still at the poker table. Check out these two charts. The first chart shows the ratio of S&P insider selling to insider buying. In July 2018, for every $1 that S&P 500 insiders bought, $58 was sold - that's bearish. The second shows smart money inflows, the difference between the first 30 minutes of each trading day and the last 60 minutes. The most recent reading is extremely bearish.

Lastly, as has been very well reported, tax reform and continued cheap debt funding have catapulted the largest share buyback programs in history. This has been a crucial floor for markets in the past two quarters and the main reason why markets have limited downside in Q3 and Q4. When insiders are selling but their corporations are buying big, investors should be concerned. As Paul Tudor Jones said in a recent June interview, as monetary policy wanes and fiscal policy has already extinguished much of its politically feasible stimulus measures, the next recession will "have no stabilizers". To an extent we agree, but if history is any indicator, policymakers will stop at no end to quell any major downturns, regardless of the fiscal irresponsibility of such actions.


Part III

So, moving forward, as always, we recommend investor caution. Unlike before, we call for more scrutiny when analyzing individual companies.

In the foreseeable future, monetary policy will tighten and market choppiness will continue. In the short term, protectionist rhetoric will likely continue, although spontaneous attempts of resolution will continue to make daily one-off market pops commonplace. Furthermore, in the near term, manic dip buying is to be discouraged, and investors should especially distance themselves from the FAANG group. As encouraged by BofA’s Michael Hartnett, long positioning in emerging markets may be prudent, although much of that argument is predicated on a pause in Fed rate hikes. Lastly, for investors who do not already maintain a conservative portion of their portfolio in risk-on allocations, buying insurance may prove prudent. Very limited notional value positioning in long volatility vis-a-vis the purchase of (UVXY) out-of-the-money call options will likely expire remuneratively given the recent return of surprised volatility.

In the longer term, we will continue publishing long ideas, although select short ideas will also be considered. While many of our recent ideas have been frustrating, mainly the recent dividend hikes on Santander Consumer USA (NYSE:SC), the general partners' decision to buy out Boardwalk Pipeline Partners (NYSE:BWP) for a deep discount the day after our initial publication, and Vina Concha Y Toro’s (OTCPK:VCOYY) decision to delist its New York Stock Exchange-listed shares a mere month after our initial writing, other long ideas have remained intact.

Moving forward, in the longer term, we will be looking for smaller-cap American companies with revenue growth, first and foremost, and healthy free cash flow. Following the strategy of the famed Warren Buffett, we will look for industries of simultaneous consolidation and margin expansion. Industries with major players moving towards monopoly will prove valuable to long-term investors. Additionally, moving forward investors can count on certain governmental trends which will have a lasting impact on global capital markets. Governments will continue their path towards fiscal irresponsibility, leading to increasingly massive treasury issuances and falling bond prices. Additionally, behind-the-scenes deals and individual corporate subsidization will continue, especially in the face of protectionism and politicians’ attempts to financially support their base. Most recently, this was seen in the Trump Administration's decision to provide $12 billion in subsidies to U.S. farmers under the 1933 Commodity Credit Corporation plan. Particular industries which may prove interesting to us in Q3, and which meet these aforementioned assumptions, may include the governmental consulting, pharmaceutical, private prison, medical real estate, and/or defense industries.

In the face of uncertainly and with an ear to the ground, we will diligently continue our publications. We will continue to follow these trends and recommend accordingly. Until then, happy investing!

Disclosure: I am/we are short SC.

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.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.